China aviation SWOT: Airlines cash starved, China Eastern-Shanghai Air merger likely to stumble

19th June, 2009

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China’s airline industry faces an enormously challenging year. Geared for growth, under-capitalised and unrestructured, the sector has been rocked by external events and economic malaise, while internal rivalries and policy inertia threaten to undermine what on paper appears a potential aviation growth bonanza. We review China’s aviation sector prospects in this SWOT analysis.

This report is drawn from The Centre’s widely read Monthly Essential China publication.

STRENGTHS – World’s brightest growth prospect

a) 400 million passenger milestone surpassed

China’s aviation industry exhibits all the hallmarks of a huge potential aviation growth market: the world’s largest population, rising incomes, increasing urbanisation, strong inward investment in infrastructure and a significantly improved safety regime.

Like some other growing economies, the airline sector has become accustomed to double-digit increases in traffic. But 2008 was a setback year for China’s airlines industry (as were 2003: SARS and 1998: the Asian Financial Crisis).

Overall, Chinese Mainland airports handled 405.8 million passengers in 2008, up just 4.7% year-on-year (following a 16.7% increase in 2007), according to the CAAC. Domestic passenger numbers rose 5.3% to 368 million, while international traffic (including routes to/from Hong Kong/Macau) slipped 4.4% to 37.9 million.

Chinese Mainland international, domestic and regional (Hong Kong/Macau) airport passenger numbers (mill): 1984 to 2008

After a difficult start to 2008 with the devastating snow-storms in the south, Guangzhou Airport bounced back more strongly than its main rivals Beijing and Shanghai, where security restrictions surrounding the Olympic Games and the economic downturn had more of an impact on traffic later in the year.

Chinese Mainland airport passenger numbers (mill) and passenger numbers growth (% change year-on-year): 2008

Cargo was also subdued. Mainland airport cargo volumes were subdued in 2008, with domestic and international volumes both rising just 2.6%, to 5.6 million and 3.2 million, respectively – for a total of 8.8 million tonnes. The increase in 2007 had been 14.3%. Shanghai Pudong and Hongqiao airports reported positive cargo growth last year, while cargo volumes retreated at Beijing, Guangzhou and Shenzhen airports. The stand-out performer was once again Tianjin, near Beijing, while Chengdu in Southwest China also performed well (it benefited from the earthquake response).

Chinese Mainland airport cargo volumes (mill tonnes) and cargo volume growth (% change year-on-year): 2008

Chinese air traffic controllers were kept busy, with a 7.2% increase in aircraft movements at Mainland airports last year, to 4.2 million. This outstripped the increase in passenger and cargo traffic, meaning aircraft load factors were weaker as airlines expanded capacity ahead of demand and as smaller gauge aircraft were used. Domestic aircraft movements rose 7.8% to 3.8 million, while international movements rose 2.1% to 388,000.

WEAKNESSES – The cost of growth, internal rivalries and favouritism

a) Regular strong growth rates have covered up a multitude of problems

Strong growth breeds complacency – and nowhere is this exhibited more clearly than the Chinese domestic airline sector. Structural inefficiencies, duplication of resources and pervasive government involvement has left the sector exposed to the inevitable downturn in demand – particularly a prolonged economic downturn.

Last year’s losses were breathtaking in scale and have continued into the early months of 2009. After combined losses of some USD4 billion last year, the Mainland carriers turned in a USD200 million combined operating loss in the first quarter of 2009, according to The Centre’s calculations.

Select Chinese carriers’ key financial results: Three months ended 31-Mar-09

USD (millions)	Revenue	Operating Costs	Operating profit	Net profit
China Southern	1,888	2,001	-101	33
Air China	1,645	1,613	37	144
China Eastern	1,306	1,230	-124	6
Hainan Airlines	503	398	5	5
Shanghai Airlines	398	416	-18	4
Shandong Airlines	169	133	4	9
Total	5,909	5,791	-198	199

On the surface it would seem the airlines are stemming the flow of red ink. Various measures of Government support helped China’s airlines report profit at the net level in the first quarter, but this is not a true reflection of the state of the sector’s financial health.

When compared to the combined USD450 million operating profit in the corresponding period last year, China’s state-owned carriers have suffered a USD650 million turnaround at the operating level.

Furthermore, the latest batch of poor numbers was achieved at significantly lower fuel prices than last year, which suggests that Chinese airlines are suffering more from the destruction of demand caused by the global economic downturn than they did from last year’s record oil prices.

In this they are hardly unique. But in these conditions, inefficiencies can bit deeply. As a result, more cash handouts to China’s weakest airlines are on the cards – a factor that has been a key driver of Chinese airline share prices over the past 18 months.

Share prices of the main carriers have risen since the start of this year, particularly as the domestic traffic environment has improved, though Hong Kong’s Cathay Pacific’s share price has had only muted gains as its premium traffic revenues continue to show weakness.

Chinese airline share price index Jan-2009 to Jun-2009

Cathay’s passenger numbers continue to deteriorate this year, while Mainland carriers are enjoying solid domestic growth (over last year’s depressed base), which is keeping their overall passenger growth in positive territory while international remains depressed.

Air China, Hainan Airlines, China Eastern, China Southern and Cathay Pacific passenger number growth: Jan-07 to May-09

China Southern and Air China have been more careful with their application of capacity and their load factors are climbing back into positive territory. China Southern is seeking more government financial support, while Air China is expecting to be marginally profitable in 2009.

b) Consolidation not a silver bullet, just a bullet

The proposed China Eastern Airlines-Shanghai Airlines merger would combine two loss-making and structurally flawed carriers. Their respective backers (the central and Shanghai Municipal governments) are attempting to stem the flow of red ink at both carriers, but risk creating a loss-making behemoth.

China Eastern’s problems stem from the failed policy of airline industry mergers enacted by Beijing at the end of the last decade in response to the previous catastrophic financial event for the sector, the Asian Financial Crisis, coupled with an overheated domestic competitive market. The subsequent enforced merger process was sound in principle – in creating three large carriers – but in practice has created often unwieldy commercial giants, where political leadership and organisational efficiencies leave them ill-equipped to adjust quickly to a downturn.

Newly installed management at China Eastern has indeed even tried to undo part of the consolidation effort – the transfer of assets and proposed sale of its Yunnan branch (formerly the profitable Yunnan Airlines).

Shanghai Airlines’ problems stem from its management’s inability to cope with intense competitive pressures as mid-size player at China’s commercial capital, which has been particularly hit by the economic downturn.

While China Eastern is a product of the CAAC (with its bureaucratic legacies), Shanghai Airlines grew out of the Shanghai Municipal Government’s ambitions. Navigating the complex relationships and distrust that exists between the two will not be easy for China Eastern Chairman, Liu Shaoyong. And nor will any of the outcomes from a merger significantly improve China Eastern’s prospects over the near term.

As is standard practice in China, staffing levels will be maintained following the merger, and while some duplication of routes (particularly at Hongqiao airport) is expected, there are unlikely to be major cost savings from network rationalisation. Some pricing power may return, but Shanghai will remain an intensely competitive air market. Billions more will need to be (and probably will be) pumped into China Eastern to keep it aloft in the years ahead.

The real game lies in applying enough make-up to China Eastern to attract a suitor, so it can attack its structural and competitive issues with a hard edge. Removing the challenge from Shanghai Airlines (at least in name) and priming China Eastern’s balance sheet should eventually attract the likes of Singapore Airlines back to the table, once the global economic crisis is well and truly just a memory.

But that will not happen soon. The threat of further meddling by Air China and the ‘super carrier’ ambitions of its former Chairman and current CAAC Minister Li Jiaxiang still remain in the background and a risk to any would-be buyers.

OPPORTUNITIES – Leadership and North Asian liberalisation

a) Opening up sleepy North Asian markets

South Korea has made some attempts to open up its skies to fresh competition, while Japan is making a once in a generation step to open up the ground at Tokyo (in the form of runway developments at Haneda and Narita) that promise to shake up the moribund Japanese market and stimulate new entry in 2010.

New entrants in China remain mired in bad business model choices, weak management skills and the government’s stranglehold over so many operational aspects of the business.

Nevertheless, North Asian aviation is emerging from its slumber and could be one of the global hot spots over the next decade, led by an investment in new capacity and progressive liberalisation of aviation access. It is the one seriously untapped region, where high per capita GDP and a generally restrictive regime has created opportunity pressures that will spill over once the bottleneck is removed.

If anything, the economic crisis should spur Tokyo, Beijing and Seoul to open their aviation sectors to more competition, to stimulate economic growth. In practice, there will be the inevitable nationalistic calls for protection by incumbents, but the overall momentum should be for change and increasing openness. The route to financial viability is expansion, not government bailouts.

Taiwan’s increasing engagement with the Mainland is also an opportunity for carriers on both sides. How far the pendulum swings depends on political and economic considerations in Taipei, but as the chill economic winds persist, increasing engagement is vital.

b) The world stage is set for the Middle Kingdom

It is no coincidence that China, which shares more physical national borders than any other country, is increasingly viewed as a leader in global geo-political affairs. Its role in the North Korea issue is pivotal, for example. The same can be said of global aviation, where China’s leadership on key issues such as liberalisation of access and ownership will be increasingly sought.

That is why the China Eastern issue is so important in establishing China’s credibility in the international market. If it can get the Shanghai airline mess under control, China can look adopt its rightful position as a global leader as the next decade progresses. The opportunities that will bring will be enormous for China’s economy, and its airlines.

THREATS – Protracted economic slump in the west, planes and pigs

a) Economic downturn and swine flu

One of the Chinese aviation industry’s biggest threats therefore remains a protracted economic downturn in the west, which will impact the flow of people and goods. The spread of swine flu is also impacting demand in the region, Japan in particular.

b) Fragile balance sheets

But a key issue remains the fragile state of airline balance sheets in the face of an enormous funding requirement, as huge numbers of new aircraft arrive in the coming years.

China fleet expansion plan: 2009 to 2013

China's airlines ended 2008 with a fleet of 1,254 aircraft (120 more than in 2007). But the net fleet addition in 2008 was 16 less than the original growth plan, due to Boeing delivery delays.

The CAAC has confirmed China's airlines originally planned to import 241 aircraft in 2009 (including the 16 delayed from 2008), but have "cancelled" 43 deliveries (it is not clear if these orders have been cancelled or if deliveries have been deferred). This will still result in a net increase of 198 aircraft in 2009, or 65% more aircraft than added in 2008, providing a 16% lift in capacity after retirements.

With lower predicted increases in demand off a lower base (the CAAC is predicting a 10% increase in system traffic (tonne kilometres) in 2009, including an 11% increase in passenger traffic and an 8% lift in cargo traffic), load factors (and therefore yields and profitability) will come under pressure in 2009, unless there are further aircraft order deferrals, cancellations and/or lease renegotiations.

Overall, the CAAC's traffic forecast for 2009 could be achievable, if only because the 2008 growth rate was so sluggish. But this outlook is well below the long-term development trend in China over the past two decades and the 20%+ growth rates seen in previous recovery years. And if slowing freight carriage is a true indicator of the Chinese economy, achieving double-digit growth will be unlikely.

The international headwinds, falling load factors and the apparent lack of another bold domestic restructuring plan, should ensure the Chinese airline industry as a whole will not report a profit again in 2009.

At the end of the day however, profits aren’t that important for the Chinese aviation sector at this stage of its development – funding is King. Domestic and foreign banks will continue to loan funds to the Chinese carriers, while foreign lessors will remain happily engaged, so long as the implicit sovereign support for Chinese airlines remains in place.

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