Hong Kong's Cathay Pacific Airways is to acquire 9.9% of Air China during its pending initial public offering in a surprise move that has the potential to change all assumptions about strategic alliance ambitions of the major Chinese carriers.

The tentative agreement caught financial analysts and industry observers off guard, as there had been no hint such a deal was even being discussed. It has long been assumed that flag carrier Air China will eventually join the Star Alliance, and its codeshare partner and founding Star member Lufthansa had been rumoured as a possible equity investor. Cathay is a member of the rival oneworld grouping, however, and that alliance would hope the deal keeps Air China out of Star.

Under the terms of a memorandum of understanding (MoU), Cathay will acquire the near 10% stake at the time of Air China's initial public offering (IPO), which is expected shortly. After the IPO Air China's shares will trade on the Hong Kong stock exchange and probably another international exchange such as London. Analysts estimate the stake may cost Cathay around $200 million.

Air China will be the last of the Chinese "big three" to be listed outside China, but the first to have another airline as a strategic investor. Both Shanghai-based China Eastern Airlines and Guangzhou-based China Southern Airlines are traded in Hong Kong and New York. Some observers believe the Air China-Cathay deal will prompt the two other major carriers to seek foreign airline equity partners of their own.

If consummated, the deal will be regarded as a win-win partnership. Air China's IPO will immediately gain credibility as Cathay is an admired, conservative company that chooses its investments carefully. Air China can also draw on Cathay's expertise in management and onboard services. It already does the latter, as it recently agreed a deal under which it will send cabin crew recruits to Hong Kong for a year of training. Cathay has a similar tie-up with China Eastern.

Cathay and its main shareholder, UK-controlled but Hong Kong-based conglomerate Swire Pacific, have been seeking to expand their ties with Chinese airlines, given the vast potential of the market. Cathay has had limited success, however, as its initial partnership target, China Eastern, rejected its advances.

Cathay flew to China until 1990 when it bought into Hong Kong's Dragonair and handed over all its mainland routes to this carrier. Although Cathay still has a minority stake, Dragonair has since come under the control of Chinese interests and focuses heavily on operations to the country, where passenger traffic is growing at double-digit percentage rates.

After a bitter public fight with Dragonair last year, Cathay managed to return to China, albeit with just three weekly flights to Beijing. It recently secured rights to increase that frequency to daily, but it especially wants passenger rights to serve Shanghai, which it cannot secure until late 2006 under a recently reviewed air services agreement. It clearly hopes a link with Air China will advance its ambitions and help it expand its China route network.

But Dragonair makes most of its money from China services and has sought to prevent Cathay from competing with it. Given that Cathay is a minority stakeholder with board representation, this highlights just how convoluted Hong Kong's aviation sector is in terms of ownership ties and vested interests.

In part because of this complicated ownership scenario, it will be some time before the impact of the proposed Air China-Cathay partnership becomes clear - such as what this means for the world's alliances and, perhaps more importantly, for Dragonair and its future plans.

All three major alliances have been seeking a member in China for some time and the situation is shaping up towards Air China joining Star, China Eastern becoming a oneworld member and China Southern joining SkyTeam. China Southern recently signed a tentative agreement to join SkyTeam, but to date it is the only Chinese carrier to have committed to an alliance.

Air China and Cathay say their MoU "sets out the framework for discussing, among other things, the objective of exploring the opportunities for developing a close partnership and co-operation between the aviation and related businesses of Cathay Pacific and Air China in Hong Kong and mainland China".

They add: "The potential alignment of the networks of Cathay Pacific and Air China should assist in further developing and maintaining both Hong Kong airport and Beijing Capital airport as gateways to, and hubs for, mainland China."

Air China has close ties to several key members of Star, such as Lufthansa and United Airlines. It codeshares with both these airlines, as well as with smaller Star members, while Air China and Lufthansa are joint venture partners in maintenance company Ameco Beijing.

Star chief executive Jaan Albrecht says he is not concerned about the Air China-Cathay tie-up, insisting that Air China is still the preferred carrier to join the alliance and saying that operational relationships are separate from financial arrangements. Although anything is possible, for now Cathay's surprise move makes the picture anything but clear.

Hong Kong's tangled airline ownership web

Cathay is more than 40%-owned by Swire and 25%-owned by China-backed Hong Kong-based conglomerate CITIC Pacific. Cathay, Swire and CITIC are direct minority shareholders in Dragonair, which counts another China-backed, Hong Kong-based company, China National Aviation (CNAC), as its biggest single shareholder, with 43%. CNAC is directly controlled by Air China, which in turn is controlled by CNAC's ultimate parent, Beijing's state-owned China National Aviation Holding. CITIC is a minority shareholder in Air China Cargo, which is majority owned by Air China.


Source: Airline Business