July 3,2006 Asia Pacific: Transportation: Airlines Goldman Sachs Global Investment Research 1 July 3,2006 Asia Pacific: Transportation: Airlines New HK-China bilateral:win-win for CX-Dragonair-AC Industry context Hong Kong and Mainland China have signed a new air services agreement (ASA), which could pave the way for Cathay to start passenger flights to Shanghai by 4Q06. While full details are not available yet, the bilateral appears to be fairly liberal: HK- based carriers will be able to fly to 56 Mainland destinations from 45 currently; capacity restrictions will be lifted eventually; more HK-carriers can be designated to fly to the Mainland; and so forth. Source of opportunity The Shanghai route is important, representing 35% of the passenger market and 68% of the cargo market between HK and Mainland. We believe the Shanghai and Beijing routes could be among the most profitable among HK-Mainland city pairs. Cathay has been lobbying, without success, since 2004 to gain passenger access to Shanghai; now it only has freighter services to Shanghai. Currently capacity on the Shanghai route is split half-half between Dragonair and CEA. We believe this ASA is very positive for Cathay Pacific, Dragonair and Air China. For instance, if Cathay gets access to Shanghai, the combined Dragonair/Cathay market share could rise further, at the expense of Chinese carriers such as CEA. On the other important route of Beijing, CX-Dragonair-Air China already control around 90% of capacity. The ASA is also important for Hong Kong, in that it further helps to cement Hong Kong as the most important hub from Asia to Mainland China in terms of width (number of Mainland destinations) and breadth (frequencies); this could help to mitigate the impact of any potential direct links between Taiwan and Mainland China in the future. Catalyst An important catalyst for Cathay would be the HK’s government’s decision as to which second Hong Kong-based carriers get approval to fly to Shanghai in 4Q06. Risks The risks for the airline sector include a further, sharp spike in jet fuel prices. Another risk for Cathay could be execution risk: translating its eventual 100% ownership of Dragonair and cross shareholding with AC into higher firmwide profitability. Best buy idea We rate Air China Buy with a target price of HK$3.85 (1.3X 2007EP/B). We rate Cathay Neutral, with a target price of HK$14.30 (1.25X 2007EP/B). RELATEDRESEARCH Cathay Pacific: Restructuring +ve but largely priced in, upgrade to IL, tgt px HK$14.30, deal hinges on significant synergies – June 122006 Air China: CX-Dragonair-Air China deal creates a win-win combination; raising target price to HK$3.85, reiterate OP – June 122006 Julie Lim +65-6889-2470 | firstname.lastname@example.org Goldman Sachs (Singapore) Pte Jean-Louis Morisot +65-6889-2466 | email@example.com Goldman Sachs (Singapore) Pte Analysts employed by non-US affiliates are not required to take the NASD/NYSE analyst exam. The Goldman Sachs Group, Inc. does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. For Reg AC certification, see the text preceding the disclosures. For other important disclosures go to /research/hedge.html. The Goldman Sachs Group, Inc. Global Investment Research July 3,2006 Asia Pacific: Transportation: Airlines Goldman Sachs Global Investment Research 2 New Hong Kong-Mainland bilateral fairly liberal Today, the Hong Kong Economic Development and Labour Bureau (EDLB) announced that it had concluded a new air services agreement with the Civil Aviation Authority of China. Full details are not available yet, but so far this is what has been announced by the EDLB: 1) Hong Kong-based carriers will be able to fly to 56 Mainland destinations, an increase of 11 routes. 2) The existing capacity restrictions (in terms of number of seats) on 35 routes will be lifted completely in two phases between winter 2006 and summer 2007. The capacity limits on the remaining routes will be substantially increased. The EDLB did not give further details as to which route fell under which category. 3) Starting from winter 2007, each side can designate three airlines to operate passenger and cargo flights between Hong Kong and the Mainland. Another carrier will be able to operate all-cargo flights on most routes. 4) Starting in winter 2006, another Hong Kong-based carrier can fly between Hong Kong and Shanghai. Currently, the only Hong Kong-based carrier to fly there is Dragonair. Higher market share for Cathay-Dragonair-Air China entity Currently on the HK-Shanghai passenger route, Dragonair has around 51% market share (in available seat kilometer terms), with the rest controlled by China Eastern Airlines. If Cathay enters this market in 2007, the combined Dragonair-Cathay market share could rise, driven not just by higher frequency but also the introduction of a better front-end product and service by Cathay in order to attract more corporate travelers. Cathay will apply to the Hong Kong government to fly passenger services to Shanghai in 4Q06; the government will then decide on which second HK carrier gets the designation. On the HK-Beijing route, the combined Cathay-Dragonair-Air China entity already controls around 90% of capacity. Note that Cathay and Air China will operate all HK-Mainland routes jointly by pooling revenues and costs. Currently, Cathay has passenger services to Beijing and Xiamen only. Exhibit 1: If Cathay gets approval to fly to Shanghai by end 2006, its combined market share with Dragonair could increase significantly Market share on HK-Shanghai and HK-Beijing routes in ASK terms 2002200320042005 Hong Kong-Shanghai Pudong route Dragonair 52% 52% 52% 51% China Eastern Airlines 48% 48% 48% 49% Hong Kong-Beijing route Dragonair 46% 52% 53% 44% Air China 46% 42% 36% 33% Cathay 0% 0% 5% 13% China Southern Airlines 7% 6% 6% 10% Source: BACKAviation, Goldman Sachs Research. July 3,2006 Asia Pacific: Transportation: Airlines Goldman Sachs Global Investment Research 3 RegAC I, Julie Lim, hereby certify that all of the views expressed in this report accurately reflect my personal views about the subject company or companies and its or their securities. I also certify that no part of my compensation was, is or will be, directly or indirectly, related to the specific recommendations or views expressed in this report. Investment profile The Goldman Sachs Investment Profile provides investment context for a security by comparing key attributes of that security to its peer group and market. The four key attributes depicted are: growth, returns, multiple and volatility. Growth, returns and multiple are indexed based on composites of several methodologies to determine the stocks percentile ranking within the region's coverage universe. The precise calculation of each metric may vary depending on the fiscal year, industry and region but the standard approach is as follows: Growth is a composite of next year's estimate over current year's estimate, e.g. EPS, EBITDA, Revenue. Return is a year one prospective aggregate of various return on capital measures, e.g. CROCI, ROACE, and ROE. Multiple is a composite of one-year forward valuation ratios, e.g. P/E, dividend yield, EV/FCF, EV/EBITDA, EV/DACF, Price/Book. Volatility is measured as 30-day historical volatility, annualized and adjusted for dividends. Quantum Quantum is Goldman Sachs proprietary database providing access to detailed financial statement histories, forecasts and ratios. It can be used for in- depth analysis of a single company, or to make comparisons between companies in different sectors and markets. Disclosures Coverage group(s) of stocks by primary analyst(s) Julie Lim: Asia Pacific Airlines, Asia Pacific Shipping. Jean-Louis Morisot: Asia Pacific Airlines, Asia Pacific Shipping. Asia Pacific Airlines: Air China, AirAsia, Cathay Pacific, China Airlines, China Eastern Airlines, China Eastern Airlines (ADS), China Southern Airlines, China Southern Airlines (ADS), EVAAirways, Jet Airways, Korean Air, Singapore Airlines, Thai Airways. Asia Pacific Shipping: China COSCOHoldings, China Shipping Container, China Shipping Development, Evergreen Marine, Great Eastern Shipping, Hanjin Shipping, Malaysian Int'l Shipping, Neptune Orient Lines, Orient Overseas Int'l, Pacific Basin Shipping, Precious Shipping, STXPan Ocean, Thoresen Thai, Wan Hai Lines, Yang Ming Marine. Company-specific regulatory disclosures The following disclosures relate to relationships between The Goldman Sachs Group, Inc. (with its affiliates, "Goldman Sachs") and companies covered by the Global Investment Research Division of Goldman Sachs and referred to in this research. Goldman Sachs beneficially owned 1% or more of the common equity (including derivatives exercisable or convertible within 60 days but excluding positions held by GSAsset Mgmt.) as of the second most recent month end: Air China (HK$3.15) Goldman Sachs expects to receive or intends to seek compensation for investment banking services in the next 3 months: Air China (HK$3.15) Goldman Sachs has received compensation for non-investment banking services in the past 12 months: Air China (HK$3.15) and Cathay Pacific (HK$13.55) Goldman Sachs had an investment banking services client relationship during the past 12 months with: Air China (HK$3.15) Goldman Sachs had a non-investment banking securities-related services client relationship during the past 12 months with: Air China (HK$3.15) and Cathay Pacific (HK$13.55) Goldman Sachs had a non-securities services client relationship during the past 12 months with: Air China (HK$3.15) and Cathay Pacific (HK$13.55) Goldman Sachs makes a market in the securities: Cathay Pacific (HK$13.55) Distribution of ratings/investment banking relationships Goldman Sachs Investment Research global coverage universe Rating Distribution Investment Banking Relationships Buy Hold Sell Buy Hold Sell Global 26% 59% 15% 58% 52% 47% July 3,2006 Asia Pacific: Transportation: Airlines Goldman Sachs Global Investment Research 4 As of April 1,2006, Goldman Sachs Global Investment Research had investment ratings on 2,048 equity securities. Prior to June 26,2006, Goldman Sachs utilized a relative rating system of Outperform, In-Line and Underperform, which, for the purposes of the above disclosure required by NASD/NYSE rules, equated to Buy, Hold and Sell. As of June 26,2006, Goldman Sachs assigns stocks as Buys and Sells on various regional Investment Lists; stocks not so assigned are deemed Neutral. Such assignments equate to Buy, Hold and Sell for the purposes of the above disclosure. See 'Ratings, Coverage groups and views and related definitions' below. Price target and rating history chart(s) Regulatory disclosures Disclosures required by United States laws and regulations See company-specific regulatory disclosures above for any of the following disclosures required as to companies referred to in this report: manager or co-manager in a pending transaction; 1% or other ownership; compensation for certain services; types of client relationships; managed/co- managed public offerings in prior periods; directorships; market making and/or specialist role. The following are additional required disclosures: Ownership and material conflicts of interest: Goldman Sachs policy prohibits its analysts, professionals reporting to analysts and members of their households from owning securities of any company in the analyst's area of coverage. Analyst compensation: Analysts are paid in part based on the profitability of Goldman Sachs, which includes investment banking revenues. Analyst as officer or director: Goldman Sachs policy prohibits its analysts, persons reporting to analysts or members of their households from serving as an officer, director, advisory board member or employee of any company in the analyst's area of coverage. Distribution of ratings: See the distribution of ratings disclosure above. Price chart: See the price chart, with changes of ratings and price targets in prior periods, above, or, if electronic format or if with respect to multiple companies which are the subject of this report, on the Goldman Sachs website at . Additional disclosures required under the laws and regulations of jurisdictions other than the United States The following disclosures are those required by the jurisdiction indicated, except to the extent already made above pursuant to United States laws and regulations. Australia: This research, and any access to it, is intended only for "wholesale clients" within the meaning of the Australian Corporations Act. Canada: Goldman Sachs Canada Inc. has approved of, and agreed to take responsibility for, this research in Canada if and to the extent it relates to equity securities of Canadian issuers. Analysts may conduct site visits but are prohibited from accepting payment or reimbursement by the company of travel expenses for such visits. Hong Kong: Further information on the securities of covered companies referred to in this research may be obtained on request from Goldman Sachs (Asia) L.L.C. Japan: See company-specific disclosures as to any applicable disclosures required by Japanese stock exchanges, the Japanese Securities Dealers Association or the Japanese Securities Finance Company. Korea: Further information on the subject company or companies referred to in this research may be obtained from Goldman Sachs (Asia) L.L.C., Seoul Branch. Singapore: Further information on the covered companies referred to in this research may be obtained from Goldman Sachs (Singapore) Pte. (Company Number: 198602165W). United Kingdom: Persons who would be categorized as private customers in the United Kingdom, as such term is defined in the rules of the Financial Services Authority, should read this research in conjunction with prior Goldman Sachs research on the covered companies referred to herein and should refer to the risk warnings that have been sent to them by Goldman Sachs International. A copy of these risks warnings, and a glossary of certain financial terms used in this report, are available from Goldman Sachs International on request. European Union: Disclosure information in relation to Article 4 (1) (d) and Article 6 (2) of the European Commission Directive 2003/126/EC is available at Ratings, coverage groups and views and related definitions Buy, Neutral, Sell -Analysts recommend stocks as Buys or Sells for inclusion on various regional Investment Lists. Being assigned a Buy or Sell on an Investment List is determined by a stock's return potential relative to its coverage group as described below. Any stock not assigned as a Buy or a Sell on an Investment List is deemed Neutral. Each regional Investment Review Committee manages various regional Investment Lists to a global guideline of 25-35% of stocks as Buy and 10-15% of stocks as Sell; however, the distribution of Buys and Sells in any particular coverage group may vary as determined by the regional Investment Review Committee. Return potential represents the price differential between the current share price and the price target expected during the time horizon associated with the price target. Price targets are required for all covered stocks. The return potential, price target and associated time horizon are stated in each report adding or reiterating an Investment List membership. Coverage groups and views: A list of all stocks in each coverage group is available by primary analyst, stock and coverage group at . The analyst assigns one of the following coverage views which represents the analyst's investment outlook on the coverage group relative to the group's historical fundamentals and/or valuation. Attractive (A). The investment outlook over the following 12 MJJASONDJFMAMJJASONDJFMAMJJASONDJFM 2003200420052006 8 10 12 14 16 18 20 4,000 5,000 6,000 7,000 8,000 9,000 ILOP Aug 10 IL Aug 11 U Sep 8 Cathay Pacific (0293.HK) Goldman Sachs rating and stock price target history Currency: Hong Kong Dollar Source: Goldman Sachs Investment Research for ratings and price targets; Reuters for daily closing prices as of 04/01/06. Rating Price target Price target at removal MSCIHong Kong; pricing by FactSet Covered by Jean-Louis Morisot Not covered by current analyst 1313.50 15.50 20 16 13 14 11.5011.80 St oc k P ric e In de x Pr ic e The price targets shown should be considered in the context of all prior published Goldman Sachs research, which may or may not have included price targets, as well as developments relating to the company, its industry and financial markets. MJJASONDJFMAMJJASONDJFMAMJJASONDJFM 2003200420052006 2.25 2.50 2.75 3.00 3.25 3.50 8,000 10,000 12,000 14,000 16,000 OP Mar 3 Air China (0753.HK) Goldman Sachs rating and stock price target history Currency: Hong Kong Dollar Source: Goldman Sachs Investment Research for ratings and price targets; Reuters for daily closing prices as of 04/01/06. Rating Price target Price target at removal Hang Seng Index; pricing by FactSet Covered by Julie Lim, as of Feb 1,2005 Not covered by current analyst 3.50 3 3.35 St oc k P ric e In de x Pr ic e The price targets shown should be considered in the context of all prior published Goldman Sachs research, which may or may not have included price targets, as well as developments relating to the company, its industry and financial markets. July 3,2006 Asia Pacific: Transportation: Airlines Goldman Sachs Global Investment Research 5 months is favorable relative to the coverage group's historical fundamentals and/or valuation. Neutral (N). The investment outlook over the following 12 months is neutral relative to the coverage group's historical fundamentals and/or valuation. Cautious (C). The investment outlook over the following 12 months is unfavorable relative to the coverage group's historical fundamentals and/or valuation. Not Rated (NR). The investment rating and target price, if any, have been removed pursuant to Goldman Sachs policy when Goldman Sachs is acting in an advisory capacity in a merger or strategic transaction involving this company and in certain other circumstances. Rating Suspended (RS). Goldman Sachs Research has suspended the investment rating and price target, if any, for this stock, because there is not a sufficient fundamental basis for determining an investment rating or target. The previous investment rating and price target, if any, are no longer in effect for this stock and should not be relied upon. Coverage Suspended (CS). Goldman Sachs has suspended coverage of this company. Not Covered (NC). Goldman Sachs does not cover this company. Not Available or Not Applicable (NA). The information is not available for display or is not applicable. Not Meaningful (NM). The information is not meaningful and is therefore excluded. Ratings, coverage views and related definitions prior to June 26,2006 Our rating system requires that analysts rank order the stocks in their coverage groups and assign one of three investment ratings (see definitions below) within a ratings distribution guideline of no more than 25% of the stocks should be rated Outperform and no fewer than 10% rated Underperform. The analyst assigns one of three coverage views (see definitions below), which represents the analyst's investment outlook on the coverage group relative to the group's historical fundamentals and valuation. Each coverage group, listing all stocks covered in that group, is available by primary analyst, stock and coverage group at . Definitions Outperform (OP). We expect this stock to outperform the median total return for the analyst's coverage universe over the next 12 months. In-Line (IL). We expect this stock to perform in line with the median total return for the analyst's coverage universe over the next 12 months. Underperform (U). We expect this stock to underperform the median total return for the analyst's coverage universe over the next 12 months. Coverage views: Attractive (A). The investment outlook over the following 12 months is favorable relative to the coverage group's historical fundamentals and/or valuation. Neutral (N). The investment outlook over the following 12 months is neutral relative to the coverage group's historical fundamentals and/or valuation. Cautious (C). The investment outlook over the following 12 months is unfavorable relative to the coverage group's historical fundamentals and/or valuation. Current Investment List (CIL). We expect stocks on this list to provide an absolute total return of approximately 15%-20% over the next 12 months. We only assign this designation to stocks rated Outperform. We require a 12-month price target for stocks with this designation. Each stock on the CIL will automatically come off the list after 90 days unless renewed by the covering analyst and the relevant Regional Investment Review Committee. Global product; distributing entities The Global Investment Research Division of Goldman Sachs produces and distributes research products for clients of Goldman Sachs, and pursuant to certain contractual arrangements, on a global basis. Analysts based in Goldman Sachs offices around the world produce equity research on industries and companies, and research on macroeconomics, currencies, commodities and portfolio strategy. This research is disseminated in Australia by Goldman Sachs JBWere Pty Ltd (ABN 21006797897) on behalf of Goldman Sachs; in Canada by Goldman Sachs Canada Inc. regarding Canadian equities and by Goldman Sachs & Co. (all other research); in Germany by Goldman Sachs & Co. oHG; in Hong Kong by Goldman Sachs (Asia) L.L.C.; in Japan by Goldman Sachs (Japan) Ltd; in the Republic of Korea by Goldman Sachs (Asia) L.L.C., Seoul Branch; in New Zealand by Goldman Sachs JBWere (NZ) Limited on behalf of Goldman Sachs; in Singapore by Goldman Sachs (Singapore) Pte. (Company Number: 198602165W); and in the United States of America by Goldman, Sachs & Co. Goldman Sachs International has approved this research in connection with its distribution in the United Kingdom and European Union. European Union: Goldman Sachs International, authorised and regulated by the Financial Services Authority, has approved this research in connection with its distribution in the European Union and United Kingdom; Goldman, Sachs & Co. oHG, regulated by the Bundesanstalt für Finanzdienstleistungsaufsicht, may also be distributing research in Germany. General disclosures in addition to specific disclosures required by certain jurisdictions This research is for our clients only. Other than disclosures relating to Goldman Sachs, this research is based on current public information that we consider reliable, but we do not represent it is accurate or complete, and it should not be relied on as such. We seek to update our research as appropriate, but various regulations may prevent us from doing so. Other than some industry reports published on a periodic basis, the large majority of reports are published at irregular intervals as appropriate in the analyst's judgment. Goldman Sachs conducts a global full-service, integrated investment banking, investment management, and brokerage business. We have investment banking and other business relationships with a substantial percentage of the companies covered by our Global Investment Research Division. Our salespeople, traders, and other professionals may provide oral or written market commentary or trading strategies to our clients and our proprietary trading desks that reflect opinions that are contrary to the opinions expressed in this research. Our asset management area, our proprietary trading desks and investing businesses may make investment decisions that are inconsistent with the recommendations or views expressed in this research. We and our affiliates, officers, directors, and employees, excluding equity analysts, will from time to time have long or short positions in, act as principal in, and buy or sell, the securities or derivatives (including options and warrants) thereof of covered companies referred to in this research. This research is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be illegal. It does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual clients. Clients should consider whether any advice or recommendation in this research is suitable for their particular circumstances and, if appropriate, seek professional advice, including tax advice. The price and value of the investments referred to in this research and the income from them may fluctuate. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Certain transactions, including those involving futures, options, and other derivatives, give rise to substantial risk and are not suitable for all investors. Current options disclosure documents are available from Goldman Sachs sales representatives or at or from Research Compliance, One New York Plaza, New York, NY 10004. Copyright 2006 The Goldman Sachs Group, Inc. No part of this material may be (i) copied, photocopied or duplicated in any form by any means or (ii) redistributed without the prior written consent of The Goldman Sachs Group, Inc.