A merger’s in the air

With time and patience”, promises the Chinese proverb, “the mulberry leaf becomes a silk gown.”

China Eastern’s intrepid shareholders will be hoping that perseverance will pay similar dividends on their own investment, although sometimes a mulberry leaf is destined to remain one.

But not for want of trying by government planners, with news this week that China Eastern executives have begun a 20-day review with local rival Shanghai Airlines on how best to establish a merged entity.

The proposed deal is the latest headline-grabbing moment for China Eastern, the country’s third largest carrier.

The airline’s most recent travails began two years ago, with the failed $923 million bid from Singapore Airlines, in conjunction with its parent Temasek Holdings, for a 24% stake.

Next up was a woeful set of financial results for 2008, followed by a management overhaul and an Rmb7 billion ($1.02 billion) bailout at the beginning of this year.

A further Rmb2 billion of emergency support was made available in May. Now there is the news of the takeover of a local competitor. It looks likely to go through too, probably accompanied by another slug of government cash. So is China Eastern finally about to get its house in order?

China Eastern: victim or villain?

Last year was a poor one for all of the Chinese carriers. Revenues were undercut by capacity expansion, the Sichuan earthquake, poorer than expected sales during the Olympics and a slowdown in premium travel as a result of the financial crisis. China Eastern bosses were also still miffed (understandably) at Air China’s unexpected blocking of the Singapore deal the year before. They had hoped the transaction would bring in additional cash, management expertise and (most importantly) flight connectivity into Shanghai from the Singapore carrier.

But others – looking at the $2.04 billion annual loss – point the finger at problems of the airline’s own making. They blame a misjudged fuel hedging policy, weak leadership and a poor underlying product offering.

The carrier has continued to run up operating losses this year (another Rmb692 million for the first quarter of 2009, according to HSBC).

In fact, the latest HSBC research has problems with valuing the airline in earnings or asset-based terms. The share price now reflects less the fundamentals (which are dreadful) and more the news flow on potential government support, the value of route rights and airport slots, and the ongoing rumours of industry restructuring.

So how about the news flow on the Shanghai Airlines tie-up?

A few optimists are still ready to talk about the benefits of scale across the combined entity.

The new airline will leapfrog China Southern to second place in numbers of aircraft, for instance. The combination of the two carriers’ market shares in Shanghai will also exceed 50%, which is thought to be significant as Shanghai is expected to overtake Beijing in passenger volumes within five years.

Merging the two competitors could (perhaps) allow the new entity to raise fares. Pricing power needs to be improved as China Eastern’s yields (average fares per passenger) have been falling faster than costs.

But the doubters wonder how combining two loss-making operators (Shanghai Airlines lost a reported Rmb1.25 billion last year) is going to create a profitable one.

The Chengdu Business News thinks that many of the two airlines’ routes are structurally unprofitable, for example.

Others ask where the cost savings will come from. China Eastern spokesmen are already saying that there will be no job losses. And with both airlines flying different aircraft types, lower servicing costs and related synergies will be harder to achieve.

Even the hoped-for Shanghai hub dominance comes with a caveat. The local government seems determined to maintain a dual airport strategy (Pudong and the older Hongqiao) and it will be difficult to achieve full cost savings without a single base of operation.

So why go ahead?

It’s best to think of the deal as an old style marriage made by the parents, says website Phoenix Financial Net.

The matchmakers are two different layers of government; SASAC (the central government’s State- Owned Assets Supervision Administration Commission) and the local city government (which holds a stake in Shanghai Airlines).

Previously, Shanghai authorities have resisted efforts to combine the two carriers, although some of their concerns may have been allayed by assurances that Shanghai Airlines will retain its independent brand – and keep the ‘Shanghai’ in the name. More likely SASAC insisted on a deal as part of the Rmb1 billion in emergency cash it injected into Shanghai Airlines in May.

Both parties may also have grown frustrated by the city’s failure to nurture a leading airline, especially when Shanghai seems to be anointed on an almost weekly basis as a future global leader in something or other. A world class city needs a world class airline.

Shanghai’s airlines should be doing better, as they serve China’s most industrious city and its affluent Yangtze River Delta hinterland. This should add up to more international traffic, more premium passengers, a higher yield business, and more cargo revenue.

How does this all fit into the bigger picture?

It’s part of the jostling for position within the Chinese aviation landscape.

By signing-off on the deal, SASAC seems to be saying that – for the time being – there will be no further consolidation among the so-called Big Three of Air China, China Southern and China Eastern.

Just as China Southern enjoys a market share lead at is own base in Guangzhou, and Air China in Beijing, so China Eastern now seems to have been given a leg up in Shanghai.

That’s disappointing news for Air China, which probably has greatest claim to emerge as a single Chinese “super-carrier”. The plan, which could help it wrestle business away from international competitors, may have involved hopes of absorbing China Eastern.

Instead, for the foreseeable future at least, it looks like China will stick by its Big Three strategy.

This mirrors the industry structure in China’s telecoms and oil businesses, where a troika of major players also dominates.

So the future remains murky, especially for the Shanghai carriers?

Perhaps we shouldn’t be too critical: the aviation industry is in a mess in most countries at the moment. And there are aspects of China’s airline scene that deserve a more positive spin. Safety standards have been revamped. Investment has been ploughed into airports and their associated infrastructure. The Chinese aviation regulator (the CAAC) opened up its skies to foreign carriers in 2004 (a factor in China Eastern’s struggle to win more business on key international routes).

As a result, passenger traffic was growing at 14% annually until recently, three times the global average. Despite this demand (and maybe because of challenges in scale and complexity that it creates)

China’s airlines have struggled to cash-in.

Perhaps they will be more successful in future. There are rumours too that the Singaporeans may be sniffing around China Eastern again. For the moment, however, they will have to wait.

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