Cablegate: China Eastern - Singapore Airlines Deal: Bellwether For

DE RUEHGH #0012/01 0111138
R 111138Z JAN 08





E.O. 12958: N/A

(U) This cable is sensitive but unclassified and for official
use only. Not for distribution outside of USG channels.

1. (SBU) Summary: On January 8, China Eastern Airlines (CEA)
shareholders rebuffed a deal that would have allowed Singapore
International Airlines (SIA) to buy a strategic share of the
company. The move has sparked a wave of speculation regarding
the meaning for CEA and the greater airline industry in China.
The rejection occurred against the backdrop of maneuvering by
CEA competitor China National Aviation Holding Corporation
(CNAC) and new leadership at the General Administration of Civil
Aviation of China (CAAC). Shanghai-based financial industry
analysts said the move was a mix of capital market forces and
the hand of the Chinese Government moving the industry towards
consolidation, a hallmark of the new CAAC leadership.
Shanghai-based airline executives believe the rejection was
simply a manipulation by the competitor, and noted that the
original government approval of the deal is a signal that the
Chinese Government is still on a path of liberalization. The
next move by CNAC and Beijing's reaction will be a good
indicator of China's future direction on civil aviation reform.
End Summary.

A Doomed Deal?


2. (U) Financial industry analysts with whom we met were not
surprised by the rejection of the SIA-CEA deal by CEA
shareholders. They noted that it was virtually impossible for
the deal to be approved given that CNAC's and its supporters'
(Cathay Pacific and Barclay Bank) combined votes surpassed the
required one-thirds threshold to reject the deal. Expectations
that CNAC would put a higher price on the table also caused
investors to bid up the price of CEA shares, far past what was
viewed as a reasonable price when SIA made its initial offer.
This new price then led many minority shareholders to believe
SIA's offer was too low.

3. (U) CEA and SIA began negotiations on the deal in 2006 and
won government approval for it in September 2007. Under the
deal, EAC would sell 1.75 billion shares (a 24 percent stake) to
SIA and Temasek Holdings. This would be the first time a
foreign entity was allowed to purchase strategic ownership in a
Chinese state-owned airline. The purchase price of HKD 3.80
(USD .49) was close to the share price at the time CEA share
trading was suspended in late May 2007. CEA shares virtually
doubled in value following the announcement.

The Sharks Circle


4. (U) Soon after the deal was approved, Cathay Pacific
announced plans to team up with Air China to block it. (Note:
Cathay Pacific and Air China, along with Dragon Air have
connecting ownership ties, which already makes them one of the
strongest airline groupings in Asia. End note.) Cathay Pacific
dropped its bid on opposition from Beijing. However, CNAC, the
parent company of Air China, bought up CEA H shares, increasing
its stake to 12.07 percent. Meanwhile CEA launched an effort to
convince shareholders that the agreed upon share price (almost
half the current market value) was still a fair price.

Add Some Political Intrigue


5. (U) On December 28, Air China and CNAC head Li Jiaxiang was
promoted to Acting Minister of CAAC. Quickly following the
appointment, CNAC announced it would offer a counter-bid of no
less than HKD5 (USD .64) if minority share holders rejected the
CEA-SIA deal. Cathay Pacific announced it would reconsider

SHANGHAI 00000012 002 OF 004

teaming up with CNAC in the counter-offer. CEA issued a
statement accusing CNAC of trying to mislead shareholders.

Deal Rejected by a Wide Margin


6. (U) Spurred on by the higher bid from CNAC, more than
seventy seven percent of the H share holders and ninety four
percent of the A share holders voted against the deal on January
8. Immediately after the rejection, CEA Chairman Li Fenghua
stressed the importance of cooperation with SIA, reiterating his
wish to adopt SIA's top-notch management skills and operation
efficiency. Although CNAC is able to offer at least 40 percent
higher per share and has more domestic resources to allocate to
China Eastern, domestic carriers lack SIA's "software." Li will
"continue to communicate with the national government and CAAC
to work out a better restructuring plan for China Eastern." He
publicly ruled out the possibility of merging with Air China.

SIA - The Biggest Loser


7. (SBU) The shareholder rejection negated two years of
negotiation between CEA and SIA and will hamper SIA's plans to
tap demand in China, where domestic flight demand is expected to
increase fivefold by 2026, according to analysts of China's
aviation market. SIA's original plan was to utilize China
Eastern's base in Shanghai, and enable it to challenge Air China
and Cathay Pacific inside China. According to media reports,
SIA CEO Chew Choon Seng said on Dec 12 that the company will not
raise its offer as "nothing is a must-have."

CEA Shareholders -- The Biggest Winners


8. (SBU) In discussions with ConGen, civil aviation market
analysts opined that a strategic alliance with Air China would
be more beneficial to CEA by enabling it to expand market share
outside of Shanghai. This belief has lead many investors to
believe a rejection of the CEA-SIA deal would drive the stock
price even higher. One analyst said "the biggest beneficiary of
the bid rejection, however, will be the shareholders since they
receive a counter-bid that is thirty to fifty percent higher."
Other analysts noted that shareholders vetoed the deal because
investors simply pay the most attention to the offer price.
However, on news of the failed bid, shares of CEA immediately
dropped 1.75 percent.

What About the Service?


9. (SBU) In a recent meeting with Econoff, CEA's management
said the company's major competitive strategy is to compete by
providing better service, rather than adjusting fares. CEA's
goal on international flights is to improve its overall
management skill and efficiency, which is why the company
decided to partner with SIA in the first place. CEA needed an
"infusion" of customer service skills to compete
internationally. CEA management also hoped the partnership with
SIA would also bring better customer service skills and
management to their domestic flights as well.

10. (SBU) Besides looking to a deal with SIA, CEA outlined
other measures it has taken to increase its customer service
orientation. For example, CEA views the recent capacity sharing
program with other carriers for the Shanghai-Beijing route as
positive for the industry. This program was designed to offset
negative effects from flight delays as consumers are free to get
on the next available flight in this program. It also

SHANGHAI 00000012 003 OF 004

alleviates many discounted tickets since all flights in the
program must set their fares at similar rates and charge the
same service fees. CEA operates 14 flights each day between
Shanghai and Beijing.

Shanghai Analysts See Consolidation in the Future

--------------------------------------------- ----

11. (SBU) In conversations with Congen, Shanghai financial
industry analysts said they believe the Chinese Government was
partially behind the rejection. They expect CEA will eventually
merge with Air China to create a giant carrier, with 60 percent
market share in Beijing and 50 percent market share in Shanghai.
They opined that Air China could bring in a much better balance
sheet than SIA. If they merge, their combined first year
revenue could be as large as USD 500 to 700 million, compared
with the USD 150 - 200 million under an SIA merger.

Other Shanghai-Based Airlines Say Liberalization on Course

--------------------------------------------- -------------

12. (SBU) The Contract and Planning Department Manager from
Shanghai Airlines asserted that the rejection of the deal will
negatively impact CEA, given the twenty-four percent stake
purchase from SIA would have immediately lifted the book value,
debt ratio and cash flow of CEA. Even though CNAC announced a
higher counter-bid, he noted this offer is still not officially
proposed through the China Securities Regulatory Commission
(CSRC). He believes this is only a strategy from CNAC to
influence minority shareholders to veto the SIA deal. The
failure of the deal, however, would likely benefit Shanghai
Airlines, since its major competitor in the Shanghai hub would
not get bigger (Note: CEA has 41.1 percent market share in
Shanghai versus Shanghai Airlines' 18.7 percent. End note). He
was also skeptical that Air China could actually afford to
acquire CEA. He doubted the Chinese Government intended an
industry restructuring to combine Air China with China Eastern
and China Southern, despite CAAC President Li Jiaxing's public
support for consolidating the industry.

China Still Welcomes Foreign Investment in Airlines

--------------------------------------------- ------

13. (SBU) A top executive from Juneyao Airline, one of China's
first fully private airlines, concurred that there would likely
not be an industry restructuring resulting in a mega Chinese
airline. The rejection was a result of "insider" maneuvering
and some capital market forces that had driven the share prices
beyond that of the initial agreement. He emphasized the move
was not a result of government pushing for consolidation, or a
backtracking on the path of liberalization and deregulation.
Despite CAAC Acting Minister Li's arguments for consolidation,
consensus in the government is still firmly in favor of
improving Chinese airlines through allowing greater competition,
citing the long deliberation process that resulted in approval
of SIA's investment in CEA in the first place.

14. (SBU) The Juneyao executive maintained the Chinese
Government still welcomes strategic investors that can increase
competitiveness and the quality of Chinese airlines. Some
government moves were misconstrued by outsiders and so they
believe the government is moving in the opposite direction. He
cited a 2007 move by the Chinese Government putting a moratorium
on licenses issued for new private airlines. The stop was not a
move by government to limit private competition but a direct
result of bottlenecks created by a shortage of pilots and
airport and air corridor space. China is expected to
experience a shortage of 30,000 pilots in the next 3 to 5 years,
and the demand created by new airlines had taxed the available
pilots to the limit. It had become a safety issue because of

SHANGHAI 00000012 004 OF 004

"overworked" pilots.

15. (SBU) The Juneyao executive said the Chinese Government
will allow CEA's investors to make the final decision, but the
Government's ultimate goal is still to bring foreign expertise
and capital into China's airlines. He was quick to point out
that the SIA deal was approved at the State Council level, not
only CAAC. And, any potential deal with CNAC would also likely
require the State Council's approval. Hence, CAAC Acting
Minister Li's push for consolidation would be tempered. He also
noted another reason that a deal with Air China is highly
unlikely. Citing a personal relationship with the CEO of China
Eastern Group, the holding company of CEA, he said the CEO is
very much against any deal with Air China and would work to stop
any such deal. As for impact on his own company, he said the
result had no impact because Juneyao does not compete directly
with CEA.

Background on CEA - One of China's Top Three Air Carriers

--------------------------------------------- ------------

16. (U) Established in 1997, CEA is one of the top three air
carriers in China (the other two are Air China and China
Southern). CEA is headquartered in Shanghai. Currently CEA
operates a total of 423 routes, of which 299 are domestic
routes, 19 are Hong Kong routes and 105 are international
routes. It operates approximately 5,650 scheduled flights per
week, serving a total of 136 foreign and domestic cities. The
company's main aircrafts are Airbus A340, A 330, and A321 and
Boeing 737 and 777. Among them, Boeing 737 and 777 are more
focused on its domestic small cities routes while Airbus A340 is
used for international flights. CEA also operates 5 Canadian
Regional Jet aircraft and 5 Embraer Regional Jet aircraft to
serve its Wuhan and Nanjing routes. CEA's main revenue (90
percent) is generated by passenger service and the remaining 10
percent from its cargo business.

CEA's U.S. Routes


17. (U) CEA's predecessor entity started Shanghai-Los Angeles
service in 1991. That route was the airline's first route to a
U.S. destination. Currently CEA provides daily flights on this
route and it is one of CEA's most profitable routes. In 2006,
CEA launched the world's first direct flight between Shanghai
and New York. Presently the passenger load factor (PLF) is over
80 percent for this route. However, the first class and
business class customer load on this route is still below the
company's expectation. Hence, they plan to replace A340s on
this route with Boeing 787s to reduce passenger capacity and
increase its PLF. CEA also attributes its weak high-end
passenger load on its NY route to an unsuccessful marketing
strategy and the company will increase its marketing expense for
this route in the future. Overall, CEA's major international
markets are the United States and France.



18. (SBU) Comment: Most agree the CEA-SIA deal rejection was
largely due to the high counter-bid price from CNAC and the
resulting speculative current share price. It is also clear
CNAC, as a partner of Cathay Pacific and a competitor of CEA,
had a strong incentive to scuttle the deal. However, it remains
unclear if and to what extent the government was involved and
whether CNAC's move was merely a way to slow the competition, or
whether it truly intends to work for consolidation of the major
Chinese airlines. How Beijing reacts to CNAC's next move will
provide light on how the Central Government will push civil
aviation reform in the near term.

© Scoop Media

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