Main Story
CHALLENGES OF CHANGE
China’s airlines are at a watershed in their development as the government continues to loosen the levers of a once protected industry.
October 1st 2014
When China Eastern Airlines (CEA), the country’s biggest operator, recently booked a disappointing first half profit of just $8 million, down from $93 million in the same period a year ago, it was only the beginning of the bad news for its shareholders this year. Read More »
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The second half started badly when Chinese military exercises throughout July and early August caused widespread flight delays and cancellations across eastern and central China, including services from CEA’s hub at Shanghai’s Pudong international airport.
But the revenue hit brought on by military control of airspace is hardly the only challenge facing CEA and other carriers. Yet it epitomizes the complexities of operating in the local market for the country’s airlines as changing economic circumstances and the arrival of up to 20 local budget carriers across China fracture yields as over capacity grows.
China’s passenger numbers continue to rise, but yields are dropping. Planemakers are forecasting 6,000 plus new jets will be needed in China in the next two decades, but there are questions about the system’s ability to cope with the predicted expansion of the Mainland commercial airline fleet.
Infrastructure insufficiencies are not being addressed fast enough, despite a massive government program of airport development. At the same time, a slowing national economy continues to trim airline revenue.
Adding to the airlines’ woes is the rapid expansion of the country’s high-speed rail system. It has grown to nearly 10,000 kilometres since 2009 and will expand to 19,000 kilometres by the end of next year. The on ground competition has forced airlines to discount fares substantially to attract passengers away from more convenient and reliable long-distance rail journeys.
Last year, Guangzhou-based China Southern Airlines (CSA) saw domestic revenue decline by 5.5%. National flag carrier, Air China, headquartered in Beijing, experienced a 5% profit drop, despite a 7.3% increase in passengers carried. “The rapid development of high-speed railway and the evolution of low-cost carriers on the Mainland will further intensify competition on domestic routes,” the company warned.
But the most dramatic recent development for the industry was Beijing’s announcement last December that it would support the start-up of more local budget carriers. It is believed the Beijing bureaucrats like what they see at privately owned Spring Airlines, which now operates a fleet of 44 Airbus A320s. A recent report revealed that Spring, founded by a travel agent, enjoyed a net margin of 41%, which compared with a China airline industry average of 12%. Its load factor was 94%. The industry average is 76%.
The central government’s enthusiasm for more local LCCs is interpretated by analysts as a way to catch up with Southeast Asia’s rapid growth in budget operators as well as providing a boost to the country’s slowing economy.
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| Spring Airlines operates with a net margin of 41% compared with a Mainland airline domestic average of 12% |
In the last 18 months, China’s central government has introduced several aviation reforms, including relaxation of some air fare pricing controls, reduced airport charges and processes that simplify and speed up approval for budget carrier start-ups. The industry had to adjust to all of them - both good and challenging.
With Beijing aboard the budget bandwagon, there has been a virtual stampede of investors wanting to operate LCCs. And Airbus and Boeing are benefitting from the new business.
Spring is already an Airbus customer. Last year, the French manufacturer signed commitments with two new Chinese carriers, Qingdao Airlines and Zhejiang Loong Airlines, for 43 A320s.
At Boeing, more than 70% of its sales in China have been to LCCs. It has recently sold 93 B737s to three new operators, Ruili Airlines, 9 Air and Donghai Airlines. In addition, most of a CEA order for 80 B737s is expected to join the fleet of the airline’s subsidiary, China United, which is being converted into an LCC. Rival, CSA, is reported to be converting its subsidiary, Chongqing Airlines, into a budget carrier.
While the planned large capacity increase would appear to pose a serious threat to the incumbents, analysts are quick to point out budget start-ups face several serious issues on their path to profit.
The first is infrastructure, said David Yu, the Beijing-based executive director Asia Pacific for the International Bureau of Aviation (IBA) group, a UK consultancy which provides independent business analysis to the aviation industry.
“The major airports are going to suffer congestion no matter what so unless you’re the Big Three, you’re going to have trouble getting slots at the major airports. It’s a congestion issue more than anything else,” he said.
In Yu’s view Beijing’s promotion of LCCs is really directed at the country’s western regions, where the government wants to boost air traffic growth, and is not aimed at flooding the Beijing- Shanghai- Guangzhou triangle with budget competitors.
Skaiste Knyzaite, chief executive of AviationCV.com, a global provider of aviation specialist resourcing solutions for airlines, MRO providers and other industry players, agreed. “Efficiency will not be easy to achieve for these new entrants, as even Spring Airlines still has trouble securing prime slots and cutting turnaround time,” he said.
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| 'Low cost carriers seem to be the most promising sector in terms of [China] growth, due to strong government support' |
| Randy Tinseth Vice president marketing Boeing Commercial Airplanes |
“In other words, while demand may be growing for cheap air travel in China, tapping the potential of this market could come at a steep price.”
A recent report by strategy consultancy, Roland Berger, said the cost of fuel, maintenance, gate usage fees and other fixed expenses accounts for about 60% of most carriers’ operating expenses in the region. Large, established airlines entering the LCC sector with subsidiaries will find it a challenge to stay profitable in the budget travel segment given current industry conditions, it said.
“Budget aviation in China faces many of the same problems as regional aviation, for example, scarcity of runway slots at major airports and congested airspace along important routes. While these are all strong reasons for maximizing revenue for each aircraft, such an environment cannot be appealing if airlines have to allocate precious resources [airport slots] that are specifically designed to generate lower fares. Other difficulties included recruiting experienced pilots able to fly in crowded airspace controlled by the military, Roland Berger said.
Knyzaite said the successful implementation of the low-cost business model, apart from appropriate infrastructure, would depend on finding qualified staff, not only pilots, to deliver on ground support.
“The low-cost business model is based on spending the shortest time possible on inspection-related works. Meeting that requirement of completing all required tasks in a 40-45 minute time frame can be a challenge for less experienced professionals, especially as it will take time to build the in-house capabilities required to support quick and competent turnarounds,’’ he said.
In the meantime, while China’s growth has slowed to between 6% and 7%, from the double digit expansion of recent years, air traffic continues on an upward trend. In the last five years, China’s airline industry revenue has been growing at an annual rate of 14.4%, to $108.2 billion.
Passenger volume is expected to reach 391.1 million by year end, an increase of 10.3% over 2013. According to China’s current five-year plan, which ends in 2016, 82 new airports will be built across the country. By then, 415 million Chinese are predicted to take an airline flight at least once a year, forecasts the International Air Transport Association (IATA). Although there are some doubts this would be achieved if the economy continues to slow in 2015.
Boeing’s latest market outlook said China will need 6,020 new aircraft, valued at $870 billion, in the next 20 years, based on the country’s forecast economic growth and the entry of more carriers into the market.
The new aircraft will account for 45% of the demand for all aircraft in the Asia-Pacific to 2033. Annual average passenger growth in China will be around 6.9%, while average GDP growth will be 6.2%, said Boeing.
“China’s aviation market is going through dynamic changes,” said Randy Tinseth, Boeing’s vice president of marketing. “New business models like low-cost carriers and airplane leasing companies will provide the growth impetus. Low-cost carriers seem to be the most promising sector in terms of growth, due to government support. Though the number of low-cost airlines increased from just one to five this year, several other carriers are considering the change-over. The growth in low-cost carriers will stimulate air traffic and increase demand for single-aisle airplanes.”
Tinseth is not fazed by the economic slowdown in China. He said Boeing’s outlook is long-term and it is normal for the global civil aviation industry to go through ups and downs. “It is a flexible market and can recover very soon,” he said.
IBA’s Yu believed that the number of new aircraft will exceed Boeing’s numbers. “Whilst there is no doubt China must meet dramatically increased flight demands, the forecast must also take into account government policies to promoting airline traffic, particularly that of the low-cost airlines, and improving airline access in ill-served western China,” he said.
“It is also important to consider that more than 900 aircraft are expected to be retired over this period. According to JetData, IBA’s commercial aircraft database, the Chinese fleet stands at least a 2,400 aircraft, with an average age of 7.8 years.”
With a current outstanding backlog of 42 A320 family aircraft, 35 A330 aircraft, 24 A350 aircraft, 87 737 family aircraft, six 747 aircraft, 50 777 aircraft and 22 787 family aircraft, coupled with predicted aviation growth in the next 20 years, there will be an abundance of opportunities created for the supply chain, and especially for local aircraft leasing companies, who have steadily grown over the last five years. At present, 34% of the current fleet is on lease, said Yu.
Given the volatile nature of the industry, there are no guarantees any of these growth projections will ultimately be fulfilled. “There’s always that threat that the growth might not hit the projections for whatever reason, be it shocks such as 9/11 or something else,” Yu said.
“From an infrastructure point of view, the government is quite keen to promote airline growth. At the same time, they don’t want to go superfast right away. That’s why there are caps on the amount of growth per year for each airline. Understanding and navigating this aspect is important in understanding the market.”
As for the rapid expansion of fast rail, which is carrying some two million passengers a day - twice as many passengers as domestic airlines - on trains that are rarely delayed, it isn’t all bad news for airlines.
Consultancy CAPA has pointed out that even without a rail network, all these passengers wouldn’t necessarily have chosen to fly. Some might not have traveled at all. Others may have taken their trips by car, bus or slow train.
There is no doubt, however, that airlines have been impacted by the development of high speed rail as airline expansion has slowed from its 2011 peak. Said Yu: “people sometimes take the train because it is more convenient. It’s definitely a good option for the traveler. At the same time, rail can increase traffic flow because high speed trains are bringing people from the provinces, from second and third tier cities, to major cities like Shanghai and feeding them on to airlines. Pudong is an example of an aero-transport hub that links rail with air so it does create some additional flows. So it’s not all bad.”
And the policy changes keep coming. In September, the country’s official news agency, Xinhua, reported China may open its skies to foreign carriers with no restrictions on their number or capacity. It cited a speech by Han Jun, head of the international division of the Civil Aviation Administration of China (CAAC), at an industry forum. Xinhua said Han revealed that traffic rights will be gradually liberalized in an orderly and controlled manner, but did not provide a precise timetable for the policy change.
Analysts caution that overseas carriers shouldn’t get too excited about such pronouncements. “I think wider liberalization is going to take a while,” said Yu. “Congestion is still a major factor. If you talk to the management of any foreign carrier and ask where they want to fly, they don’t want to fly to Wuhan or Chengdu. They all want Beijing or Shanghai. So if you ask officials about open skies per se, its open skies everywhere except the major cities.”
The latest CAAC statistics show 111 foreign carriers from 55 countries are flying to 46 Chinese cities at a rate of 2,705 flights a week. Nineteen Chinese airlines fly to 120 cities in 49 countries with an average of 2,854 flights each week.
The major Chinese airlines have made significant inroads onto international routes and are now flying A380s and B787s. However, many of the routes are unprofitable and while analysts agreed that equipment is now best standard Chinese airlines are not matching their foreign rivals in service.
As well, their profitability remains shaky. Much of the blame has been laid on the unexpected reversal of the renminbi’s exchange rate against the U.S. dollar earlier this year but there have been other factors. “I definitely think the currency has had a major affect,” said Yu. “Obviously, a slowdown of growth in the economy, the controlled growth, is another issue. But (Chinese government), austerity measures that are in place have affected the “Big Three”. Given a lot of the folks who would be taking first or business class tickets have downgraded to economy, that has obviously created a slackening of the market and has a big effect because obviously up front is where these carriers make their money.”
Fuel costs are also an issue. China’s regulator banned its airlines from buying crude future contracts – a key form of protection against rising fuel costs – after they incurred heavy losses in 2009. But it is understood airlines are contemplating a resumption of fuel hedging activities.
Air China said in March that its board had approved a return to fuel hedging “according to market conditions”, but it confirmed in August that it had not yet resumed the practice, said CAPA. China Eastern and China Southern won’t comment on any plans to resume hedging.
John Grant, executive vice president of OAG, the global provider of aviation information and analysis, said the Chinese market and aviation in particular remain a paradox for many in the travel industry and that China is still perceived as an ‘emergent’ market.
Emergent it may be, but China is a country where dramatic change is likely in the next five years.
Today’s Chinese market is based on rock solid foundations of distribution, airlines, airports and traditional relationships across the market. Tomorrow’s market will see revolutionary change in its structure, creating new business opportunities for everyone as travel increasingly becomes a commodity rather than a perceived luxury. Changes in technology will also fuel this growth, said analysts.
“Whatever the present problems, there is a universal belief that the future remains assured. “Even though economic activity overall has slowed a bit, this really won’t affect the long term prospects for the industry’s growth,” said Yu. “People are now used to flying. It is getting more and more entrenched.”
