As businesses, airlines have a way to go

The deal, said to cost Cathay around US$180m, marks the first investment into a Chinese carrier by a non-mainland-based airline, and opens the door for others to follow.

After the trauma of SARS in 2003, Air China's upcoming IPO has helped refocus world attention on what is still the planet's fastest growing aviation market. "Certainly, all the Chinese airlines are keen to find foreign investors," said Jim Lam of investment bankers Morgan Stanley.

That point was underscored by Beijing's recent decision to raise the ceiling on foreign ownership in carriers from 35% to 49%.

And given impressive growth figures – in the first three quarters of this year, industry profits hit $1.24bn – the sector would seem to have value to offer. According to government data, passengers using Chinese airlines are expected to exceed 100m this year for the first time – and annual passenger growth is projected to average 8.8% until 2022 (although Boeing's projection is just 7.3%.)

Last year, China's carriers carried 2.19m tonnes of cargo, making the Mainland the second largest cargo market outside of the US. And annual growth in that sector is expected to average 10.3% through to 2021.

But it gets better: China is projected to become the world's fourth largest tourism destination by 2020, the 2008 Olympics and 2010 World Expo being two big spurs along the way.

Air China's upcoming IPO, of course, is not China's first. China Southern, China Eastern, Shanghai Airlines and Hainan Airlines – famous for having George Soros as a one-time investor – are all already listed, either in Shanghai or Hong Kong.

So why aren't foreign airlines busy signing MoUs with them?

"After the creation of the carrier groups in 2003, everyone is watching to see how they will work," said Fernando Grau, a market analyst with Brazilian plane maker Embraer. "We want to see how well they do their job as no one will invest if they do not show commitment to reform and improve."

Data from the Centre for Asia Pacific Aviation gives some indication of the ground to be covered. In a 2003 report on revenue per kilometer per employee, a standard productivity measure, China Eastern employees accounted for a third the revenue their Cathay counterparts accounted for and just a quarter that of Virgin Blue staff. China Southern scored fractionally better.

Oil price rises will only expand that performance gap: both China Eastern and China Southern have admitted they hedged only 10% of their fuel needs in 2004; international carriers normally hedge between 30% and 50%.

Chinese airlines are now trying to coordinate timetables, match routes with appropriate plane sizes, improve management training and increase pilot numbers – but it will take several years for the results to be fully visible.

At the same time, Chinese airlines are also actively seeking new routes, both domestic and international. For example, Hainan is looking to expand into Southeast Asia, and Shanghai Airlines this year began flights to Korea.

But Embraer's Frau says China's airlines, like China's other businesses, have to come clean if they hope to attract investors. "After Enron, investors are pushing for transparency of figures and this is a problem for Chinese companies. They need to restructure their figures so assets are clearly explained." One example of the problem surfaced at Hainan Airways. It bundled together assorted airline, hotel and tourist agency interests and in May had its credit rating downgraded from a B to CC by Xinhua Far East Ratings, who cited its RMB18.2bn mountain of debt emerging from layers of different businesses. Hainan Airlines has mooted plans to seek an offshore listing.

With China's safety and maintenance levels moving up to international standards, international airlines are partnering with mainland carriers in code-sharing deals in an effort to cut costs and offer more routes. All of China's listed airlines, and Air China, now engage in some form of code share, either regional or further afield.

China Southern has taken the first steps to joining the SkyTeam alliance and there has long been talk of Air China joining the Star Alliance group with Lufthansa, although with Cathay Pacific taking its stake, joining the OneWorld alliance the Hong Kong flag carrier belongs to looks like an option. That said, Air China has a maintenance partnership with the German carrier already, although both sides bristle as to what the JV should be doing: Lufthansa wants it to get more outside business; Air China wants it to stay focused on servicing their own fleets.

One potential area of investment interest is the budget carrier business. Although government officials have said that in principle they could allow discounters to operate, hurdles include restrictions on ticket pricing, air traffic control regimes that favor larger aircraft, current controls on fuel purchases, and the need for more secondary airports – not to mention potential opposition from existing airlines.

"I think if investors want to invest in China now, it would be easier with a start-up airline than trying to understand one of the big carriers," says Frau. "And it may be that CAAC's allowing private investors to start up small airlines is a reaction to the lack of investment in the major carriers."

In 2004 for the first time, 100% privately owned airlines were allowed to apply for licensing, a process reckoned to take several years. Average domestic standard tickets cost about 10% to 15% of average annual incomes, compared with 0.5% in the West. Bringing that ratio down could pay dividends.