Seeking Alpha
Long only, foreign companies, tech
Profile| Send Message|
( followers)  

There has been some buzz about Air China (OTCPK:AIRYY) spending US$812.8 million to buy an additional 12.5% stake in Cathay Pacific Airways, Ltd. (OTCPK:CPCAY) from CITIC Pacific, another state-owned enterprise. That's a lot of greenbacks to lay down at a time when the world economy, rising fuel prices, and the spectre of an influenza pandemic hover over the airline business.

Of course, as both a government-owned business and the national flag carrier, Air China doesn't need to worry as much about empty coffers as, say, EasyJet (EJETF.PK) or Southwest Airlines (NYSE:LUV). So the cash issue is a bit of a red herring.

The Hong Kong Squeeze Theory

The Wall Street Journal piece about it raises an interesting issue. As UBS analyst Damien Horth noted, Air China is most concerned in the near term about "promoting its base in Beijing as a major travel hub. 'Anything [Air China] can do to reinforce the position of that hub is critical, by limiting competition from Hong Kong.'"

No conspiracy theorist or long-term China resident could resist the speculation Mr. Horth's remarks seem designed to arouse. "Hmm," one might think: "could it be that Air China wants to control Cathay Pacific in order to restrict its growth, and by extension, the growth of Hong Kong International Airport as a regional or global hub?"

Living but a stone's throw from Air China's opulent new headquarters just west of Beijing Airport, not only would I not be surprised if this were so, I might even be inclined to be sympathetic.

Sadly, I doubt this is the case. Instead, I think Air China has wisely made other plans for Hong Kong.

The Second Hub Theory

First, Air China still sees the heart of its long-term opportunity as leadership in PRC domestic air travel, where demand looks set to grow for the foreseeable future. Armed with leadership at home, it can then fill planes to overseas destinations with Chinese who are starting to travel with increasing frequency.

With that in mind, you can understand why Air China sees its nearest rivals not as Cathay Pacific or Dragonair, but Shanghai-based China Eastern Airlines (NYSE:CEA) and, especially, Guangzhou-based China Southern Airlines (NYSE:ZNH).

As the Journal points out, Air China was rebuffed last year in its attempt to buy its way into a hub in Shanghai. The idea behind that was to either secure Shanghai as a second hub for itself, or deny it to a rival.

Unable to take on one of its domestic rivals directly, Air China is now pursuing the indirect approach, this time taking on not China Eastern in Shanghai, but China Southern. If Air China can lock down control of a Hong Kong hub either directly (by dominating the airport with its own flights) or indirectly (through its ownership/influence/control over Cathay), it effectively "flanks" China Southern with a south China hub for outbound international traffic.

And for such a large country, that is going to be essential. While Beijing makes for an excellent hub feeding into Europe, Russia, and North America, it does not make sense for over two-thirds of China's population to fly through Beijing to get to the Middle East, Africa, South Asia, Southeast Asia, Australia, Hong Kong, Taiwan, and the South Pacific.

Other Fish

Air China is better off letting Cathay worry about Hong Kong for now. The flag carrier needs to turn its attention elsewhere, optimizing its domestic route structure to feed into its international hubs, improving the efficiency of its fleet and it operations, and continuing to improve service on the routes it has.

A partnership with Cathay leaves China free to concentrate on the areas that will make it the most money in the long run, while building the route system and the know-how to compete against global carriers. Even better, Cathay remains the competitive foil to sustain pressure on the other premium Asian carriers while Air China matures.

None of which is to say that at some point in the future, keeping Air China, Dragonair, and Cathay running as independent airlines will stop making sense. But for now, each of these three operations - and their attendant brands - are doing well in their own space.

Which is exactly why any concern about Air China putting the squeeze on Hong Kong is overblown. For now.

Source: Air China's Growth Strategy: One Dragon, Two Nests