China's "Big Three" trundle ahead November 2014

China’s Big Three — Air China, China Southern and China Eastern — have faced tough market conditions over the last 24 months, and all of them have seen profits fall despite rising revenue. However, all three airlines are still in profit, and with a virtual oligopoly of the huge domestic market the future for the Big Three remains secure.

In relative terms, it has a been tricky couple of years for the Chinese economy; according to the World Bank its GDP growth “slowed” to 7.7% in each of 2012 and 2013 (compared with 10.4% in 2010 and 9.3% in 2011) — though of course that’s a growth figure that western economies can only dream about.

More significantly, China is still well on course to become the largest economy on the world over the next few years (though in absolute terms and not in GDP per capita). In parallel, it will also become the world’s single largest domestic aviation market. According to Airbus, domestic passengers will grow by an average 7.1% per annum over the next 20 years (see chart below), and “by 2033 the Chinese domestic market will be more than 60% larger in terms of passenger than today’s largest market — the US”. Boeing is only slightly less bullish, forecasting passengers carried domestically will rise at an CAGR of 6.6% over the 20 year period to 2033.

So far much of that domestic traffic has been concentrated on routes along and to the prosperous east of the country, in a strip from Beijing through Shanghai and down to Hong Kong and Guangzhou, but analysts see a lot of growth coming from point-to-point routes into the centre and west of China. Cities that many in the west have barely heard of — such as Zhumadian, with a population of 8.2m, or Nanchong, with 7.2m — offer immense potential for new routes, many believe.

The government, of course, is encouraging aviation development — though often at a pace that seems glacial by western standards. Huge investment in airport infrastructure (though there are at least 30 major Chinese cities without airports) is now being accompanied by gradual reductions in airport fees and some easing of strict governmental regulations, and that is encouraging LCCs and other independent airlines to compete.

However, the reality on the ground is that it is still China’s Big Three airlines — Air China, China Southern and China Eastern — that are best placed to exploit Chinese passenger growth, particularly domestically. Over the last three years and despite rising revenue all the Big Three have seen their profits fall (see graphs on pages 14 and 15), but they are profitable nonetheless and, once the depreciation of the renminbi is excluded, all three are performing better through full 2014. Over the next few pages Aviation Strategy takes a look at each of these carriers in turn.

Air China

China’s flag carrier is based in Beijing and its 39,500 employees (of which 25,300 work at the mainline Air China) operate more than 300 routes to 162 destinations in 32 countries, comprising 106 domestic cities and 56 international ones.

For the first nine months of 2014 Air China reported a 77% rise in revenue to RMB78.9bn (US$12.8bn), although operating profit was down 35% to RMB3.4bn ($0.6bn) and net profit fell 23% to RMB3.4bn ($0.6bn) — though this was largely to foreign exchange losses; the renminbi has depreciated significantly against the US Dollar over the last few years, and exchange losses “cost” Air China RMB2.3bn ($0.4bn) in the January to September period.

Air China has consistently had the best results of the Big Three over the last few years, and that’s due largely to the fact that it is the flag carrier, which generates large amounts of tangible and intangible benefits — from a dominant position at Beijing airport, to enjoying substantial government travel in and out of Beijing, to being merged with stronger domestic airlines than its Big Three rivals under the government-mandated aviation industry consolidation plan.

And as can be seen in the chart (one the next page), it has higher international traffic than China Eastern or China Southern, with Air China’s international RPKs as a proportion of all RPKs being 31% in the first three-quarters of 2014 (compared with 27% at China Eastern and 21% at China Southern).

Altogether the Air China mainline has a fleet of 316 aircraft (of which 40% are owned), which is the smallest mainline fleet among the Big Three. It comprises 119 737s, 113 A320s, 49 A330s, 30 777s and five 747s. They have an average age of six and a half years, with narrowbodies having the youngest profile and widebodies the oldest (the 747s, for example, have an average age of more than 18 years). On firm order at the mainline are 66 aircraft, comprising 15 787s, 12 737-800s, four 747-8s, 10 A350-900s, five A330-330s and 20 Comac C919s.

The order for 20 C919s was forced on Air China (and each of the other Big Three airlines) by the government; it is highly unlikely any of these airlines would have chosen the model given a free choice. The first of an order for five 747-8s arrived in late September (the rest will be delivered by the end of 2015), while the 787s will start delivery from late 2015 onwards. If subsidiaries such as Air China Cargo, Shenzhen Airlines and Air Macao are included, the Air China group fleet comprises 500 aircraft.

Strategically the focus for the next 18 months or so is to concentrate on maintaining its strong position in Beijing and building up operations at Chengdu and Shanghai. Air China’s domestic and international network connects largely at its key Beijing hub, which accounted for 2.5m transfer passengers in the first half of 2014 (following a 17.3% rise in connecting flights at the airport) and provided RMB2.7bn ($0.4bn) of revenue in the six month period (and half of all transfer traffic at Air China in the January-June period).

But the flag carrier is also expanding operations at other airports too, most notably at Shanghai (from where it has launched a route to Munich, bringing its European routes there up to four), and Chengdu (where its transfer passenger topped 0.25m in the first half of 2014). Internationally the priority is to open more routes to North American and Europe, and the airline is increasingly using 777-300ERs on these sectors.

Air China is also increasing co-operation with its strategic partner, Cathay Pacific Airways (in which it has a 29.9% stake, while Cathay has a 20.1% stake in Air China) in everything from joint purchasing to maintenance.

China Southern

Guangzhou-based China Southern employs around 80,000 and its route network serves more than 190 destinations in 35 countries, of which 125 are domestic. Its primary hub is Guangzhou, but it has also built up significant services at Beijing (in competition against Air China of course) as well as Chongqing (in the south-west of China) and Ürümqi (in the north-east), the last two of which are domestic hubs.

It is by far the leading domestic airline in China, with 77% of its RPKs in January to September 2014 coming from domestic traffic (compared with 69% at China Eastern and 65% at Air China over the same period).

In the first three-quarters of 2014 China Southern’s revenue rose 9.9% to RMB81.8bn ($13.3bn), although operating profit fell RMB2.9bn in January-September 2013 to RMB772m ($125m) in the first three-quarters of 2014. At the net level there was a similar reduction, with China Southern posting a net profit of RMB1.8bn ($0.3bn) in 1Q-3Q 2014 compared with RMB3.1bn in the same period of 2013 — and again this was largely due to a huge exchange loss in the first nine months of 2014, thanks to the depreciation of the renminbi. The airline also says that it facing “increasing pressure due to the drop in the Chinese economic growth rate and slower consumption growth, as well as relative over capacity in the airline industry and increasing competition from high speed rail”.

Nevertheless, China Southern is optimistic about its prospects thanks to “the background of deepening aviation reform, the improvement of living standards in China and the development of the country’s tourism industry”.

Operationally the focus is on making its network more efficient, and specifically improving transit between domestic and international flights at its hub operations. In the first six months of 2014 international transit passengers totalled 1.1m, up 5% year-on-year, and 225,000 of those were sixth freedom passengers (up 6.8% year-on-year). Altogether transit passengers generated RMB0.8bn ($130m) for China southern in the first six months of 2014, some 6.5% up on January-June 2013.

Whether at a mainline or group level, China Southern has the largest fleet of any Big Three carrier. The mainline operates a fleet of 471 aircraft (of which 41% are owned), comprising 226 A320s, 155 737s, 30 A330s, 13 757s, 12 777s, 10 787s, five A380s and 20 EMB 190LRs. Including subsidiaries, the China Southern group has a fleet of 589 aircraft.

On order at the mainline are 54 aircraft: six 777-300ERs, four 777Fs, two 737-800s, 10 A330-300s, six A320ceos, six A321ceos, and 20 Comac C919s.

China Southern is the only Chinese carrier to operate A380s (the first of which it received in 2011), although it has struggled to find suitable routes for the equipment. They have been used primarily on domestic trunk routes such as Beijing–Hong Kong and Beijing–Guangzhou, but these have racked up substantial losses.

The obvious solution — to operate the model on international routes — is also problematical, as the government forbids airlines from competing against other Chinese carriers internationally, which essentially rules out virtually all potential routes out of Beijing. China Southern entered into talks with Air China on joint operations of the A380 out of the capital, but they came to nothing and so unless government regulations change (a situation that Air China is unlikely to want), then China Southern can only use the model on routes out of Guangzhou, such as to Los Angeles — and this service has been reported to be heavily loss-making too.

China Eastern

Based at Shanghai (at both Hongqiao and Pudong airports) and with secondary domestic hubs at Kunming and Xi'an, China Eastern has 68,500 employees and operates to 121 destinations, with around 44 of those outside of China.

During January to September this year China Eastern saw a 2.4% rise in revenue to RMB68.7bn ($11.1bn), though — as with the other Big Three airlines — profits were hit drastically by the depreciation of the renminbi against the dollar. Exchange rate losses helped turn a RMB1.8bn operating profit in 1Q-3Q 2013 into a RMB1bn ($162m) operating loss in the same period of 2014, while the net profit fell from RMB3.4bn to RMB2.1bn ($340m) in the same nine month period year-on-year.

China Eastern’s mainline fleet comprises 374 aircraft (of which two-thirds are owned or under finance lease) — 216 A320s, 104 737s, 37 A330s, 10 ERJ 145s, five A340s and two 777s. At a group level the fleet rises to 471 aircraft. The mainline order book totals 104: 40 737-800s, 18 777-300ERs, nine A320ceos, eight A330s, seven A321ceos, two A319ceos and 20 Comac C919s. China Eastern received the first of 20 Boeing 777-300ERs on order this September, and these will become the mainstay of the long-haul fleet as they are delivered.

In revenue and profit terms, China Eastern is the smallest of the Big Three, and that’s largely a function of being “stuck in the middle” — as one analyst puts it — strategically: it has neither the international dominance of Air China nor the domestic strength of China Southern.

In the face of increasing competition from the other Big Three airlines (and other carriers), China Eastern is endeavouring to maintain its grip on its hub airports, though this is far from easy — in the first half of 2014 China Eastern’s market share at its hub airports were 49% at Shanghai Hongqiao, 38% at Shanghai Pudong, 43% at Kunming and 30% at Xi’an.

Interestingly China Eastern converted one of its wholly-owned subsidiaries — China United Airlines, into a low-cost airline company in July 2014. Based at Beijing’s Nanyuan airport, the airline was launched in 1986 as a civil transport offshoot of the People's Liberation Army, and today (as an LCC) operates a fleet of 30 A319s, 737-700s and 737-800s to 20 domestic destinations, some of which are military (and hence low fee) airports. The progress of this LCC “trial” is being followed by Chine Eastern’s group management.

Its other strategic imperative is increasing the benefits it receives from SkyTeam; China Eastern became the last of China’s Big Three to commit to a global alliance when it joined SkyTeam in 2011. The alliance also has China Southern as a member, which has led to inevitable and (as yet) unfounded speculation about a merger between the two giant carriers at some time in the future.