"The management of Shanghai Airlines was mostly opposed to the merger, because they are wary of their company losing its identity after the tie-up. In addition, no one would like to be acquired by a rival with a poorer performance record," said an analyst on condition of anonymity.

China Eastern had also remained lukewarm to the merger because its management, under the newly installed chairman Liu Shaoyong, was busy grappling with the myriad operational and financial problems facing the company.

The carrier said it plans to introduce a revised business model focusing on hub operations and also tackle the huge hedging losses as a result of wrong bets on fuel price movement.

But none of these considerations mattered when the parents of the two carriers reached a consensus on marriage.

Alliance planned

In 2008, the domestic aviation industry saw its fortunes nosedive with combined losses mounting to 28.2 billion yuan, prompting the SASAC to consider a consolidation in the aviation sector.

Around this time, the Shanghai municipal government was also quickening its steps to build a super size local carrier.

Hint of the impending marriage came on March 25, when Fan Hongxi, general manager of Shanghai Airlines and Zhou Xiao'e, his deputy, announced their decision to retire, six months ahead of time. The company did not name their successors, and their posts were temporarily taken over by chairman Zhou. "This was a clear signal that a merger between the two carriers is in the offing," a Shanghai Airlines employee said on conditions of anonymity.

Zhang Xun, analyst, TX Investment Consulting, said the merger of the two carriers is a prelude for Shanghai becoming an international aviation hub. "As early as 2003, the Shanghai municipal government worked out a strategic plan to transform Shanghai into an international air transport hub in the Asia-Pacific region, as well as a key link in the world's aviation map," said Zhang. According to the plan, Shanghai was expected to achieve the goal by 2015 when passenger traffic was slated to touch 110 million passengers a year and cargo flow 7 million tons.

Daunting task

Hit by the global economic downturn, passenger traffic in Shanghai dwindled to 51.12 million in 2008. To achieve the above-mentioned goal, air traffic would have to grow at an average rate of 20 percent a year to reach the projected number of 84 million in 2010. That on paper looks too daunting to achieve in the next two years considering the slow pace of economic recovery.

The only solution within the control of the authorities was to eliminate the perceived domestic problems that inhibit growth. These included fragmentation of the market and undue competition between the two Shanghai-based airlines.

"The segmented market share and intense competition between two city-based carriers disrupted Shanghai government's timetable and hence called for immediate action," said Yao Jun, analyst, China Merchants Securities.

Shanghai's economic planners have also noticed the intense efforts of the out-of-town carriers in their bid to grab market share. Both Air China and China Southern have greatly expanded their presence in Shanghai in the past several years anticipating the increase in passenger traffic in 2010 due to the World Expo.

"Shanghai needs a strong local airline to defend its turf," said Yao. Experts estimate that the World Expo Shanghai 2010 could bring nearly 70 million tourists to Shanghai from other parts of the mainland and abroad.

Preparations for the merger seemed to have reached the finishing stages when Shanghai Airlines announced on June 19 it would raise 1 billion yuan from its third largest shareholder Jinjiang International Holdings in a 222 million new share issue. A few days later, China Eastern also announced a private placement of 7 billion yuan worth of new shares.

"These announcements indicated that the two carriers were trying to raise new capital to strengthen their financial structure before a merger," Li Lei, analyst, CITIC China Securities, said.

Air pockets ahead

A partnership of weaklings isn't going to impress anyone, he said. "Two minuses don't make a plus in the business world."

Sources close to the carriers revealed that China Eastern has hired China International Capital Corporation Ltd (CICC) as its financing consultant for the restructuring, while Shanghai Airlines has roped in Haitong Securities as its financing consultant.

Though the two carriers have all the makings of a promising airline group, the previous purchase experiences have made China Eastern wary. During an industry-wide consolidation in 2002, China Eastern expanded dizzily by taking over Great Wall Airlines, Wuhan Airlines, Yunnan Airlines and Northwest Airlines. However, except the acquisition of Great Wall Airlines, the rest have all been unsuccessful marriages due to bad localized management and overstaffing.

Rival carriers also cast doubts on the "weak-weak" merger. "The consolidation of China Eastern Airlines Corp and Shanghai Airlines might not create a stronger carrier. I don't think putting two weak carriers together would necessarily make a stronger one," said Christopher Pratt, a top executive from Cathay Pacific Airways, after the two carriers set up a task force to proceed with the merger.

"The two carriers' combination is mostly driven by administrative forces. We cannot say such a tie-up would generate great outcome, but the carriers, especially China Eastern should learn how to digest its former rivals' assets," said the anonymous analyst. "If this combination proves successful, we will see more restructuring actions across the aviation sector in following years, including the participation of some international airlines with abundant experience and expertise," he said.

(China Daily July 14, 2009)