Only way is up for China’s airlines

As investors worldwide nervously monitor the impact of China’s slowing economy on world markets, the airline industry is bucking the downward trend.

by CHIEF CORRESPONDENT, TOM BALLANTYNE  

September 1st 2015

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Shaken by a housing slowdown, uncertain foreign and domestic demand and, most recently, a sudden stock market slump and a currency devaluation, China is having a difficult year. Read More » With growth at 7% in the first six months of 2015, a figure that could change in coming months, 2015 is shaping up as the nation’s worst 12 months in economic performance in a quarter of a century.

China’s central bank, the People’s Bank of China (PBOC) said in its second-quarter monetary policy report in August that China’s economy may face headwinds in coming months due to its reform efforts, with monetary policy blunted by a lack of growth drivers and a lukewarm appetite for new investment.

For airlines, whose growth and fortunes are traditionally tied to national economic performance, the report should be bad news. But not so.

Carriers have reported healthy profits to date for the year. In August, the Civil Aviation Administration of China (CAAC) said income for its airlines reached a historic high in the first half of 2015 and already had surpassed the full year results of 2014.

CAAC’s latest figures, to May 31, reported 12.9% year-on-year overall passenger growth for China’s carriers, with domestic travel accounting for 10.1% of the increase and international passengers contributing a stunning 47%.

Even cargo traffic, which has been in the doldrums for several years, is on the up, with 5.2% year-on-year growth, comprising a 2.1% expansion in the domestic sector and 13.4% growth on international routes.

Guangzhou-based China Southern Airlines (CSA) is forecast to announce net income of between $544 million and $587 million for the first half of this year, reversing a $164 million loss in the same period twelve months ago.

Shanghai’s China Eastern Airlines (CEA) announced a profit of $556 million for the same period, up from a meagre $2.3 million profit in the same six months of 2014. In Beijing, Air China is looking at a half year profit of $787.5 million, an 82% increase over the 2014 half.

The country’s “Big Three” carriers are not the only winners in 2015. Hainan Airlines’ profit has quadrupled in 2015. Juneyao Airlines’ first half income climbed 170% and the country’s first low-cost carrier, Spring Airlines, launched in 2005, said its interim profit will increase by between 130% and 150%.

There are solid reasons for this remarkable performance. Despite the economic slowdown, domestic market demand has remained robust. At the big carriers, international expansion is gathering pace. Most importantly of all, a lower fuel price has underpinned improved profitability by dramatically reducing operating costs.

As oil dropped towards $40 a barrel, Chinese carriers became winners in the industry, almost by default. After suffering substantial losses during the 2008 Global Financial Crisis, China’s airlines stopped hedging fuel as it climbed above US$100 a barrel.

And then there was the August 2% devaluation of the yuan. Most analysts and industry observers believed the impact of the recent devaluation of China’s currency had been overstated by the media. Director general of the Association of Asia Pacific Airlines (AAPA), Andrew Herdman pointed out the US$ has been strengthening for 18 months, and particularly in the past six months when many Asian currencies devalued.

“The Chinese currency has been strengthening for a decade, said Herdman. “It is worth commenting that we don’t obsess about such movements in other currencies whether it’s the US$, the Euro, British Sterling or the Yen. We are used to their changes. Next week it will be a different story.”

Domestically, the market is expanding as more budget carriers are set up, with the encouragement of China’s central government, which is keen for a genuine low-cost carrier industry to be established.

Internationally, China’s airlines are entering a new phase. For years, they were regarded by the industry as being in development because their management processes were not as sophisticated as their western rivals and their service levels were below par.

But not anymore. The big Chinese airlines have emerged as major players internationally, operating big fleets of new jets and constantly expanding their medium and long-haul networks to match rivals elsewhere in Asia, Europe and the U.S.

A key report by consultants, McKinsey & Company, said more than 97 million Chinese traveled overseas in 2013 and spent $129 billion while abroad.

Last year, the number of Chinese travelling overseas jumped to an estimated 112 million with Chinese official data estimating the group spent a record-breaking $164.8 billion.

China Eastern, China Southern and Air China are linking secondary Chinese cities with the world. China Eastern recently launched a Chengdu-Nanjing-Los Angeles service. Air China started Chengdu-Colombo in February, Hangzhou-Osaka in March, Tianjin-Dalian-Sapporo in April, Beijing-Minsk-Budapest in May,Beijing-Melbourne in June and Beijing-Hakodate in July. Addis Ababba will be added in October, as will Beijing-Johannesburg, making Air China the first Chinese carrier to fly directly between Mainland China and South Africa. China Southern will launch Shanghai-Pudong -Chicago in October.

Hainan Airlines B787: Rising competition from high-speed rail in China is prompting carriers like Hainan to find more opportunities internationally

Head of the CAAC, Li Jiaxiang, said due to growth and reduced operating costs, Chinese carriers introduced 158 aircraft into their fleets in the first-half of 2015; 24 wide bodies and 134 narrow bodies. These included 28 aircraft to China Eastern, 22 to China Southern, 17 to Air China and 16 to Hainan Airlines.

China recently ordered 75 A330s, worth $11 billion, with Airbus. The French headquartered company is setting up an A330 completion and delivery facility in Tianjin to take advantage of the partnership between Airbus and the Mainland following the successful establishment of an A320-family final assembly line in 2008, also in Tianjin.

China Eastern chairman, Liu Shaoyang, said last month the carrier was considering a wide-body order to add to its growing fleet of 20-on-order B777-300ERs. “We are looking closely at options and studying their compatibility with our networks. We may have a decision to announce by the end of this year or early next year,” he said.

In the meantime, China Eastern announced last month it will acquire 15 A330s for about $3.6 billion to meet booming demand.

The Shanghai headquartered airline, which operates a fleet of more than 400 aircraft that flies close to 2,000 flights a day, signed a purchase agreement in early July with Boeing for an additional 50 B737-800s for its wholly-owned Nanyuan-based budget carrier, China United Airlines, as well as other subsidiaries.

Deliveries are scheduled between 2017 and 2019. In June last year, the airline announced a similar deal with the U.S. manufacturer for 80 B737s, made up of -800s and MAXs, set to arrive at the carrier between 2016 and 2020.

Spring Airlines, based at Shanghai’s second airport, Hongqiao, plans to raise $725 million in private share placements to fund upgrades to its IT infrastructure, including fitting its 50 current A320s with Wi-Fi connectivity, as well as fleet expansion.

It intends to buy an additional 21 A320s. SkyTeam alliance member, Xiamen Airlines, has ordered four additional B787s, with talks continuing about the acquisition of another ten. It has taken delivery of five of the six Dreamliners it originally ordered and is operating them to Amsterdam, where the service connects with partner Air France-KLM. Xiamen has plans to launch services to Australia in the near future.

An insight into Chinese airline thinking about international expansion was provided in a recent Chinese interview with Hainan Airlines chairman, Xin Di. He said the carrier expected its international business to account for 40% of its total revenue by year end.

In 2014, offshore flying accounted for 13% of Hainan’s revenue (now at 16%.) compared with Air China, which earned 37% of its revenue internationally. Xin, made chairman of Hainan last year, attributed the expansion of the country’s carriers into global markets to government policies and market demand.

He said the government has been encouraging more enterprises to go abroad under “The Belt and Road Initiative”, a development strategy proposed by President Xi Jinping in 2013. It refers to the Silk Road Economic Belt, which will link China with Europe via Central and Western Asia, and the 21st Century Maritime Silk Road, which stretches from eastern and southern China to Southeast Asia, South Asia, Africa and Europe. Xin said he anticipates a huge surge in international business on the back of this strategy.

Hainan, China’s fourth largest carrier, has been expanding rapidly this year with new services from Beijing to San Jose in the U.S., and Rome, as well a more flights from Shanghai to the U.S. This year it intends to add services to Tel Aviv in Israel and Prague in the Czech Republic.

Xin said rising competition from high-speed rail in China is prompting carriers like Hainan to find more opportunities internationally. As a result, Hainan has been on a shopping spree abroad. Its leasing unit, Bohai Leasing, in July announced it will acquire a 20% stake in Irish lessor Avolon Holdings for $429 million, with recent reports it has offered to acquire the remainder of the Dublin-based lessor.

In May, it purchased a 6.2% stake in South Africa’s Comair and is negotiating acquisition of ground handling company, Swissport International.

In another development that underscored the growing importance of China’s airline market, Delta Air Lines in the U.S. announced in July it had agreed to buy 3.55% of China Eastern for $455 million, which made it the first U.S. carrier to invest in a Chinese airline. Delta said it will have an “observer” seat on the China Eastern board.

The buy-in could allow Delta and China Eastern to seek approval to co-ordinate pricing and flight capacity. United Airlines chief executive, Jeff Smisek, said he would be “keenly interested” in exploring a Chinese joint venture once the United States and China negotiate an Open Skies agreement that would ease air route restrictions.

Profits aside, China’s airlines do face challenges. Despite huge investment in airport infrastructure, congestion is a major problem, particularly at the hubs of Beijing, Shanghai and Guangzhou.

Flight delays have led to an inordinately high level of air rage incidents. Last month the CAAC ordered South China’s Shenzhen airport not to add flights and routes, or submit charter flight applications, because the airport was ineffective in handling flight delays. The suspension, started on August 1, will remain in place until year end.

In May alone, several mass disturbances occurred, including angry passengers forcing open cabin doors and fights erupting between airline staff and incensed passengers. The administration criticized Shenzhen Airlines and China United Airlines for their poor management after flight delays and cancellations caused by heavy rain angered passengers.

In July, the CAAC banned privately owned Okay Airways from buying more aircraft and ordered it to reduce flying hours, accusing it of overworking its pilots. It said there had been 21 instances this year in which crew did not take enough time off and another 65 instances of pilots working overtime. Okay has a fleet of 30 aircraft - B737s and Chinese MA60s. Its main hub is Binhai Airport in Tianjin. It flies mainly domestic routes although it added a few Asian destinations in the last quarter of 2014.

The McKinsey China consultancy said China’s “Big Three” carriers and their subsidiaries have been a bright spot in the airline industry globally, averaging until recently annual returns of 15% compared with the global industry average of below 5%.

“China is moving ahead with reforms in state-owned enterprises, designed to promote efficiency and profitability. Regulations on new entrant airlines and the speed of growth of private airlines are being relaxed.

Overall, McKinsey considered China’s major airlines face “significant but surmountable barriers” in the coming years. “Competition is increasing, putting downward pressure on the price of airline tickets, it said. With yields per kilometer of around 9.5 U.S. cents, China’s domestic fares rival those of the U.S., where travelers have more disposable income.

This contrasts with carriers in adjacent markets, notably Southeast Asia, where new budget airlines are selling very low fares. By offering lower fares on domestic travel, the Chinese incumbents can awaken latent demand, stimulate consumption and reduce exposure to any new entrants, McKinsey said.

Presently, distribution is disproportionately centered around direct sales and traditional travel agencies, with little e-commerce.

McKinsey’s research on the Chinese millennial traveler (20-30 year-olds) revealed a more globally minded generation that is confident, independent and looking forward to traveling.

They are Internet-savvy. Fifty eight per cent of the respondents said they liked to book online.

Like airlines everywhere, China’s carriers will likely be confronted with new problems and unexpected crises on the road to greater growth. But most analysts agree that Mainland Chinese carriers will soon take their place among the leading airlines of the world.