China’s New Merger Math

There is an old Chinese proverb: “The world will unite after being long divided.” This may be equally applicable to China’s airline industry. Although there appears to be little chance that it will return to the era prior to 1987 when CAAC was the equivalent of Aeroflot in the heyday of the Soviet Union, nonetheless the industry is becoming more concentrated.

Having broken up the CAAC monolith, the Beijing government stage-managed the first phase of reconsolidation in 2002 following China’s entry into the World Trade Organization. The rationale for the restructuring was a concern that the airline industry was too weak and fragmented to compete effectively against foreign carriers. It also is possible that CAAC was concerned about the challenge of regulating what had become a dizzying number of national, regional and local carriers spread across the country.

Individual airlines had little say during this process as CAAC maintained tight control. Air China was merged with China Southwest and China National Air Corp. to form China National Aviation Corp. China Southern Airlines was pushed into a merger with China Northern Airlines and Xinjiang Air, creating China Southern Air Holding Company. China Eastern Airlines was merged with China Northwest Airlines and Yunnan Airlines in what became China Eastern Air Holding Company.

These steps insured that the big three state-controlled airlines retained their primacy during a period that saw the emergence of many new entrants including the country’s first LCCs. Successive mergers and acquisitions, however, largely have been owing to the same factors driving consolidation in the US and Europe. These include the desire to grow networks and expand into new markets, remove capacity and competitors and reduce vulnerability to the economic cycle.

Among the big three, CA probably has been the most aggressive in seeking to build its network through acquisition. In large part this is owing to its weaker domestic situation relative to China Southern, the largest domestic airline, and China Eastern, which enjoys a leading position in Shanghai, China’s biggest and most important commercial city. In early 2009, CA bid for East Star Airlines. “Wuhan [the capital of Hubei Province] is a hinge city that can lead to nine Chinese provinces, which makes it so strategically important that we can’t miss it,” CA Chairman Kong Dong said in explaining the desire to acquire that airline. Although the deal failed when the two could not agree on a purchase price, CA was able to pick-up many of the pieces of East Star during the latter’s financial liquidation, acquiring aircraft and hiring former East Star staff to launch its Hubei Branch Company, which now has a 10% share of the Wuhan market.

Long Pursuit 

CA’s long pursuit of Shenzhen Airlines is another example of its strategy. Its eagerness to take control of Shenzhen, the country’s fifth-largest carrier located in dynamic Guangdong Province just north of Hong Kong, is not a recent phenomenon. In 2005 it made a joint bid with the Shenzhen government to acquire a 65% stake being sold by Guangzhou Development Bank. This effort failed after two private companies, Huirun Investment Co. Ltd. and Yiyang Group represented by Li Zeyuan, won the bidding with a surprisingly high offer of CNY 2.72 billion ($401 million).

Earlier this year, however, Li, along with former Chairman Li Kun, were placed under arrest for unspecified financial crimes, enabling CA—the airline’s second-biggest investor with 25%—to step in and take control. CA was firmly supported in this action by the Shenzhen municipal government; indeed, without the support of the government its takeover could not have been implemented so smoothly.

According to a March 2010 filing with the Hong Kong Stock Exchange, CA gained control with a CNY682.1 million investment that boosted its stake to 51%. Although there is a dispute over the carrier’s financial performance—Shenzhen claims it has been profitable in each of the past 16 years and was CNY500 million in the black through the first 11 months of 2009 while CA says it lost CNY863.7 million in 2009 and CNY31.3 in 2008—it’s a worthwhile deal for CA.

“We can fill our void in the South China market by controlling Shenzhen Airlines, whose route network can be complementary with our domestic network, which can help us build flight banks and improve our position of being a hub-and-spoke network carrier with Beijing as main hub,” CA Board Secretary Huang Bin tells ATW. Prior to its acquisition of the controlling stake it held a 10% share of the Guangzhou and Shenzhen markets; incorporating Shenzhen’s network is expected to raise this to 20% and 42% respectively.

So far the acquisition is going well. The carriers have launched shuttle service from Shenzhen to Beijing and Chengdu in Sichuan Province and from Chengdu to Guangzhou and are conducting codeshare operations on 158 domestic flights on 13 routes. In April, CA signed a cooperation memorandum with the Shenzhen government under which it promised to keep Shenzhen Airlines’ name and brand and its status as an independent carrier while the municipal government agreed to supply financial incentives to encourage the airline to open more international routes, provide cargo subsidies and formulate policies favorable to CA’s operation in Shenzhen. 

Survival Need 

Whereas CA’s acquisition of Shenzhen was driven largely by the desire to grow its network, Sichuan Airlines acquired Shenyang-based Dongbei Air and Chengdu-based United Eagle Airlines primarily to maintain its viability against larger rivals. “We are more for survival instead of expansion,” Sichuan Chairman Lan Xinguo admitted. Indeed, the takeover of United Eagle last year was dubbed the “Chengdu defense war.”

As a Chengdu-based carrier, Sichuan has faced increasing encroachment from other airlines seeking to make the valuable city their own. The capital of Sichuan Province, Chengdu is one of the three so-called “Golden Triangle Cities” of southwestern China, the others being Chongqing and Kunming. Among those with designs on the city is CA, which seeks to make it a regional hub. It had around a 35% share of passengers there compared to 28% for Sichuan, while United Eagle held under 10%.

For this reason, Sichuan purchased an additional 56.2% of UEA for CNY200 million in March 2009 as that carrier was on the verge of bankruptcy, raising its holding to 76.2%. Lan was candid that he didn’t want UEA going to a rival. Then last October Sichuan announced that Commercial Aircraft Corp. of China and Sichuan Communication Investment Group purchased 48% and 11% in UEA respectively and changed the name of the carrier to Chengdu Airlines. This resulted in Sichuan’s stake being diluted to 40.97%, but it still exerts operational control over the new entity and has stabilized its position in the Chengdu market. And Lan predicts Chengdu Airlines will earn a profit this year owing to the domestic market’s strong rebound.

Sichuan’s pursuit of Dongbei Air also came about out of competitive pressures. It had intended to stay close to home with its Golden Triangle strategy but was forced to revise it in the face of new threats created by the launch in 2007 of Chongqing Airlines, which is 60% owned by China Southern, while China Eastern and Hainan Airlines seized a major part of the Kunming market by launching respective subsidiaries in Yunnan. CEA’s is named China Eastern Yunnan Company with ownership split 65/35 between the airline and the Yunnan provincial government. Hainan Airlines’ subsidiary will be called Yunnan Airlines Company and is expected to be launched based on Hainan subsidiary Lucky Air. Under an agreement signed between HNA and the Yunnan government in 2008, another HNA subsidiary, Grand China Air, will be the controlling stakeholder of Yunnan Airlines while the provincial government will have a holding.

What to do in the face of this onslaught? Sichuan Airlines started to look for opportunities elsewhere. Dongbei Air, which became Hebei Airlines in June, is such an example. Launched in February 2006, Dongbei initially was based at Shenyang Taoxian and Sichuan originally held a 33.5% stake to explore the northeast market. But owing to the global financial crisis and management missteps, Dongbei has been suffering from operating losses since its launch. It transferred its operating base from Shenyang to Guilin in Guangxi Province last December in an attempt to attract a capital injection from the Guangxi government but was unsuccessful and was on the verge of bankruptcy.

Sensing an opportunity, Sichuan took over troubled Dongbei by investing CNY400 million to raise its stake to 97% in June. It then persuaded the Hebei provincial government, represented by Hebei Aviation Group, to acquire 62%, leaving Sichuan with 35% and Shenyang Zhongrui Investment Co. with its original 3%. Sichuan launched Hebei Airlines based on the assets of Dongbei Air on June 28 in conjunction with the provincial government. As it does with Chengdu, it exerts operational control over Hebei although it is only the second-largest shareholder. Hebei Province is quite near Beijing, but its air transport market remains underdeveloped. Analysts note that through Hebei, Sichuan can try to develop northern China including Hebei, Beijing and Inner Mongolia.

CEA and Shanghai 

China Eastern’s merger with Shanghai Airlines is an example of a carrier seeking to build mass at its hub while also eliminating a tough competitor. It is noteworthy that both were experiencing financial difficulties and operating losses when they merged, not a situation of a stronger airline scooping up a much weaker one (ATW, 6/10, p. 24). The two have an estimated 50% passenger share in Shanghai.

Earlier this year, CAAC Minister Li Jiaxiang initiated “a strong aviation nation” strategy. As part of this strategy, the regulator aims to push forward M&A activity through market means so that there will be at least one international carrier with a world-famous brand by 2030. It is widely assumed that CA will be the one to shoulder this historic mission. Interestingly, it was Li who promoted the “super big carrier” theory three years ago when as CA’s chairman he acted to prevent CEA’s stake sale to Singapore Airlines by making a counteroffer.

The “super big carrier” theory is quite similar to the idea of a “national champion” in that it aims to build a competitor strong enough to face up to global megacarriers. Since Li was appointed CAAC Minister afterwards, the theory seems to have come to a standstill. But CA’s domestic expansion pace has never stopped and it seems to be well on its way to becoming China’s leading airline and also has enhanced its position in international markets.

However, challenges remain. Significantly, CEA joined SkyTeam in April, aligning itself with China Southern to counter CA. The two carriers have signed an agreement to conduct cooperation in a number of areas including marketing, aircraft purchase, ground handling and training and they also codeshare on many domestic routes.

Will China’s airline industry continue to remain the big three or become a big two or only one “super big carrier”? This will remain a question for the foreseeable future. One thing is certain: Chinese carriers will continue to merge. As Huang puts it, “It is decided by economic tendency.”