FLYING TANDEM
Xu Jiebo may be CFO of a publicly listed company, but he has company in the cockpit - namely, his largest shareholder, CAAC. Does he have enough freedom to make China Southern Airlines soar?
By Enid Tsui

Take off, It's an aviation term that has become synonymous with any thrusting enterprise that soars away from the mediocre, any project that makes the leap into a triumphant new world after a laborious build-up. In fact, it's turned into a tame cliche, hauled into use whenever there is a need to describe the success of China's multi-faceted new economy. Ironically, it is seldom applied to China's air industry.

So far, there isn't a single Chinese airline that has built up the traffic, the profits or assets that come close to any of the international players. This seems odd when you consider that tiny United Arab Emirates has its own international air carrier. And it seems increasingly odd now as China's aviation sector is growing faster than anywhere else in the world.

This year, China's total commercial air traffic will jump by 10 percent, compared to a 10 percent drop worldwide. So why doesn't China have a world-class air carrier? The answer is simple - there are too many operators. No less than 44 independent commercial airlines operate in the domestic market. Xu Jiebo, CFO of China Southern Airlines (CSA), knows this better than most. His ambition? To turn China Southern into a world-class airline.

This hope, however, depends on some help from his largest shareholder and the one he can influence the least - the Civil Aviation Administration of China (CAAC). China Southern is a publicly listed company, with shares traded in Hong Kong and New York, but its CFO is currently working hand-in-hand with the CAAC on plans he hopes will secure greater value for all its shareholders. Can he succeed? Read on.

On April 27, 2001, the authority announced blueprints for the consolidation of the 11 CAAC-controlled airline operators. The plan is to roll the smaller companies under the wing of the three dominant ones - China Eastern Airlines, Air China and China Southern Airlines.

Showing unusual haste, CAAC wants to see all the mergers completed by the end of this year. Few governments in the world can introduce this kind of grand reform at one stroke - imagine the US Federal Aviation Administration telling American airlines to merge within 16 months! The fact that CAAC is the majority owner of all 11 airlines does speed things up a bit. Reform of such scale and urgency, affecting a total of 70,000 employees, is best led by a central authority. Still, both China Eastern and CSA have a subsidiary shareholding company listed in Hong Kong and New York. The China Eastern subsidiary is also listed in Shanghai.

For Xu, the next 6 months will be tough ones. "We are merging with Xinjiang Airlines and Northern Airlines. This will involve removing overlapping flight routes, retiring and upgrading the older jets owned by the two airlines, and redistributing our combined human resources," he says. Luckily, CSA is used to enormous overhauls.

In 1993, the CSA Group was created when the CAAC Guangzhou office, a combination of a regional regulatory body as well as a commercial aviation conglomerate, split up into four separate entities, including a fuel retailer, the Guangzhou airport authority and CSA Group. A similar exercise was carried out in Beijing and Shanghai, creating the Air China Group and the China Eastern Airlines Group respectively.

The restructuring left the regional offices still bearing the CAAC name, in this case CAAC Central-Southern Administration Bureau, focusing on regulations and air safety. It also freed the commercial arms to modernize their management structure, set up subsidiaries and seek external financing.

Letting Go

Almost immediately, the then CFO of the new CSA Group, Zhu Deci, announced that he wanted to list the company's shares. Although China Southern was one of three main domestic operators with close to 30 percent domestic market share, it was also a bulky, over-diversified company, saddled with an advertising company, a property developer, and a whole lot more non-aviation related businesses.

In order to launch an IPO it needed to slim down. So, in March 1995, CSA was created through an injection of the group's core aviation businesses. After more delays, the IPO finally took place in July 1997, raising US$1 billion largely through issuing H shares in Hong Kong and ADRs in New York. The result, however, was more than a money-raising exercise. Xu says: "As a publicly listed company, we report to a wider shareholder base, meaning there are more people watching over us. This gives us the impetus to improve our efficiency and profitability quickly. Also, the listing allowed us to optimize our capital structure, as well as getting to grips with international finance standards."

CSA used most of the proceeds to buy new planes, repay US-denominated debts and upgrade various IT systems. Today, the listed arm remains the brightest star in the CSA Group, which is typical of a state-owned enterprise. Xu is well prepared for the challenges he now faces, having spent his whole working life in the aviation industry. He studied engineering and management at Tianjin University, which gave him solid grounding in both the technical aspects of operating airplanes and prepared him as a manager.

He first joined the finance department of CAAC's Guangzhou subsidiary, and after the 1993 restructuring moved up to become the finance manager of the CAAC Central-Southern Administration Bureau. In July 1998, he joined CSA as the general manager of the finance department and was promoted to CFO and director in 2000.

Today, he runs the finances of the largest air operator in China in terms of numbers of passengers, flight routes and planes. CSA is the majority owner of four regional operators in southern China and also runs around 50 international routes. So far, shareholders have been kept reasonably happy. The company has recorded operating profits since 1996, though it had a bad year in 1998 when it reported a net loss of US$61 million.

Business has picked up since - net profit for 2000 was US$61 million on sales of US$1.8 billion, six times that of 1999. As for its safety record, its last crash was in early 1997 and CSA has since invested in a pilots training school in Australia. The company also owns one of the youngest fleets in China, with few planes older then six years.

Heavenly Timing

Xu is very positive about the proposed merger plan and claims the CSA Group was given the option of choosing its future partners. In fact, he's positively poetic about it. "There's a popular Chinese saying that to get a new project off the ground, one needs tienshi (heavenly timing), dili (favorable location) and renhe (harmonious relationship). We've got all three," says Xu. "My definition of heavenly timing is how the three airlines will be able to complement each other with different peak and low seasons. The countrywide network resulting from the merger will give us three favorably located operational hubs," he adds. "Also, we enjoy overwhelming support from management and staff from all three companies - that's the human aspect," he says.

Specifically, since CSA's major routes are concentrated in the south where the climate is moderate all year round, the number of visitors arriving is more or less the same each month. It's very different in the north.

Northern Airlines, he explains, sees a sharp peak during the Harbin Ice Festival, though northern cities also receive a rush of visitors between the warm months of April to October. "And in the winter, our own Hainan route is extremely popular," Xu adds. What he expects to see is that, once the three fleets are slimmed down, the load factor and the proportion of planes mobilized can improve throughout the year. This can make a huge difference in the airline's operational efficiency. The fixed costs of running an airline are incredibly high. For example, it cost CSA over US$604 million in 2000 on aircraft lease payments, maintenance, depreciation and amortization.

The main benefit of merging, according to Xu, is to give CSA the power to cut surplus routes. Until now, Xinjiang Airlines and Northern Airlines have been competitors, and if either one started a new south-north route, CSA would have to follow. Though the situation has somewhat improved following the gradual introduction of code-sharing among competing airlines, Xu expects a significant reduction of the CSA Group flight network. "The future network will be centered on three hubs - Guangzhou, Urumqi and Shenyang. We'll be able to spread our operational resources between them and cut overlapping routes and expenditure," says Xu. "Also, the network forms a big triangle stretching across the country. It'll make it easier to expand our market coverage," he says.

Tim Ross, head of transportation research in Asia at UBS Warburg in Hong Kong agrees. "CSA's grouping will see more routes overlapping than both the Air China or the China Eastern Airlines grouping. The merged network, once it has been trimmed, will be a lot more efficient," he says. Surplus and overlapping routes is a serious problem in China at the moment. The average load factor in China is only around 60 percent. "That's why so many airlines are operating at a loss," Ross says.

The Master Plan

And what does Xu think of the fact that the merger is mandated by a ministerial authority? He claims he has absolutely no problem with it. "We are a listed company and CAAC fully supports our adherence to market rules," he says. CSA's parent group will absorb Xinjiang Airlines and Northern Airlines some time this year, he explains.

That's stage one. In stage two, the shareholding company, CSA, will get to choose which assets owned by the two airlines it would like to acquire, pending approval by its minority shareholders, of course. CSA Group will have no say in this because such an acquisition will be treated as a connected transaction since, by then, the two smaller airlines will be owned by the parent group. He is confident that CSA will get the green light from shareholders because the company will only take over operations that will add value to the operations.

Also, he believes that if Air China and China Eastern Airlines do the same, CSA can only remain competitive by merging. Otherwise, CSA will join the ranks of the 30-odd small regional players that are fretting because they will be severely disadvantaged by the bulk of the CAAC giants. Aviation experts agree. Independent aviation consultant Peter Harbison of Sydney-based Centre for Asia Pacific Aviation says the mergers are an essential development for China's aviation sector. He explains that globally the sector is changing rapidly. "China has to consolidate, really, before the country further opens up its aviation sector to the rest of the world," he says.

Harbison says the same process of consolidation in Europe and the US took two to three decades. "There, the strong international operators were able to grow from a strong, captive domestic market. China's domestic market is fragmented and competition is unstructured," he says. The proof can be found in the figures: in 2000, CSA's net profit margin was 3.3 percent. The margin for Hong Kong's Cathay Pacific was 14.5 percent, and for Singapore Airlines, 15.6 percent, though CSA is expected to suffer less from the September 2001 events than its international counterparts.

Big Move

At the same time as this consolidation, CSA remains heavily involved in Guangzhou's new airport, which is scheduled for completion by the end of 2003. CSA has committed US$435 million to the move itself as well as building new support facilities for its own operations at the new site. Most of the funding for this will have to be borrowed from banks, while 30 percent will come from the company's own resources.

Is Xu overstretching his company considering the demands of the merger which should be completed by the end of the year? According to the company's annual report, it's net debt (total borrowings net of cash and cash equivalents) amounted to US$1.4 billion as of December 31, 2000. Meanwhile, shareholders' equity came to US$1 billion, giving a net debt/equity ratio of 1.3 times. These figures have not taken into account the amount needed for moving to the new airport.

According to Xu, the company has only recently begun to negotiate the total of US$302 billion loans needed for the airport project and expects to receive it in separate tranches up to 2003. That's quite an increase in gearing. The airline industry is, by nature, highly leveraged, but in China it is even more so. "Most airlines are majority held by municipal governments. Add to that the fact that Boeing and Airbus have been trying to establish dominance there. Chinese airlines, as a result, have enjoyed generous lending terms from domestic and foreign banks so the temptation is to go on borrowing," says UBS Warburg's Ross.

But if you think CSA has a daring capital structure, you've seen nothing yet. The company is committed to buying another two 747 freighters and 20 737-800 passenger planes from Boeing before 2005, and plans to finance the purchases with more loans. As of June 2001, CSA has committed US$387 million towards buying new planes and flight equipment. That, according to Boeing's catalogue, will just about cover the two 747 freighters. The price of the 20 737s should come to around US$1.2 billion, which will be paid through leasing arrangements.

Truth is, Xu and his colleagues rather wish they hadn't signed for them now. Since the September 11 tragedies in the US, the dip in traffic, and the fact that European and US operators are canceling their leasing orders have meant that it has become more economical to rent planes than to buy them. "The State Council approved our purchases before September 11 and we are under contractual duty to complete the purchases, even though we would rather rent the planes," says Xu. "We are currently having further negotiations with Boeing to see if they can possibly give us a discount. After all, the air industry is facing tough times and we should help each other pull through," he says.

Xu has gone to great pains to seek financing for the planes. Fortunately, he won't have to borrow all of it since a new listing on the mainland's A-share market, set for the end of this year, appears to be going smoothly. Also, CSA managed to convince the Hong Kong Stock Exchange that different disclosure requirements should apply to the acquisition and disposition of its aircraft. Under the conventional net asset and consideration tests, the value of a new jet almost certainly triggers the need for disclosure under chapter 14 of Hong Kong's listing rules on acquisition and disposition of assets. The new test - the so-called available ton kilometers (ATK) test - is based on the maximum capacity of a new plane and the distance of a regular journey. The ATK test is a better measure, argues CSA, of how an acquisition (or disposition) of aircraft affects the company's operating results.

To date, there's been no news on how much CSA aims to raise from the new listing, but analysts generally agree on US$362 million. The rest, says a company press release, will be made up by further bank loans. The company has made it clear that the listing proceeds will not be used to finance the mergers.

Caveat Emptor

In fact, the company has not made any announcement on how it plans to cope with the additional burden of the mergers, assuming they are going ahead. Xu says he is not particularly worried with today's gearing. After all, China Eastern Airlines has 2.3 times more debt than equity. United Airlines in the US has three.

Unfortunately, with the government sharing the controls for the moment, Xu is flying through some pretty dense fog. He actually says he doesn't know how much he will need to raise to fund the mergers. It is a curious situation. While senior managers from CAAC and the three airline groups remain confident, at least in public, that the merger of all state-owned assets will be completed by the end of this year, it is not unusual to read of rifts between the partners in the press.

On the positive side, Xu claims that CSA has not made any promises or commitments so far and it's only the parent group that has agreed to merge with Xinjiang Airlines and Northern Airlines. But he can give no figures for the two airlines at this moment, he says, since the parent group has yet to complete the audit on their accounts.

At the same time, CSA shareholders have not been told the kind of assets, apart from the obvious, that CSA will be interested in. Xu continues to stress that both are excellent companies that can create a tienshi, dili, renhe synthesis with CSA. He does confess that although Xinjiang Airlines is as efficient as CSA, Northern Airlines may need a bit of work.

One particular concern is its aging fleet. Harbison observes that Northern Airlines runs roughly double the number of routes of Xinjiang Airlines and operates a few international routes to Korea and Japan. Both have much older planes then CSA, and have kept on a few Macdonald Douglas and Russian-made planes. What is public knowledge is that the combined state-owned assets of the three airlines should add up to US$6 billion. Still, analysts are panting for more numbers from the two smaller airlines.

"To be honest, the amount of financial data available is extremely limited and of dubious accuracy," says UBS Warburg's Ross. He adds that CSA should be worried about the renhe aspect, since rationalizing the three networks will inevitably result in significant lay-offs. Both Ross and Harbison believe, however, that regardless of the practical difficulties in bringing the three operators together, the resulting entity should be competitive against the other two giants.

Invisible Hand

Xu, of course, is used to working with the heavy hand of government regulators. Take pricing, for example. CAAC retains control over all airline tickets even though the sector continues to suffer from oversupply. Back in 1997 and 1998, CAAC gave operators the freedom to offer discounts. The airlines, however, squandered the opportunity to show CAAC that pricing should be left to market forces by blindly slashing 40 to 50 percent off the price of all tickets. There was no agreement on how they could collectively benefit from the exercise. "Established airlines would know how to balance the proportion of low-end discount tickets that have restrictions on payment method or travel period, to the proportion of full-priced tickets. What happened in China then was that no full price tickets were ever sold, and the operators ended up killing each other," says Harbison.

By the end of 1998, airlines had suffered dramatic revenue losses and CAAC imposed a strict ban on all forms of discounts. These days, CAAC allows a few select routes to offer discount tickets but operators are not supposed to come up with creative pricing policies.

There is little Xu can do about the price of fuel either. It accounted for a whopping 53 percent of CSA's flight operations expenses in 2000. All domestic airlines have to buy fuel from the CAAC-owned monopoly, China Aviation Oil Supply (CAOS). According to a Goldman Sachs report published in January, China's fuel price often lags behind the global cycles and operators have been known to pay 70 percent more then their international competitors. Worse, domestic operators are not allowed to hedge on oil futures. Xu does buy oil futures to cover the small proportion of foreign fuel that CSA purchases for plane refills abroad, but that is all he can do for now.

Buying airplanes is another area under strict government control. Each order by CSA, Air China and China Eastern Airlines has to be approved by the State Council, which turns to the Ministry of External Affairs and the Ministry of Foreign Trade and Commerce for advice. Airplanes are so expensive that they are frequently used as a diplomatic tool. For example, President Jiang's visit to Europe last year gave Airbus, Boeing's arch-rival, an order for 28 planes. It was received by the French and German governments as a friendly gesture from Beijing. Despite all this, Xu and his colleagues say that the end result of the merger will be a stronger, more commercially led airline sector in China. Ross, for example, believes that until the three new groups are firmly established, CAAC will not give up its control over pricing.

Still, the authority itself has dropped hints that eventually pricing will be left to the market. Indicators of this change in mindset have been cropping up - CAOS cut fuel prices by 7 percent in January in order to reflect the lower oil price. Several domestic operators reacted immediately by cutting ticket prices for certain routes and were not reprimanded by CAAC. These are not black and white guarantees that the CAAC will withdraw to a more passive role, but there is certainly the feeling in the air that Xu will be given more space to exercise his talents in the future.

Enid Tsui is a senior writer for CFO Asia based in Hong Kong.