Shanghai to become a one airline town

China Eastern buys Shanghai Airlines for $1.3 billion, but the success of the merger is far from assured.

In a long-anticipated deal, Shanghai-based China Eastern Airlines and Shanghai Airlines have announced they will merge. The deal consolidates the former's hold on China's second largest air travel market and makes the combined entity the only carrier to be based in Shanghai.

According to separate stock exchange filings by the two airlines late Sunday, the boards of both China Eastern and Shanghai Air have agreed to a share swap merger agreement worth an estimated Rmb8.9 billion ($1.3 billion). China Eastern will buy 100% of the equity in the smaller carrier, swapping one Shanghai Air share for 1.3 of its own Shanghai-listed A-shares. China International Capital Corporation is advising China Eastern on the deal.

Citi analyst Ally Ma said the deal "makes sense" because it will eliminate a large number of overlapping routes, reduce operating costs associated with having bases at both Shanghai Hongqiao and Pudong airports, and raise passenger yields for the combined carrier.

The share prices of both China Eastern and Shanghai Air were up over 5% on the Shanghai Stock Exchange yesterday, closing at Rmb5.6 and Rmb6.22 respectively. Based on their closing share prices, Shanghai Air stockholders will receive a 17% premium for their shares.

When the merger is completed, China Eastern will raise its Shanghai air travel market share to 50% from 32% and will control 30% of the Chinese domestic market. By comparison, China's other two large airlines -- Air China and China Southern Airlines -- already have hometown market shares of 45% in Beijing and 50% in Guangzhou respectively.

Still, the merger's success is far from assured. Both airlines are considered financially weak. China Eastern lost Rmb15.2 billion last year, while Shanghai Air was Rmb1.25 billion in the red.

Different corporate strategies could also make integration difficult. China Eastern is a critical state-owned enterprise known for operational inefficiency. Its seven bases around the country operate as if independent of one another, creating significant management and staffing duplication. Shanghai Air, on the other hand, is a much more profit-driven enterprise with much higher staff and aircraft utilisation.

According to a Citi analyst report, China Eastern has 150 employees per aircraft while Shanghai Air operates with nearly half that at 87.

"The coming together of these two entities will create a more vibrant entity," said Paul Ng, global head of aviation at the law firm Stephenson Harwood. He expects the deal to open the door to more government capital for the airlines and for some of Shanghai Air's management style to be adopted at China Eastern.

According to Ma at Citi, the deal was government driven in response to the weak financial position at both airlines. "China Eastern's and Shanghai Air's severe losses for years and equity depletion were making normal business operations difficult," she wrote. "The government cannot afford to let such major state-owned air carriers go into bankruptcy, especially in view of the upcoming Shanghai World Expo."

China Eastern has long been Shanghai Air's larger hometown competitor. The airline has 240 aircraft versus Shanghai Air's 66, carried 37.2 million passengers in 2008 versus 10.1 million, and last year posted revenues of Rmb42 billion compared to Rmb13.4 billion for its smaller rival.

As with most mergers in China's critical sectors, the government had a heavy hand in the deal. Ever since Air China president Li Jiaxiang was promoted to head China's aviation regulator in December 2007, he has made it known he supports industry consolidation. Shanghai's two hometown airlines have since been at the centre of industry consolidation speculation -- first with Singapore Air's thwarted 24% stake purchase in China Eastern, next over a hostile takeover bid for the airline by Air China, and finally with a China Eastern-Shanghai Air merger.

While China Eastern has been eager for at least a strategic partner, Shanghai Air has not. The airlines' chairman, Zhou Chi, long dismissed merger speculations and said as recently as April that a strategic investor may be necessary because of the economic climate but added that to date there had been no discussions of a merger or strategic planning sessions held with its larger competitor.

In addition to the merger announcement, China Eastern will issue 1.35 billion new A-shares at Rmb4.75 a share worth a total of Rmb6.4 billion.

¬ Haymarket Media Limited. All rights reserved.
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