Excess Baggage at Air China
3 December 2004
On Monday this week, investors successfully blocked a proposal by China Oilfield Services Ltd (COS) to lend money to its parent group.
Now the jumbo-sized Air China Ltd (Air China, 0753) prospectus touches down in Hong Kong with a plan to raise HK$6,522m (US$838m) for the company net of expenses. We're not going to comment on the merits of this stock - decide for yourselves.
But wait. Before you decide, you should be aware of a company called China National Aviation Finance Co., Ltd (CNAF), which is a 52% subsidiary of Air China's parent, China National Aviation Holding Company (CNAHC). Air China also holds 42.5% of CNAF.
You guessed it. CNAF is another one of these "non-bank finance companies" the only customers of which are members of the CNAHC group and its "investees" - companies in which the group owns less than 50% of the stock..
In the prospectus, nestled in the undergrowth of 30 pages of connected transactions you will find the lesser-spotted section dealing with this on pages 133-135. It discloses that Air China both lends (or, as they would put it, "deposits") money to CNAF as well as borrowing smaller amounts from it. In the 3 years to 2003, Air China lent as much as RMB2,357m to CNAF, and borrowed up to RMB1,180m from it. The Stock Exchange has granted Air China a waiver until 31-Dec-06 to continue with this practice, subject to a maximum deposit of RMB5bn with CNAF, and maximum borrowings of RMB3bn. After that, they will have to go to independent shareholders with a request for approval - which of course, we would not give.
The only slight mitigating factor is that CNAF has undertaken that the aggregate of its loans and investments outside of Air China will not exceed the aggregate of the deposits from customers other than Air China plus the equity of CNAF. However, this is not much comfort, for the following reasons:
- Other group depositors may presumably withdraw funds from CNAF at any time, but CNAF cannot necessarily recover the money by recalling loans to group companies, particularly if the loans have gone sour. That could leave CNAF in breach of the undertaking. There is no obligation or undertaking from CNAHC to "top up" the CNAF balance sheet with extra funds to bring it back into compliance, and even if there were, we don't know whether CNAHC would have the financial ability to fulfil such an obligation.
- One way to ensure that the outstanding loans don't exceed deposits would be to make bad loans and the write them off! Obviously that doesn't improve the ability of CNAF to repay deposits from Air China or anyone else.
- Air China would rank alongside all the other creditors in the event that CNAF became insolvent and was liquidated. The impact of the bad loans to other members of the group would be shared by Air China in proportion to the amounts it and the other customers had lent to CNAF.
- An undertaking from CNAF is not worth anything if CNAF goes bust.
What all this boils down to is that Air China could lend up to RMB5bn (HK$4.72bn, US$602m), an amount equivalent to about 72% of the IPO proceeds, to CNAF, a member of its parent group. It is often said that in Asia, ageing parents rely on their children for financial support due to the underdeveloped social welfare system. The same seems to be true of Chinese companies and their offspring, particularly state-controlled ones.
Even in Hong Kong, no tycoon today would dream of seeking "deposits" from his listed company to fund his private enterprises, or pooling all the private and public company monies in one vehicle. OK, maybe he would dream of that, but they wouldn't get approval for it from shareholders - we've moved on from that kind of behaviour which was more common in the 1980s, when Tung Chee Hwa's private companies almost bankrupted Orient Overseas (Holdings) Ltd, as it then was known. He wrote at the time:
"In the course of 1985 the OOHL Group's financial position seriously worsened principally as a consequence of the rapid deterioration in the financial position of the Tung Private Group, with which the OOHL Group is closely associated and from whom substantial amounts were owing."
So now you know. Take your seats if you want, but remember, this flight comes with excess baggage.
© Webb-site.com, 2004
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