It was a perfect deal and it had approval from the top levels of Chinese government. Singapore Airlines (SIA) and its parent company, Temasek, were set to purchase a 24% stake in Shanghai-based China Eastern Airlines.


It looked like a win-win situation for all parties. China Eastern, an unprofitable carrier with a reputation for poor service, would have gained the management expertise of Singapore Airlines, which is known for its superb passenger amenities and top-notch management. China Eastern would also have received a critical cash infusion that might have helped it convert rising passenger numbers into bottom-line profitability. Other winners would have included Singapore Airlines, which would have gained access to a second hub in Shanghai, and Shanghai-based passengers, who would have enjoyed vastly improved service from China Eastern. 


“There is no doubt that the 24% minority investment by Singapore Airlines, which is consistent with the new M&A rules issued in September 2006, would have been in the best interests of the traveling public in China, and would have improved the competitiveness and economic performance of China Eastern,” said Raphael Amit, a professor of management at the Wharton School. “The service culture and managerial practices of Singapore Airlines would have enhanced the efficiency, safety and effectiveness of China Eastern.”


But circumstance can change very quickly in China, and a few weeks after it was announced, the deal fell through. A rising stock market, an apparent government about-face, some behind-the-scenes maneuvering by a competitor and a dose of old-fashioned Chinese nationalism combined to scuttle the acquisition.


The failure of the SIA-China Eastern investment came as a shock to the foreign business community, and it even surprised Li Fenghua, chairman of China Eastern Airlines (CEA), that a deal that had received central government approval could be killed by CEA shareholders and competitor Air China, the largest carrier in the country.


But there are lessons to be learned. A close look at the aftermath of the failure offers a useful object lesson for any foreign company that wishes to make a high-profile investment in a Chinese company.


Indeed, the SIA-China Eastern investment is not the only foreign acquisition to recently run aground in China. As previously reported in China knowledge@wharton, the China Securities Regulatory Commission (CSRC) rejected Goldman Sachs’s proposed investment in Fuyao Glass for similar reasons. The deal was signed on November 20, 2006, at a price of RMB 8 per share. A year later, after many regulatory delays, Fuyao’s share price had risen to RMB 31. The application was then rejected on the grounds that the share price was too high and the valuation of Goldman’s original deal was too low.


China Eastern Courts Singapore Airlines

China Eastern, the biggest carrier in Shanghai but the smallest and weakest of the country’s ‘big three’ state-owned carriers (a group that also includes Air China and China Southern), has struggled to turn rising traffic into profits. China Eastern posted losses in 2005, 2006 and the first half of 2007. Last year, the airline started looking for a foreign investor that could inject foreign management expertise, and cash, into the struggling carrier.


Singapore Airlines began to show interest, and in September 2007, it signed a landmark deal with China Eastern. The HK$7.16 billion (US$918 million) offer, made through Singapore Airlines’ parent Temasek Holdings Pte, would give SIA a 24% stake in Shanghai-based China Eastern at HK$3.80 per share. The offer was for China Eastern’s newly issued Hong Kong-listed H-shares.


China Eastern Air Holding Co., the parent company of China Eastern, was also due to buy HK$4.2 billion worth of new shares at the same price as Singapore Airlines in order to maintain its majority under the deal.


The SIA investment then received approval from the Chinese government, including the State Assets Supervision and Administration Commission (SASAC). SASAC, an arm of the China State Council, China’s cabinet, controls the country’s big three carriers. After that, China Eastern only needed final approval from its shareholders.

China Eastern held three shareholder meetings on January 8, 2008, in Shanghai: one for holders of Hong Kong-listed H shares, one for holders of Shanghai-listed A shares, and one for holders of both. Each of the three groups needed to have two-thirds of the minority shares represented on the day of the meetings to approve the deal.


At the shareholder meetings, CEA’s minority shareholders rejected the proposed sale to Singapore Airlines and Temasek Holdings. The meetings came two days after China National Aviation Corporation (CNAC), a Hong Kong-based company that has the same parent as Air China (National Aviation Holding Co.), pledged to offer at least HK$5 a share for the stake in CEA – 32% more than the Singapore bid of HK$3.80 – should the Singapore Airlines deal be rejected.


A Victory for Air China

The shareholders’ decision was a resounding victory for China National Aviation Corporation (CNAC) and Air China. Beginning in May 2007, CNAC had been steadily buying China Eastern’s Hong Kong-listed H shares, eventually taking a 12.07% stake in the airline, enough to give it a strong minority position. At the shareholder meetings on January 8, CNAC voted against the deal.


CNAC’s ‘no’ vote came as an unexpected shock to China Eastern. During a road show highlighting the deal, Li Fenghua, chairman of China Eastern, told shareholders and the media that CNAC would not vote against the deal, because China Eastern had received official approval from the government.


An official from China Eastern also told Knowledge at Wharton that the Assets Supervision and Administration Commission had been applying pressure on some minority shareholders not to oppose the SIA investment.


Singapore Airlines and CNAC were not China Eastern’s only suitors. To further complicate matters, Air China’s parent, China National Aviation Holding Co., together with affiliate Cathay Pacific Airways, considered bidding for a stake in China Eastern last November. But their effort came to an untimely end due to opposition from the government. Air China and Cathay Pacific, Hong Kong’s largest carrier, own about 17.5% of each other following an agreement in 2006.


A Government About-Face

The government situation also changed dramatically before the shareholder meeting. The view that the government had decided to change its strategy for overhauling the airline industry was bolstered when former CNAC and Air China chairman Li Jiaxiang was promoted to head the General Administration of the Civil Aviation Administration of China (CAAC), the Chinese aviation regulator.


“Whereas his predecessor was more in favor of greater competition, Li Jiaxiang is well known as a supporter of consolidation in the Chinese airline industry,” said Li Lei, an aviation analyst at China Securities Co. in Beijing.


Indeed, Li Jiaxiang has publicly put forward a proposal to create a Chinese ‘super-carrier’ that can compete with foreign airlines. And last year, he expressed a desire to turn the company he once chaired, Air China, into that super-carrier, through expansion and cross-shareholdings with other domestic airlines, to compete with Singapore Airlines and other overseas rivals.


The ‘no’ vote at the shareholder meeting was the latest step in an unusually aggressive battle by state-owned Air China and CNAC to sabotage China Eastern’s planned tie-up with Singapore Airlines, which had already been approved by China’s State Council.


Analyzing the Government’s Change of Heart

Analysts believe CNAC would not have made such strong moves to kill the deal if it did not have some support from the government. But what made the government change its mind? 


The first reason was “China’s soaring stock markets. During the three-month process of gaining government approval for SIA’s offer to buy the 24% stake, CEA’s Shanghai-listed shares surged 160% in value. By the time the shareholder meeting finally occurred, the deal had already lost much of its gloss,” said Luo Zhuping, the directorate secretary of China Eastern.


The HK$3.80 per share offer from SIA and Temasek, Singapore’s state investment agency, represented a 36% premium over the average of the previous 30 days before share trading was suspended on May 22, 2007. But China Eastern’s share price surged to HK$6.15 by January 2008, nearly double SIA’s offer, and its Shanghai shares were trading nearly six times higher. “The share price’s rise is in line with the overall market,” said Li Lei, an analyst at China Securities Co. in Beijing. As a result, the huge gap between SIA’s offer and the market price made it a deal that shareholders could not accept. And SIA, for its part, has consistently refused to raise its bid.


Another reason for the government’s change of heart is “old-fashioned Chinese nationalism,” said Li YiXin, an expert on the airline industry. “The sale of state assets to foreign companies is a delicate issue for the Chinese government. On the one hand, the authorities want to appear open to foreign investment, especially deals that promise to bring needed management skills. On the other hand, the government does not want to help foreign groups enter the Chinese market by selling the assets of Chinese companies.”


“Although the approval for the deal was given many months ago, the central government is clearly no longer happy with the terms,” said an official from Air China, who preferred not to use his name. “Nationalist sentiment is still very strong in China now, so we think that CEA selling shares to SIA will threaten China’s aviation resources.”


In fact, government officials have various opinions about foreign investment. Some officials, including Yang Yuanyuan, the former head of the Civil Aviation Administration of China (CAAC), are pro-competition. Yang has said that he “personally wouldn’t agree” with a merger between Air China, China Eastern and the country’s largest carrier, China Southern Airlines, because China’s aviation industry needs competition.


Independent analysts agree with that pro-competition assessment. “China is a big country with large areas, so there cannot be only one airline operating in the country,” said Sylvain Grados, regional manager of Air France in Shanghai.


China Eastern Rejects Air China in Favor of SIA

At stake in the battle is Shanghai, the home base of China Eastern. Shanghai is the number two air travel destination in China, after Beijing, and the city handled a record 51.6 million air passengers in 2007, up 12% from the previous year. At the end of 2007, 71 carriers flew routes to Shanghai, connecting it with 179 cities worldwide, according to the local airport authority.


For Air China, the largest carrier in the country, a tie-up with China Eastern would add a coveted Shanghai base to its operations in Beijing and Hong Kong. And for SIA, a deal with China Eastern would give it greater access to Shanghai, making it SIA’s second hub after Singapore’s Changi Airport.


For now, the situation seems to have stagnated. The China National Aviation Corp. (CNAC) proposal, which would provide China Eastern with a capital injection of at least HK$14.9bn ($1.9bn), came two weeks after CNAC scuttled the planned investment by SIA and Temasek.


In that proposal, CNAC proposed that it become an ‘alliance partner’ with China Eastern through buying up to 30% of CEA for at least HK$5 per share. But the China Eastern board rejected the offer from CNAC and Air China, and instead wanted to continue to pursue a tie-up with Singapore Airlines. CEA said that the Air China offer didn’t show a “sincere intention” to cooperate.


“The management and board of CEA acted in a responsible manner in rejecting the higher of CNAC,” said Wharton’s Amit.


Clearly, China Eastern would rather join forces with Singapore Airlines. China Eastern Chairman Li Fenghua says an alliance with CNAC and Air China would be less beneficial than one with Singapore Airlines, because CEA needs overseas expertise.  “Singapore Airlines would be better able to improve China Eastern’s services,” Li said. “As a barely profitable carrier, we can graft SIA’s superior technology, planning and marketing know-how onto our company.” Rejection of the Singapore Airlines deal will force China Eastern to postpone development plans, he added.


Temasek Holdings and its Singapore Airlines are still interested in buying a stake in China Eastern, said Ong Beng Teck, Temasek’s managing director of investment. However, SIA will not budge from its original offer of HK$3.80 per share. “Singapore Airlines is not considering revising our proposal to buy a stake in China Eastern Airlines to win over shareholders of the Chinese carrier,” Chief Executive Officer Chew Choon Seng told China Knowledge at Wharton. “We have our own criteria and our own business plans.”


For now, the deal is on hold. “There is unlikely to be any major breakthrough in the stake transfer in the short term,” said Li Lei, the analyst at China Securities. The key hurdle is that it would be very difficult for CNAC and Air China to get approval from China Eastern’s management. However, China Eastern “needs to get a better offer, or at least the same price, to convince shareholders to reject the Air China deal.”


In any case, China Eastern, which says it will continue to pursue cooperation with Singapore Airlines, cannot consider other offers between now and August because of an ‘exclusivity’ clause that was included in the bid by the Singapore investors, according to a note to shareholders.


Time is not on China Eastern’s side, as the carrier urgently needs to improve its poor services and its suffering bottom line. “The longer the sale is delayed, the worse it is for China Eastern,” said Ma Ying, an analyst at Haitong Securities Co. in Shanghai. “They need a partner to help to improve their operations.”


However, an official from China Eastern told Knowledge at Wharton that it would be difficult for China Eastern to take any action until the government has a clear attitude toward the deal. And that doesn’t appear imminent, as the government still hasn’t appointed a new chairman of China National Aviation Holding Co.

Whatever happens, the case has already become a landmark. “Whether we can succeed in cooperating with SIA or not, the case will become a touchstone and an orientation for China’s aviation industry,” said Luo Zhuping, the directorate secretary of China Eastern.

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