Cablegate: China Eastern-Shanghai Airlines Merger Highlights

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FM AMCONSUL SHANGHAI
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INFO RUEHOO/CHINA POSTS COLLECTIVE
RHMCSUU/FAA NATIONAL HQ WASHINGTON DC
RUCPDOC/DEPT OF COMMERCE WASHINGTON DC
RULSDMK/DEPT OF TRANSPORTATION WASHINGTON DC
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UNCLAS SECTION 01 OF 02 SHANGHAI 000044

SENSITIVE
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STATE FOR EEB/TRA
STATE FOR EAP/CM
MONTREAL FOR USMISSION ICAO

E.O. 12958: N/A
TAGS: EAIR ECON EIND PGOV CH
SUBJECT: CHINA EASTERN-SHANGHAI AIRLINES MERGER HIGHLIGHTS
COMPLICATIONS IN CONSOLIDATING STATE SECTOR

REF: 09 SHANGHAI 53

SHANGHAI 00000044 001.2 OF 002

1. (U) This cable contains business proprietary information and
is Sensitive but Unclassified. Please handle accordingly.

2. (SBU) Summary: Central Government-owned China Eastern
completed its long awaited merger with local rival Shanghai
Airlines on January 29, with substantial concessions to the
locally owned competitor. Noting that the Shanghai Airlines
brand will be retained for at least another three years, China
Eastern representatives claimed that the merger would result in
close to 50 percent market share of the lucrative Shanghai
market. While officials from both carriers declined to speculate
as to which global airline alliance China Eastern would
eventually join, a China Eastern representative strongly hinted
that the Oneworld Alliance is the likely candidate. End Summary.

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Thanks to Expo, China Eastern Optimistic about 2010 prospects
--------------------------------------------- ----------------

3. (SBU) China Eastern's (CEA) merger with Shanghai Airlines
(SAL) catapults CEA ahead of Air China as China's second largest
carrier by fleet size, behind China Southern Airlines. During a
January 12 meeting, CEA representatives told CongenOffs that
CEA's market share in Shanghai will rise to around 46 percent by
passenger volume. With 70-75 million visitors predicted to
attend Shanghai's six-month long 2010 World Expo, CEA expects
2010 will be a profitable year with revenues rising by 20
percent. CEA anticipates 10-15 million Expo visitors will travel
to Shanghai by plane, 3-8 million of whom CEA hopes will fill
its flights. Following three years of massive losses from
2006-08 due to rising fuel prices, the global economic downturn
and bungled fuel hedging contracts, CEA announced in early
January that it anticipates 2009 will ultimately prove to have
been a profitable year, albeit still having required a capital
injection of RMB 14 billion (approximately USD 2 billion) from
the Ministry of Finance. CEA's revenue is split 70/30 between
its domestic and international routes, and the ultimate goal is
to achieve a ratio of 50/50, according to the CEA
representatives.

4. (SBU) In response to a question regarding competition from
several high-speed rail routes coming into service in the near
future, the CEA representatives admitted rail would probably
pose a challenge, especially for travel between 800-1500 km in
length where travel times would be comparably close to air
options. On routes longer than 1,500 km, air transport would
likely provide the more attractive option in spite of high-speed
rail availability, they commented. In addition, while security
check-in procedures for high-speed rail remained relatively less
burdensome in comparison with that at airports, the CEA
representatives highlighted a recent incident whereby a smoking
passenger on the Wuhan-Guangzhou line triggered a prolonged
delay as potentially foreshadowing more onerous security
procedures for rail travelers. Should security check-in
procedures at train stations become more time consuming, they
reasoned, air travel would remain an appealing option.

-----------------------------------------
Shanghai Accepts Merger...with Conditions
-----------------------------------------

5. (SBU) Prior to the merger, SAL was a locally administered
state-owned enterprise (SOE) of the Shanghai Municipal
Government. (Note: China Eastern Air Holding Company, CEA's
parent company, is also largely state-owned but by China's
central government. The Communist Party's Central Organization
Department approves CEA's chairman although the State Council's
State-owned Assets Supervision and Administration Commission
selects the senior vice presidents. End Note.) The CEA
representatives claimed that Shanghai municipal authorities were
supportive of the merger because the consolidation would enhance
Shanghai's goal of becoming an international shipping and
transportation center. Furthermore, CEA's resulting market share
for the lucrative Shanghai market would approach 50 percent.
Retaining the Shanghai Airlines brand, the CEA officials
explained, would also prevent additional entrants to the
Shanghai market due to a Civil Aviation Administration of China
(CAAC) regulation restricting the number of airline branch
offices per airport.

6. (SBU) SAL Senior Vice President Ms. Shao Xiaoyun told the

SHANGHAI 00000044 002.2 OF 002

Deputy Principal Officer February 4 that, while SAL would become
an independent, fully owned subsidiary of CEA, SAL's cargo
operations, marketing, ground maintenance, and unspecified other
departments would be consolidated with CEA. Furthermore, since
both airlines previously were registered in Shanghai, the
Shanghai Municipal Government would experience no significant
change in tax revenue as a result of the merger. (Note:
Enterprise income tax revenues accrue to the jurisdiction where
the firm is registered. End Note.)

7. (SBU) When asked about management personnel changes, Shao
stated that SAL's Acting President and Communist Party Secretary
Mr. Gu Jiadan had been appointed as a vice president of China
Eastern Air Holding Company. Shao claimed that no lay-offs would
result from the merger although some personnel "adjustments"
could not be ruled out. The Shanghai Airlines brand would
remain, she noted, while CEA representatives told us the brand
would be maintained for a minimum of three years post-merger.
Shao was similarly hopeful that 2010 would be a profitable year
for SAL, stating that the Central Government's State-owned
Assets Supervision and Administration Commission (SASAC) issued
a decree prohibiting SOEs from entering into any derivative
trading, to include fuel hedging contracts.

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Oneworld in CEA's Future?
-------------------------

8. (SBU) Both CEA and SAL representatives demurred when asked
about future international airline alliances. SAL's Shao said
that once CEA decides which alliance it will join, if it is not
the Star Alliance, then SAL's Star Alliance partnership would be
canceled. In the interim, however, SAL's Star Alliance
membership would continue. The CEA representatives pointed out
that given Air China's membership in Star Alliance and China
Southern's Skyteam partnership, CEA's options were more than
likely limited to Oneworld, the third of the largest global
airline alliances. Media reports indicate that CEA will make an
announcement mid-February concerning which global alliance it
will join.

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Outstanding Boeing Orders for CEA to Decide
-------------------------------------------

9. (SBU) When asked about the nine Boeing 787 Dreamliner
aircraft that SAL had on order, Shao noted that CEA itself had
fifteen on order for a total of 24 between the two airlines. CEA
plans for SAL to focus on shorter, regional routes while CEA
continues its expansion into longer, international routes, Shao
explained. Thus, ultimate disposition of the Boeing orders would
be for CEA to decide. (Note: China Eastern announced in late
December 2009 its intention to purchase 16 Airbus A330 aircraft
for delivery between 2011-14, a deal worth USD 2.6 billion. End
Note.)

--------------------------------------------- --------
Taking on Shanghai's Airline Means Taking on Shanghai
--------------------------------------------- --------

10. (SBU) Comment: On its face, China Eastern's acquisition of
Shanghai Airlines looks appealing for both sides since both
stand to gain from larger market share of one of China's most
lucrative aviation markets. Nevertheless, despite the assurances
received from China Eastern regarding continued branding and
employment, the Shanghai Municipal Government, given Shanghai
Air's close ties to local leadership, will surely miss the
ability to dole out patronage in the form of attractive senior
management positions. (Shanghai Executive Vice Mayor Yang Xiong
is a former president and chairman of SAL.) More than half a
year in the making, the deal has received widespread media
attention with speculation focused on the inherent bureaucratic
and political difficulties associated with consolidating a
centrally administered SOE and a firm controlled by a (powerful)
local government. End Comment.
CAMP

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