Trading in shares of China Eastern Airlines Corporation Limited (CEA) and Shanghai Airlines Co., Ltd. (or SAL) have been suspended beginning on June 8, reportedly concerning a merger between the two.

Details are slim. Speculation includes three possible alternatives: (1) SAL will become a wholly owned subsidiary of CEA that is operated independently; (2) SAL’s operations will be completely merged with CEA with the SAL brand ended; or (3) CEA will take a controlling interest in SAL.

The first two would be accomplished via a share exchange in which the shares of SAL would be delisted, while under the third option SAL would continue as a listed stock. The transaction is expected to be completed by the end of 2009 to assure China Eastern’s service to the Shanghai World Expo to be held in 2010.

Any hook-up between the two would be positive for the surviving entity due to the potential for merger synergies since both companies are based in Shanghai operating at two separate airports, with CEA having a 40% share of that market and SAL a 15% share.

That said, the fundamental outlook for airline carriers remains weak and a CEA/SAL tie-up will not change that fact. This was demonstrated in the first quarter when CEA reported a 16% drop in revenues due to falling passenger and air cargo traffic. Despite this, CEA posted net income of RMB40.1 million (down 81% from RMB210.8 million a year ago), largely due to a RMB513.5 million positive swing in fuel hedging to a RMB422.0 million gain from a RMB91.6 million loss in the prior-year quarter, as well as a RMB874.3 million gain from a refund and reduction in aviation levies. Excluding these items, CEA would have posted a RMB1,256.1 million loss.

Both CEA and Shanghai Airlines shares are subject to special treatment, meaning that daily share price movements are limited to 5% on the Shanghai Stock Exchange. Moreover, the shares could be delisted should CEA and SAL continue to sustain losses in 2009.

We are maintaining our Sell recommendation on China Eastern Airlines Corporation Limited.

Read the full analyst report on “CEA”
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