CATHAY AND DRAGONAIR ANNOUNCE MERGER

UNCLAS SECTION 01 OF 02 HONG KONG 002404 SIPDIS SIPDIS STATE FOR EAP/CM AND EB/TRA STATE PASS USTR TRANSPORTATION FOR PAUL GRETCH AND MARY STREET USDOC FOR ITA/EUGENE ALFORD AND ANN-MARIE CAMPBELL E.O. 12958: N/A TAGS: EAIR ECON PREL PGOV HK CH SUBJECT: CATHAY AND DRAGONAIR ANNOUNCE MERGER REF: HONG KONG 2335 SUMMARY -------------- ¶1. (U) In a joint news conference in Hong Kong on June 9, Air China and Cathay executives announced a deal that would lead to Cathay Pacific assuming 100 percent ownership of Hong Kong's second largest carrier Dragon Air. Cathay Pacific and Air China would each own 17.5 percent of the other. Cathay Pacific, Dragonair, and Air China would generate savings by code-sharing in passenger flights and combining support services, such as procurement, aircraft maintenance, and repair. As an indirect consequence of the merger, Air China's planned tie-up with the Star Alliance may fall through. End Summary. ¶2. (U) On June 9, Swire Pacific Chairman Christopher Pratt, Cathay Pacific Chief Executive Philip Chen, Air China Chairman Li Jiaxiang, China National Aviation Corporation (CNAC) Chairman Kong Dong, and CITIC Pacific Managing Director Henry Fan held a news conference to announce ownership changes among Cathay Pacific, Dragonair and Air China. Cathay Pacific is paying HKD 8.22 billion (USD 1.05 billion) to increase its share of Dragonair from 17.79 percent to 100 percent, paying about three times book value. (Swire Pacific, Cathay's parent, had also held 7.71 percent of Dragonair's stock; Cathay is also buying out the Swire share.) Dragonair will become a wholly owned subsidiary of Cathay, but would continue as an independent brand for at least six years. ¶3. (U) The Cathay-Dragonair combination will become the top foreign carrier in China, as well as the Asia-Pacific region's number one carrier in terms of revenue, by combining Dragonair's 23 mainland Chinese destinations with Cathay's profitable long-haul network. Cathay will also enjoy strengthened ties with the strongest of China's state-run carriers. Cathay Pacific will pay HKD 4.07 billion (USD 522 million) to double its ownership of Air China from 10 to 20 percent. However, Air China will issue new shares, diluting Cathay's share to 17.5 percent. Air China and its holding company CNAC will increase its share of Cathay to 17.5 percent. ¶4. (U) Cathay expects to generate cost savings by integrating Dragonair's back-office departments and management with its own. The two carriers should also be able to use their combined fleets more efficiently. Cathay's hopes that it can increase demand on Cathay's flights by offering attractive packages in combination with Dragonair. Cathay recorded a 78.7 percent load factor in 2005, 14.3 percentage points greater than Dragonair. Cathay Pacific and Air China also plan to establish a jointly-owned all-cargo airline based in Shanghai, with Air China owning 51 percent and Cathay holding 49 percent. ¶5. (U) According to Swire's Pratt, the negotiation for Cathay to assume control of Dragonair has been going on for more than two years. He said that 100 percent control of Dragonair was a "landmark development" in Cathay's history. The formation of a significant alliance with Air China would reinforce and strengthen Hong Kong's position as a global air hub. Swire would remain the controlling shareholder in Cathay, and the firm has no intention of further reducing its stake. (Note: Swire has a controlling, but not majority, ownership share in Cathay Pacific. Under the agreement, Swire's share of Cathay would fall from 46.3 percent to 40 percent, thus still higher than the 35 percent to be owned by Air China, CITIC, and CNAC. End note.) ¶6. (U) Air China's Li claimed that, although Air China and Cathay Pacific would only cross-hold 17.5 percent of each other's shares, their partnership would achieve the economic efficiency of a 50-50 enterprise. Cathay and Air China will generate savings by code-sharing in passenger flights and combining support services, such as procurement, aircraft maintenance, and repair. ¶7. (U) The Hong Kong Government was supportive of the deal. Secretary for Economic Development and Labour Stephen Ip told SIPDIS the press that "it would help strengthen Hong Kong's role as an aviation hub because both Cathay Pacific and Dragonair can make the best use of their network...We believe that it will also result in an increase in synergy and also help to enhance the efficiency of both companies." Hong Kong has no HONG KONG 00002404 002 OF 002 anti-trust legislation, and there is no likelihood of Government opposition to the merger because of competition concerns. A COMPLICATED WEB OF INVESTORS -------------- ¶8. (U) The deal actually involves five listed Hong Kong companies, all of which have a complicated web of cross-holdings, and all of which suspended trading between June 5 and 8 due to reports of the merger. The list below updates the information provided in reftel. o Cathay Pacific, the Hong Kong-based airline, which will assume 100 percent control of Dragonair, and eventually own 17.5 percent of state-owned carrier Air China. o Swire Pacific, a Hong Kong-listed entity of the British conglomerate Swire Holdings, who will own 40 percent of Cathay, higher than the 35 percent held by Citic, CNAC, and Air China. o Citic Pacific, a Hong Kong-listed red chip of the mainland financial conglomerate Citic. The firm's ownership of Cathay is decreasing from 25.42 percent to 17.5 percent. Cathay is purchasing its 28.5 percent share of Dragonair. o China National Aviation Company Ltd, the Hong Kong-listed red chip, which owns 43.29 percent of Dragonair, and is 66.36 percent held by Air China. o Dragonair, which was 97.39 percent owned by the four noted entities. ¶9. (U) Shortly before the merger was announced, Air China signed a Memorandum of Understanding to become a member of the Star Alliance -- which includes United and Lufthansa. This would have left Cathay, which belongs to the "oneworld" code-share alliance along with British Airways, American Airlines and Qantas, without a strong code-share partner on the mainland. After the merger was announced, however, there has been considerable speculation that Air China would pull out of its agreement with the Star Alliance in favor of joining "oneworld." Cunningham