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Tickers in this Article: CEA, ZNH
Just 20 years ago, flying in mainland China meant state-run monopoly CAAC. This stood for "Civil Aviation Administration of China", but unofficially it really meant "China Airlines Always Crashes".

Much has changed in the past twenty years, and CAAC has evolved into a somewhat competitive industry structure. The big three players are Air China, with a leading position in Beijing, China Eastern Airlines (NYSE:CEA) with a 35% market share in the busy Shanghai hub, and China Southern Airlines (NYSE:ZNH) based in economically robust Guangzhou Province across the Pearl River from Hong Kong. In this article we'll run down the recent events for China's big air carriers to determine if the country's growing air travel demand will equate to solid returns for investors.

Recently, Singapore Airlines, regarded by many as the premier brand in the lucrative Asia Pacific airline industry, got the green light from Beijing to go ahead with its intended purchase of a 24% strategic equity interest in China Eastern. Can one of the world's most successful airlines bring its legendary operations and style (personified by its long-running Singapore Girl icon) to a financially troubled carrier still tethered to a cumbersome state bureaucracy?

Chinese Style M&A
The Singapore Airlines bid calls for acquisition of a 15.7% stake in China Eastern for $4.7 billion Hong Kong dollars (approximately US$610 million) and for Singapore Air's parent company, Temasek Holdings, to take an 8.3% stake for HK $2.5 billion (approx. US$325 million). The combined 24% stake will consist of newly issued H-shares, resulting in the Chinese government, the owner of China Eastern parent company CEA Holdings, holding a 51% simple majority interest. Current regulations prohibit foreign investors from holding majority stakes in Chinese airline companies.

Trading in China Eastern shares, was suspended on May 22 following the initial announcement of the proposed deal. On September 3, trading reopened with an immediate 64% pop and proceeded to leap ever higher amid rumors that rival Air China and its own strategic partner, Hong Kong-based Cathay Pacific Airlines, were preparing to launch a counter bid. In fact, they did just that on Friday, September 24, only to promptly pull the bid off the table the following Monday for reasons widely assumed to be more political than economic. That took some of the speculative gloss off China Eastern, though as of market close October 1, it was still up 300% YTD with an eye-popping price-to-book ratio of 14.7, based on the June 30, 2007 balance sheet. (To learn more on the price-to-book ratio, see Value By The Book.)

Just What the Doctor Ordered?
Still, Singapore's bid may be just what China Eastern needs to improve its operations and solidify its domestic positioning in advance of next year's Beijing Olympic Games, a potential boon for the airlines. The company's revenue has grown nicely at a 30.1% compound annual growth rate over the past four years. However, it's all the stuff between the top line and the bottom line that has been the problem, resulting in anet loss of approximately US$453 million for the fiscal year ended December 31, 2006 and about US$3 billion of long-term debt on the balance sheet. That's the kind of financial condition that screams out for foreign strategic investment. Beijing's visible and firm support for this deal is evidence that the Chinese authorities want just that - to see their airlines become more profitable and compete effectively with the established regional carriers in other Asia Pacific countries.


Et Tu, China Southern?

China Southern's shares started to trend up after the China Eastern announcement in May and are up 255% year to date. From a valuation standpoint China Southern is a somewhat more attractive with a price/book ratio of 4.9 and a net profit, albeit modest, of US$29 million for the year ended December 31, 2006. So far, no potential tie-ups with foreign strategic partners have come across the radar screen. With regional leaders Singapore and Cathay Pacific already engaged, the deal speculation shifts to Japan or possibly one of the Middle Eastern carriers that are trying to make further inroads into the lucrative Asia Pacific region.

Conclusions
Chinese airline shares are neither cheap nor particularly profitable. However, there are few, if any, dissenting voices to the view that air traffic to and from China is only headed in one direction - up. Strategic partnerships like we are seeing with China Eastern and Singapore Airlines could actually make all this increased traffic profitable, and that could be worth the rather expensive price of entry.

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