Spring Airlines: China's self-styled "first LCC" April 2007
Three Chinese start–up airlines launched in 2004 but only Shanghai–based Spring Airlines seems to have survived. Spring reported a profit of RMB30.6m (US$3.9m) on revenues of RMB539.03m (US$69m) in 2006 with a fleet of five A320s. How does China’s self–styled "first LCC" work?
Prior to 2004, when the Chinese government first allowed private investment in start–up companies, an Air Operator Certificate (AOC) was regarded as a valuable scarcity. The first few airline founders seemed to be investing for a fast buck, through obtaining AOCs and then selling shares to foreign airlines or via the IPO process. The emphasis on quick returns meant a lack of care in choosing management teams, operational bases, fleet planning and any route network development. The glory of owning a licence, however, faded quickly after 2004 and the start–up airlines' lack of efficiency has dissuaded further investment. This first group of Chinese start–ups is struggling to survive. The second group of start–ups, of which Spring Airlines is the most prominent, are motivated by and implementing a simple strategy: a vertical integration of the tourism and airline businesses.
Spring Airlines is a subsidiary of Spring Tourism Group, the largest tour operator in China. Following China’s airfare deregulation in 1997, Spring Tourism began to purchase flights from the Chinese majors to carry tourists and quickly dominated the most popular tourism routes originating from Shanghai. Publicly, it was announced that Spring Tourism had launched an airline because it was constrained by the established airlines' routes, schedules and capacity, and had to have its own carrier to meet surging demand. Spring’s real reason however, was that the relationship between China’s airlines and tour operators was becoming trickier: as the airlines' finances came under pressure they attempted to recover their losses by increasing ticket prices to tour operators.
Spring Airlines was set–up in 2004 by two major shareholders: Spring International Tourism Company which owns 60% and the Spring Charter Flight Tourism Company which owns 40%, whose registered working capital is RMB80m (US$10m). Spring Airlines' Chairman, Wang Zhenghua, is also Chairman of the Spring Tourism Company and he owns 39% of the airline’s shares. About 40% of Spring Airlines traffic was provided by the Spring Tourism Group in 2006. Spring Airlines has styled itself as a low cost carrier; its strategy is to adapt the LCC model to the Chinese market, which is characterised by a huge, low income per capita population. Importantly, Spring wants to avoid the mistakes of the established Chinese carriers. China’s airlines have moved from an era of high growth and high profitability and entered a new stage of expansion with little or no profitability. From 1998 to 2003 the whole industry reported a total financial loss of more than US$1bn, although the period saw an average passenger growth rate of about 13% with more than 200 aircraft delivered to the airlines. Pricing deregulation, deflation from 1998 to 2002 and excessive competition were blamed for the financial loss, but the main reason was the inability to lower operating costs.
Like other LCCs, Spring has used relatively high aircraft utilisation in order to lower operating costs. China’s established airlines average around nine hours per day with the A320. Spring Airlines achieved 11 hours per day in 2006, reducing rental per flight hour by about 20%. The established airline employee to aircraft ratio is more than 200:1, a legacy of the past planned economy and ineffective mergers. Spring has a ratio of 100:1, reducing labour costs by more than 50%.
Normally, start–up airlines purchase revenue management systems or adopt a pay–as- you–use model provided by RM providers. The majority of China’s airlines use reservation/ distribution systems provided by Skytravel, a Chinese company owned by Air China, China Eastern and other smaller Chinese airlines. Skytravel charges about $3 for distributing one ticket. Spring Airlines uses a bespoke in–house system. Spring’s IT department is planning to set itself up as a stand–alone, serving Spring and other customers.
Overall, Spring’s goal is to achieve operating costs of about 30–50% lower than China’s establishment airlines. In 2003 the Civil Aviation Administration of China (CAAC) issued a price directory for every domestic route, stipulating that fares could not be higher than 120% of the list price in the peak season or lower than 40% in the off–peak season. Spring’s 2006 average fare was about 38% of the list prices set by the CAAC and now Spring and others are pricing tickets lower than 40% (see page 23).
The airline encourages website ticket distribution, while still selling greatly discounted group tickets to travel agents. Spring uses the established LCC yield management system but faces the problem that credit cards are not widely used in China, which limits the scale of online transactions. Even so, passengers purchasing e–tickets have continued to grow and accounted for 67% of total passengers in 2006.
Spring provides a no–frills flight service and charges for food and refreshments. This simplified service results in a cost saving of about US$2.5 per passenger. Revenue of about US$35,000 was raised from ancillary services last year, a relatively modest amount.
New base, new route
Currently Spring operates five A320s and a point–to–point model based at Shanghai Hong Qiao Airport. The bulk of its original passengers were tourists collected by Spring Tourism. Business passengers, however, generate about 20% more revenue than tourists and they are the airline’s priority target. In December 2006, business passengers accounted for 62.5% of total passengers. Recognising the importance of the revenue advantage gained from business passengers and constrained by a lack of slots in Hongqiao Airport, the airline plans to set up another base in Sanya, a popular resort by the South China Sea. Once this base is established, Spring plans to carry tourists to/from Sanya on morning and evening flights and transport business passengers on Shanghai routes during the day, maximising tourist and business traffic revenue streams. With two bases established, the airline could establish a hub–and–spoke model. Spring will stick to a point–to–point operation, which suits the Chinese internal markets. Only 8% of Chinese airline routes exceed 2,400km, while 61% fall between 930km and 2,400km and 24% between 465km and 930km. These stage lengths make a Western–style hub–and–spoke operation with several banks per day unfeasible in China. In 2006 Spring Airlines transported 1.13m passengers on 6,713 flights, producing revenues of RMB539.03m (US$69m). 97.7% of the total revenue was attributable to passenger service and 1.8% came from cargo. Unlike its European counterparts, Spring only recorded 0.5% of total revenue from ancillary and merchandising services. The carrier obtained a load factor of 94.4%, the highest load factor among all Chinese passenger carriers. Passenger numbers are expected to reach 2.6 million in 2007, a 232% increase from 2006. Another significance of the two–base operation is that aircraft utilisation could increase to 12 hours per day, further lowering Spring’s operating costs. Total direct operating costs (DOCS) reached RMB465m (US$60m). Fuel costs accounted for 43% of operating costs with aircraft lease rental accounted for 15% of the total direct costs. The third largest operating cost was for airport charges, which accounted for 12% of the total DOCS. Crew costs only accounted for 6% of the DOCS, as pilots and cabin crews serving China’s airlines, except those recruited from outside China, are paid with a Chinese rather than international salary level. The carrier’s DOCS, administration costs, capital costs and sales cost in CASK terms were 24.5%, 68%, 75% and 55% lower than the average of China’s airlines, respectively. Profit after tax in 2006 was RMB30.6m (US$4m, 655% higher than the average for Chinese airlines in RPK terms. Although the airline is making efforts to secure and consolidate its Sanya base, supported by the Hainan Province Government, its prospects still heavily rely on Shanghai and its lucrative business traffic. Besides the shortage of slots at Hongqiao Airport, the change in market focus avoids head–to–head competition with Shanghai–based China Eastern and Shanghai Airlines. Hopefully, once the airline solidifies its presence in China’s tourism market and grows its fleet and route network from its Sanya base, it will return to the Shanghai market with greater competitive power. At the moment there are no other bases planned. In 2006, Spring Airlines announced earnings of RMB0.22 ($0.03) per passenger on ancillary revenues. Most passengers were tourists, who traditionally spend little in–flight. Once business passenger numbers rise, in–flight services revenue should increase as should hotel reservations and car hire services, which still remain underdeveloped in China. Another potential area of growth comes with the reform of China’s Airport Charge and Aviation Construction Fund. The former accounted for 12% (around RMB56m) of the airline’s DOC and the latter 4% (nearly RMB19m). Airport fee regulations aimed at lowering airport charges are to be announced by the CAAC, but a much more significant improvement will come from the elimination of the Aviation Construction Fund, a $1 corporate tax for Chinese carriers. The legitimacy of the fund has been long been challenged by the airlines, it is unsure when the fund will be eliminated, but once ended all Chinese carriers will benefit.
Spring Airlines needs more capacity. The carrier currently has five A320s leased from GECAS and is approaching lessors for further aircraft. However, due to a dearth of A320s on the market, at the moment the lessors are dictating terms — high lease rates or a minimum lease of ten years. As the airline’s financial position is improving, outright purchase seems attractive and is also possible. The airline has submitted a request to China’s Reform and Development Committee to purchase 20 A320s. There are two problems, one political, the other fiscal: first, how many aircraft can the government be seen to allocate to the airline and then how can the carrier raise the finance for the aircraft. To raise funds, the airline needs to tap into the capital markets. Spring has two options: First, to sell equity to private or strategic investors or second to conduct an IPO. Introducing strategic investors to the airline is not on the airline’s agenda and institutional investors might well require a high return in a few years. Hence the two options are not ideal for the airline. The IPO process has more appeal to Spring as it provides equity while leaving the current management to run the company. Spring intends to conduct an IPO in the next two years, but before this the airline needs to deliver financially. When and where to conduct the IPO and who to underwrite it remain undecided, but the airline will need to obtain China’s Securities Supervision Committee’s approval to have the IPO in an overseas stock market.
Towards a Chinese Southwest?
The second constraint is out–dated regulations and vested benefit groups behind the regulations. In 2006 the airline was almost fined by the Jinan Pricing Agency for selling tickets at a price of RMB1 (12 US cents). A regulation issued in 2003 justified the agency’s decision that a domestic airline is forbidden to sell a ticket at a price of below 40% of the list price. Although Spring Airlines settled the argument by applying a special approval regarding pricing from CAAC and through negotiating with the agency, this event reflected a dilemma facing China’s start–up airlines. Urged on by a state–owned and Jinanbased airline, which was seeing its market share dramatically shrink since Spring’s entry into the market, the Jinan Pricing Agency used the pricing regulation to challenge Spring Airlines and protect the Jinan–based airline’s interest. Although the out–dated regulations will be abandoned eventually, Spring will have to develop under these constraints in the foreseeable future. Spring Airlines has not yet significantly impacted the market or created anything like a "Southwest Effect" in China. At the same time, China’s established airlines still have paid little attention to the start–ups. By gradually entering China’s key markets, such as Guangzhou and, in future, Beijing, and some overpriced routes, Spring Airlines will eventually engage in fierce price wars with the incumbents. Spring’s disadvantage is its comparably weak financial position, but the question is how determined and how capable the incumbents are to wage a broad price war against a start–up and how low the prices can go, given the incumbents' high and inflexible cost structure.
Air safety remains Chinese public’s concern. China’s airlines have achieved a record of no accidents for five years. Given Chinese air transport industry’s explosive growth, its weak air traffic control system and many foreign and fledgling pilots' joining the airlines in recent years, the air safety risk is expected to grow. To address this issue, Spring Airlines has adopted a stringent safety procedure and employs experienced domestic as well as foreign pilots.
There is a risk derived from the two–base operation model. The success of the model relies on the smoothness of the whole operation and dispatch reliability. Given the low efficiency of airport handling and air traffic control in China, the airline is taking a risk that might be beyond its control.
Another potential risk comes from the possible conflict between Spring Tourism and the airline business within the group. The airline’s rapid expansion relies on the stable existing market provided by Spring Tourism. On the other hand, the airline provides sufficiently low airfares to the tourism company to ensure tourism’s success. With the airline’s ownership getting complicated, how the two businesses ensure a harmonious working relationship will prove challenging.
|Avation Construction Fund