Chinese carriers likely to find M&A tailwind

A move earlier this month by Singapore Airlines and Temasek, the Singaporean government's investment vehicle, to take a minority stake in troubled state-owned carrier China Eastern Airlines likely heralds further consolidation in China's aviation sector.

Tie-up targets for international acquirers could include China Southern Airlines  , which is China Eastern's  state-owned peer, said analysts.
Air China , the other top domestic carrier, already has a strong relationship with Hong Kong-based Cathay Pacific Airways, with each holding a 17.5% stake in the other.
"We believe the entrance of SIA (Singapore Airlines) via its direct equity stake in CEA (China Eastern) would significantly change the operating fundamentals and power base in the China aviation market," wrote Morgan Stanley Asia analysts in a note to clients after that deal was announced.

The three state-owned airlines, China Eastern, China Southern and Air China, were created following industry restructuring a few years ago, in which several small and medium-sized carriers were merged into three nearly equal-sized airlines.
Together, they enjoy a nearly 80% market share. China Eastern, for example, has a fleet of some 200 aircraft, operating more than 80 international and regional routes as well as over 330 routes within China.
Shares of China Eastern have risen between 75%-80% in both Hong Kong and Shanghai trading since the deal was announced earlier this month. The shares nearly quadrupled in Hong Kong in 2007 to date. Shares of China Southern have more than tripled and of Air China have more than doubled in 2007 to date. See emerging markets page.
Adrian Lowe, an analyst with CLSA in Hong Kong, said China Southern might benefit from a link with an overseas carrier because "it needs operational assistance" and cash inflows. Total foreign investment in Chinese airlines is currently capped at 49%. Out of that, the stake of an individual company is capped at 25%.
Finding the right chemistry
"China Southern has been struggling for the past five years or so. It has only recently turned profitable, basically because of (foreign) exchange gains," said Lowe.
Recent Chinese state media reports indicated China Southern and Air France-KLM Group, which is Europe's largest airline, have agreed to talk about the creation of a China joint venture for cargo. But it's early days yet, and unclear whether the talks would also deal with passenger operations.
Finding the right partner might be easier said than done, cautioned Lowe.
"It isn't easy getting a quality partner like Singapore Airlines, who also understands the Chinese culture," he said, referring to the China Eastern deal.
Singapore Airlines is one of the most popular and profitable airlines in Asia, consistently recognized by travel organizations for the quality of its service. It operates nearly 800 flights a week to 65 destinations in 35 countries, and hopes to be the first airline to fly Airbus' A380 superjumbo carrier. See more global markets coverage.
However, it hasn't had a very successful record with acquisitions.
Shortly before its deal with China Eastern was announced, Morgan Stanley wrote in a report that Singapore Airlines "is unlikely to repeat the mistakes of the past strategic acquisitions of Virgin Atlantic and Air New Zealand" by overpaying for a minority stake.
Singapore Airlines sold its 25% stake in Air New Zealand in 2004 and is reportedly looking to sell its 49% stake in Virgin Atlantic, which is controlled by British entrepreneur Richard Branson.
Fook Tat Cho, an analyst with Tai Fook Research in Hong Kong, said further consolidation within the industry was likely, with one of the three large airlines possibly acquiring one of the many medium- or small-sized airlines in an expansion bid.

However, Cho said the Chinese government was unlikely to allow mergers between the three leading airlines, in the interests of maintaining a competitive environment. "If all three airlines are merged, the combined entity will have an 80% market share, which is not good for competition," said Cho.

Chinese aviation: too big, too fast

The weak financial profile of China Eastern, which has stacked up losses and piled up debt over the years, stands as an example of troubles within the Chinese airline industry.

Industry watchers say the airlines have expanded too fast, too soon to catch the boom in demand for air travel, while China's economy continues to grow at 10% or more each year. In the bargain, the airlines have, in financial terms, stretched themselves too far.

According to projections by Airbus, China's commercial aviation market will need about 2,650 new passenger aircraft over the next 20 years, worth $289 billion, to satisfy domestic and international travel needs, making it the world's fastest-growing market for such aircraft.

The outbound travel market looks likely to grow sharply. For the first time in 2005, the number of China-based passengers exiting the country exceeded 30 million people; 80% of them were tourists, according to Airbus data. In 2005, about 3.5 million Chinese traveled beyond Asian borders, a sum Airbus believes will rocket to 30 million by 2015.

For the moment, however, the industry is in a state of flux.

"The Chinese aviation industry has experienced a relatively faster capacity growth. But passenger load factors have remained low, and oil prices too have risen quite a lot in the last two years. All these things have contributed to record losses in the last few years," said Jack Xu, an analyst with Sinopac Securities in Shanghai.

China Eastern has posted losses for three of the past five years, including a net loss of HK$3.31 billion ($440 million) last year. China Southern also lost money in three of the past five years, though it made a profit of HK$188 million in 2006, as compared with losses of HK$1.85 billion in 2005, according to Thomson Financial data. Air China made been profitable in each of those five years.

"An airline has to expand capacity in order to grow, and for that they need to make a lot of capital expenditure. But if the capex goes on with no profits, or even losses, the financial position will of course get worse," Xu added.

V. Phani Kumar is a reporter in MarketWatch's Hong Kong bureau.