Air China-Cathay Pacific move to shake up Star Alliance and oneworld

Air China moves to 29.99% ownership of Cathay

CITIC Pacific will sell a 12.5% shareholding in Cathay Pacific to Air China for an aggregate consideration of approximately HKD6,335 million (USD817 million), representing a price of HKD12.88 per Cathay Pacific share, and a 2% shareholding in Cathay Pacific to Swire Pacific for an aggregate consideration of approximately HKD1,013 million (USD131 million).

This means Air China's stake in Cathay Pacific will increase from approximately 17.49% to approximately 29.99% (just below the 30% threshold that will require the Chinese company to make a mandatory offer for Cathay's shares).

Swire Pacific's stake in Cathay Pacific will increase from approximately 39.97% to approximately 41.97%. It stated, "Swire Pacific regards its acquisition of additional shares in Cathay Pacific as confirmation of its full support for Cathay Pacific and confidence in its future as one of the world's leading airlines and of its commitment to enhancing Hong Kong as Asia's premier aviation hub".

But Swire had little choice but to tip in further funds, to prevent its stake being diluted - and to avoid the mandatory offer trigger.

The proposed changes follow on from a major shareholding restructuring announced in June 2006 that saw:

• Air China make a strategic investment in Cathay Pacific;
• Cathay Pacific increase its strategic investment in Air China;
• Dragonair become a wholly owned subsidiary of Cathay Pacific; and
• Air China and Cathay Pacific enter into a strategic relationship that included reciprocal sales representation, the extension of codeshare arrangements between Hong Kong and Mainland China, the proposed development of a cargo joint venture in Shanghai and the strengthening of business cooperation in a number of other areas.

Air China snaps up Cathay bargain

Air China's acquisition of its initial 10.16% interest in Cathay Pacific was priced at HKD13.50 per share, so the current transaction represents a 4.6% discount since the original purchase over three years ago.

Massive fuel hedging losses last year and the global economic downturn have taken the wind out of Cathay's expansion plans - and its share price.

Overall, it is a good time for Air China to buy another block of Cathay Pacific's shares, with the business well positioned to benefit from the uptick in the regional economy, when it comes.

Profit potential aside, Air China has other reasons for increasing its stake in Cathay. It noted in response to the latest transaction that by increasing its shareholding in Cathay Pacific, the airlines can "form a closer cooperative relationship that will serve as a platform for further cooperation between, and generate greater synergy for, Air China and Cathay Pacific".

But, in the process, it makes life a lot more complicated for the global alliances.

The Beijing-based carrier added, "this increase in shareholding will be useful in terms of boosting the international competitive strengths and brand value of Air China." This brand-effect is precisely the benefit Air China used at the time of the initial Jun-2006 transaction - and later denied to China Eastern in its successful effort to scuttle Singapore Airlines' bid for the struggling Shanghai-based airline.

Citic Pacific exiting non-core investments

For Citic Pacific, the price represents a reasonable result. It can thank the massive rally in Chinese stocks since Mar-2009, with Cathay well ahead of its 52-week low of just HKD6.90 per share. China's stock market rally has shown signs of running too far ahead of the economic fundamentals, with a major correction now apparently under way.

The change in ownership has been facilitated by Citic Pacific's (long-term) agenda to dispose of non-core assets. Following the transaction, the Chinese conglomerate's stake in Cathay Pacific will fall to 2.98% from 17.5%. Citic Pacific's remaining stake could also be offloaded in future, to raise capital for the struggling company, but it will be interesting to see who picks up this stake, given Air China's position at the limit of its shareholding in Cathay.

oneworld or Star?

However, the big unanswered question for Cathay and Air China is when will they align their alliance platforms. With unaligned (but oneworld-leaning) China Eastern forced into a merger with home-town rival and Star Alliance member, Shanghai Airlines, China Eastern would probably lean towards Star, once it gets its house in order. It would also be expected to court Star member, Singapore Airlines, once the Shanghai Airlines deal is digested and the industry is on a surer footing.

Which leaves Air China to consider its Star Alliance future, particularly as its influence at oneworld partner Cathay continues to grow. If "boosting the international competitive strengths" of Cathay-Air China really is a key driver, the alliance question must be resolved at some stage.

From Beijing's point of view, it is preferable for its three major carriers to straddle the three global alliances. China Southern is embedded in SkyTeam and it would certainly not be helpful (to any of the airlines either) to have both China Eastern and Air China in Star.

That leaves China Eastern again the Cinderella. Its acquisition of Star Alliance's Shanghai Airlines leaves the residual question of whether the usual "poison-pill" provision would apply for withdrawing - probably not. So, with its existing oneworld leanings, that would appear its natural progression.

The more so if Air China pushed Cathay Pacific into the Star team. oneworld however is much more relaxed about overlapping bilateral allegiances - and Air China would be quite content to straddle both alliances in this way, particularly if it further undermined China Eastern's soggy attempts at survival.

Meanwhile, the pencils will again be being sharpened at Star and oneworld headquarters. Access to the China market will be essential for each of them in the future. The alternative will be to miss out on much of the massive growth which China will inevitably display over the coming years.