Slow Takeoff for Merger of Indebted Airlines

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A long-anticipated merger between China Eastern Airlines Corp. (SHSE: 600115; HKSE: 0670; NYSE: CEA) and smaller local rival Shanghai Airlines Co. (SHSE: 600591) is taking shape and could revive the weak, debt-laden carriers.

Each airline has reported losses for the past two years, prompting the Shanghai exchange to slap a "special treatment" label on their shares and limit daily trading movements to 5 percent. In addition, the Shanghai bourse has warned each airline to improve its financial performance or face a possible delisting.

On the bright side, the merger would create China's second largest air carrier, surpassing China Southern in rank to land just behind industry leader Air China, based on total assets reported at the end of last year.

The pending deal also marked a long-awaited victory for the Shanghai government, which controls Shanghai Airlines and agreed to the takeover by state-owned Chinese Eastern as part of its broader ambition to create an international aviation hub through the city's two airports.

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As part of the government-arranged deal, Shanghai Airlines would become a wholly owned unit of China Eastern through a share swap, people close to the transaction told Caijing.

The companies are now working out details to raise capital, rearrange flights and routes, and boost the efficiency of Shanghai's airports for international travelers. There's also talk about bringing in additional investors such as Singapore Airlines, whose bid for a China Eastern stake failed last year, and possible government aid on top of recent bailouts.

For starters, China Eastern said June 8 the airline and its parent China Eastern Air Holding Co. are "in the course of planning matters in connection with a material restructuring" of the listed company and looking at proposals for lowering its debt ratio. China International Capital Corp. Ltd. is advising China Eastern.

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Two-step Approach

The deal was near June 8 when the Shanghai exchange suspended trading of China Eastern and Shanghai Airlines shares pending an "important" announcement. That night, China Eastern Chairman Liu Shaoyong left an aviation conference in Malaysia ahead of schedule and returned to Shanghai for the merger announcement.

Liu and other China Eastern executives have been serving on a seven-member team hammering out transaction details. Also represented are the parent group and Shanghai Airlines.

Liu announced June 13 at his company's annual shareholder meeting that the deal had received a green light from the state assets management agency as well as the Shanghai city government.

A source close to China Eastern's board later explained some elements of the agreement to Caijing, calling it "a two-step deal."

The source said the 59.23 percent stake in Shanghai Airlines held by the Shanghai government would be swapped for China Eastern shares. China Eastern would then buy out Shanghai Airlines' smaller stakeholders, to make Shanghai Airlines a subsidiary while maintaining its own brand.

Based on the stock price of Shanghai Airlines on the last trading day before the suspension, the Shanghai government's stake is worth 3.1 billion yuan. Premium levels for smaller shareholders have yet to be announced, but sources close to the deal told Caijing that China Eastern might pay cash for stock now held by the small shareholders.

Market rumors say Shanghai Airlines would delist and sell its public shell company to a Shanghai financial firm. But a China Eastern official rejected that speculation, saying the larger airline has not communicated with any company about such a deal.

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Shanghai's Baby

Launched in 1985, Shanghai Airlines used to be the pride of China's largest city. It pioneered the break-up of the state-dominated airline sector, becoming the first airline in China to invite private investors and operate commercially.

Soon after Shanghai Airlines went public in 2002, suggestions for a merger with China Eastern started gathering steam. Then-CEO Fan Hongxi told the media that Shanghai Airlines' financial record was so strong – representing 28.7 percent of all profits earned by China's airlines in 2001 -- that it could "develop independently and become stronger."

However, soaring fuel price and fierce competition among domestic carriers squeezed Shanghai Airlines' profit margin. In 2005, the airline earned 46 million yuan, down 83.5 percent from the previous year. Profits slipped to a mere 8 million yuan in 2006.

According to Shanghai Airlines Chairman Zhou Chi, the company needed a capital injection that never arrived.

"Shanghai Airlines had a relatively small capital case at the listing," Zhou said. "There should have been a capital injection between 2006 and '08, which didn't happen."

And the Shanghai government's deep involvement didn't help. A capital injection plan was delayed in 2006 by a national shareholder reform program. And starting in July 2006, a corruption case swirling around the city's then-party secretary and mayor, Chen Liangyu, led to a personnel tsunami that brought down a number of local officials, forcing the airline to shelve hopes for a capital boost.   

When the aviation industry hit bottom in 2008, Shanghai Airlines' debt to equity ratio jumped to 97 percent. That year, the company lost 1.25 billion yuan.

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Shanghai Airlines received local government aid -- 1 billion yuan – to keep the airline afloat through 2009. But it's been far from enough to reinvigorate the ailing company.

Eventually, the Shanghai government realized it had neither the power nor the capital to strengthen the air carrier, and had to let go.

China Eastern emerged as a suitor, despite its financial wobbles. The airline got a 9 billion yuan bailout from the central government following its reported net loss of 13.9 billion yuan in 2008.

But selling the airline offered the city a silver lining: The proposed merger fits Shanghai's plan to create an international aviation hub.

City planners want to see combined annual passenger volume rise at Shanghai's airports to 84 million by 2010. "The merger is an opportunity" to reach that goal, said a Shanghai Airlines official, although he admitted "we are not even halfway there."

Industry analysts blame slow development of the hub plan to a lack of a strong, local carrier that could be created by combining Shanghai and China Eastern airlines. Together, the merged company would control more than 50 percent of the Shanghai market.

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In Singapore's Eye

While polishing their merger plan, the airlines continue hunting for capital. Despite the government injection, Liu has said in public comments that China Eastern still needs another 4 billion yuan.

China Eastern's immediate aim is to reduce debt. Sources familiar with the matter told Caijing that debt-cutting options include seeking more government aid and selling stakes to investors.

To that end, China Eastern is currently in talks with the China Securities Regulatory Commission (CSRC), a development that Caijing sources said could mean the carrier is seeking to resume talks with potential investors about lightening its debt load.

People familiar with the matter said talks with CSRC involve departments overseeing international affairs and supervising share issues. The talks may indicate the airline is rethinking a possible addition of strategic partners, following a failed plan to sell a stake to Singapore Airlines in January 2008.

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Singapore Airlines and Singapore's state investment company Temasek Holdings had agreed in September 2007 to buy a combined 24 percent stake in China Eastern. But China Eastern shareholders rejected the proposal in part because China Eastern's share price rose above Singapore's offer.

In addition, a key China Eastern shareholder – Air China's parent China National Aviation Corp. -- made a counteroffer that topped Singapore Airlines' bid.

Yet talk about Singapore's future involvement is still alive. A senior official at China Eastern told Caijing that a potential tie-up with Singapore Airlines would bring certain expertise to his airline, particularly in the area of premium services.

On the sidelines of a June 13 shareholders meeting, Liu responded to a question about a potential Singapore Airlines deal by saying only that "there are no arrangements for the matter at present."