Cathay Pacific and Air China finalise megadeal

Far-reaching deal sees the two airlines set up cross-ownership structure while Cathay buys rest of Dragonair for $1.06 billion in cash and shares.
Cathay Pacific Airways and Air China has sealed a wide-reaching operational agreement that will be supported by a cross-shareholding and will see the two airlines essentially work as one in the Greater China region, sources say.

As reported by local media earlier this week, Cathay will also buy out the 82.21% of unlisted Dragon Airlines that is doesnÆt already own from China National Aviation Co, CITIC Pacific and Swire Pacific.

In total, Cathay will pay HK$8.2 billion ($1.06 billion) for Dragonair, which is equal to an attractive price of 33.5 times its 2005 earnings and will value the company at about HK$10 billion. The payment will be via 90% new shares that will be issued at HK$13.50 each and 10% cash. The issue price corresponds to a 4.2% premium to the latest close.

Once the deal is completed, Air China will have full sales and marketing rights for all three airlines û Air China, Cathay and Dragonair û in the mainland, while Cathay will have the same rights in Hong Kong, Macau and Taiwan, according to the sources.

Despite being 100% owned by Cathay, Dragonair will retain its own identity for at least six years, they say.

However, the agreement also includes code sharing and states that the three airlines will pool all revenues and costs on routes where they currently compete, which effectively means they will no longer be competitors. One example of a route which all three airlines presently fly is Hong Kong û Beijing.

ôThis is by far the most fundamental restructuring in the China airline market since the handover and will give Air China a great competitive advantage over its domestic competitors,ö one observer says of the deal, which has been two years in the making.

For Cathay the agreement means it will finally be able to tap into ChinaÆs rapidly growing airline market on broader scale, which is something it has been trying to do for years. While obtaining those rights through a close cooperation with a mainland airline is unlikely to have been considered the ideal solution by Hong KongÆs flagship airline a few years ago, the deal shows that the Cathay management has accepted that going the regulatory route would take too long.

The Hong Kong airline will also see one of its key competitors on the lucrative Hong Kong to Taipei route eliminated as it starts the revenue share with Dragonair which also flies to Taiwan.

Aside from buying out Dragonair, Cathay will also double its current 10% stake in Air China which it bought at the time of the latterÆs IPO in December 2004. The price will be about HK$4 billion ($515 million), or HK$3.45 per share, which represents an 11.3% premium to Air ChinaÆs latest close of HK$3.10 last Friday.

The five listed companies involved in this deal have all been suspended since the start of trading Monday, but are expected to resume trading today.

Cathay will also pay a special dividend of HK$1.25 billion ($161 million) to its shareholders once the transaction has been completed, meaning Air China will be entitled to receive part of that payout. The total financial outlay for Cathay wonÆt be that great, however, as the bulk of the deal will be satisfied through a share swap.

Meanwhile, Air China will receive an indirect 7.5% stake in Cathay through its 69% ownership in CNAC as a result of CNAC selling its Dragonair shares. It will also buy an additional 10% directly from CITIC Pacific and Swire for a total of HK$5.4 billion ($696 million), which will leave it holding 17.5% in Cathay.

Because Air China is planning to issue A-shares, CathayÆs 20% stake is expected to be diluted to about 17.5, leaving the two companies with an equal share in one another, one source says.

Once the entire deal is completed, CITIC Pacific will also hold 17.5% in Cathay, while Swire will have 40%. Both companies will end up with slightly more as a result of selling their Dragonair shares, but will trim back their holdings in order to comply with a 25% free-float.

Prior to the deal, CNAC held 43.29% in Dragonair, CITIC Pacific had 28.5% and Swire Pacific owned a direct 7.71%. The remaining 2.71% was held by minority shareholders who will also sell.

According to the sources, Air China is considering privatising CNAC through a separate offering, which would make its entire stake in Cathay Pacific directly owned.

Merrill Lynch and China International Capital Corp acted as advisers to Air China and CNAC, while ABN AMRO advised Cathay and Swire.

The deal will need shareholders approval at all five companies as well as the nod from mainland regulators. However, with Air China being a state-controlled company, it is believed the regulatory approvals are already in place. The process is expected to take three to four months.

CathayÆs share price has been on a downward trend since hitting a high of HK$14.50 in early March, having fallen close to 11%. It is down 4.4% year to date. Air China, on the other hand is up 25% since the beginning of the year, even though it has dropped 15.6% from its record high of HK$3.675 on May 19 in line with a broader decline in the market.

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