We look at the highly-geared balance sheet of Air China, the bizarre and unfinished mini-subscription by its parent launched 6 months ago, and the likely need for a much larger equity financing if it is going to run on free-market principles, which in turn has implications for Cathay Pacific's 20% stake.

Air China's balance sheet worries
24 October 2012

What is Air China Ltd (Air China, 0753.HK, 601111.SH), the flag carrier, trying to do with its highly-geared balance sheet? On 27-Apr-2012, the airline announced a proposed subscription by its state-owned parent, China National Aviation Holding Co (CNAHC), of 188,642,729 new A-shares at CNY5.57 each, raising about CNY1,051m. The proposed new shares were equivalent to just 1.46% of its existing issued shares, and would increase CNAHC's holding from 52.06% to 52.75%, while diluting Cathay Pacific Airways Ltd (Cathay, 0293) from 19.53% to 19.25%. Incidentally, Cathay is 29.99% owned by Air China and 45.00% by Swire Pacific Ltd (19/87).

A circular went out on 8-May-2012 and other shareholders (including Cathay) approved the deal on 26-Jun-2012.

The tiny subscription was priced at a generous 10% discount to the 20-day average price before 27-Apr-2012. On 24-Jul-2012, with the subscription still not completed, the price was adjusted down to CNY5.45 for the 2011 final dividend of CNY0.118 (before tax), and the number of new shares was increased to 192,796,331 to raise the same proceeds.

To put the CNY1.05bn being raised in perspective, at 31-Dec-2011, Air China had net debt of CNY73.96bn, or 160% of shareholders' equity (CNY46.12bn). The amount to be raised was so small that it was less than the CNY1.52bn paid out in the 2011 final dividend on 23-Jul-2012. Air China could simply have paid a smaller dividend and saved the trouble of the share subscription. CNAHC could have then topped up its shareholding by buying shares in the market (without the benefit of the discount).

So the subscription made almost no difference to the balance sheet, for all the paperwork involved. Air China did not explain why that particular amount of money, and a particularly precise number of shares, was to be issued, and not a larger amount by way of a rights issue to all shareholders. Although the subscription involved a single shareholder, it was described as a "non-public offering" by Air China. An offering open to nobody except CNAHC.

On 9-Oct-2012, trading in Air China was suspended pending another "potential non-public offering of shares of the Company". To whom these shares would be offered it did not say. Obviously Cathay would have some concern if it was to be diluted. Silence ensued until this Monday 22-Oct-2012, when Air China announced that it has "actively engaged in consultations and discussions with the relevant parties", whomever they might be, and had decided not to proceed, at least for another 3 months.

Air China also disclosed that the subscription by CNAHC has still not completed, almost 4 months after shareholders approved it. No reason was given for the delay. Since the deal was first announced, the A-shares have fallen 19.4% from CNY6.12 (ex-dividend) to CNY4.93 yesterday. What was a 10% discount subscription has now become a 10.5% premium. We wonder whether this has anything to do with the delay. Is CNAHC trying to have it both ways, benefitting from a discount but walking away when it becomes a premium?

The deal was conditional on approval from the China Securities Regulatory Commission (CSRC), the State Asset Supervision and Administration Commission (SASAC), and the Civil Aviation Administration of China (CAAC). Six months after it was announced, we call on Air China to explain which conditions, if any, remain unsatisfied, and why. In the interim report filed on 13-Sep-2012, Air China said that the deal was still subject to CSRC approval, without saying why. Treat it as just another indication that China's market reforms have stalled - such an approval should be a formality.

Cathay shareholders should also be worried by all this. Ultimately if Air China needs fresh equity then it is going to be in much larger size than the April subscription, and if Cathay is going to maintain its shareholding, then it will need to pony up a substantial chunk of cash, some of which will go around in a circle if it raises the money from a rights issue itself, since Air China owns nearly 30% of Cathay. By 30-Jun-2012, Air China's net debt had risen to CNY82.36bn, or 181% of equity and almost 12 times last year's net profit. It also has commitments to purchase another CNY83.8bn of aircraft. Cutting net debt in half, and reducing the gearing to about 50% (similar to Cathay's 55%), would mean an Air China rights issue of CNY41bn (HK$51bn) and Cathay would need to come up with about HK$10bn to maintain its stake, compared with its current market capitalisation of HK$54bn.

Of course, being a state-controlled airline, in an economy with stake-controlled banks, state-owned asset managers and a state-run social security fund, the Chinese Government could continue to support Air China with state-directed loans and bond investments without diluting shareholders with an equity call, but that is not the way free markets are supposed to function.

Incidentally, the SCMP was so bewildered by Monday's announcement that it thought Air China had also scrapped the April subscription, which it hasn't, at least not yet.

© Webb-site.com, 2012

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