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China Southern's A380 problems may not be solved by possible Air China partnership


The Chinese Government may soon need to intervene in the negotiations between Air China and China Southern Airlines for proposed cooperation on China Southern's A380 aircraft, which have not been allocated necessary long-haul routes and are consequently churning up losses, reportedly around USD32 million in 2012. Beijing will not permit China Southern to fly key routes from there unless Air China is involved.

Air China and China Southern have already agreed – after a previous government intervention – to cooperate on using the aircraft internationally, but Air China prefers to wet-lease two A380s while China Southern wants to jointly operate the aircraft from Beijing to Paris and possibly later New York and other destinations. China Southern's hub at Guangzhou does not offer sufficiently high-yielding propositions and competitors have already secured prime routes from other cities, forcing China Southern to consider cooperation with Air China on long-haul flights from Beijing.

Even if the Beijing-Paris route proceeds, complementing A380 service between Guangzhou and Los Angeles, China Southern will need to find one or two medium/long-haul routes for its remaining A380s.

Beijing-Paris negotiations were prolonged because of China's leadership transition

China Southern's A380s have become a financial burden in the approximately 18 months since the carrier introduced the type. The fleet, which numbered four at the end of 2012 (a fifth was delivered in early 2013), is reported to have accumulated RMB150-200 million (USD24-32 million) of losses in 2012 as a result of China Southern facing route restrictions. China Southern quantified 1H2012 losses as under RMB100 million (USD16 million) but, amidst considerable attention from the public and financial markets, would not confirm reports out of China specifying full year losses.

China Southern's A380s in 2012 flew only on domestic and Beijing-Hong Kong routes until Oct-2012 when a daily Guangzhou-Los Angeles service started. Although international long-haul routes challenge Chinese carriers for profitability, China Southern would likely incur fewer losses from deploying A380s on international rather than domestic routes owing to higher relative yields, reduced depreciation, as well as lower landing fees and maintenance from the aircraft having fewer daily cycles.

In Aug-2012 China Southern said it was finalising plans with Air China to cooperate between Beijing and Paris, a route where Beijing grants Air China exclusive access. Under China's "one route, one airline" policy, long-haul routes are allocated to a single domestic carrier. The rationale is to have domestic carriers compete against international ones rather than amongst themselves. Even in the domestic market carriers try – with some government support – to establish mini fiefdoms. (Exceptions to this policy are often made for Air China, the flag carrier, which is allowed to operate some long-haul routes from Shanghai alongside China Eastern, which is not allowed to operate reciprocal routes alongside Air China out of Beijing.)

China Southern top 10 international routes ranked on ASKs: 1-Apr-2013 to 7-Apr-2013

China Southern international capacity by region: 1-Apr-2013 to 7-Apr-2013

The cooperation plan between Beijing and Paris has, as of late Mar-2013, still not been finalised, largely a result of the leadership transition in late 2012 bringing business to a halt across China. Major decisions in general have been postponed, and a high-profile decision like having Air China and China Southern cooperate would have been easily postponed or slowed.

Agreement will not be easily achieved, as Air China holds the cards

China is now gradually getting back into the business rhythm, with post-leadership changeover, but people - and bureaucrats in particular - are still adjusting to the new government and re-establishing their critical contact groups. The Air China and China Southern A380 cooperation became so intertwined in mid-2012 that the matter was referred to the country's National Development and Reform Commission, which broadly plans the country's economy. It appears that the NDRC's outcome left the carriers (generally fierce competitors)  to work out the details, which have since become contentious and prolonged.

China Southern CEO Tan Wan Geng wants the situation resolved within two months and is optimistic. But a resolution could be challenging. Air China is only willing to wet-lease two A380s from China Southern whereas China Southern prefers to operate the routes jointly. Joint operation could see China Southern's JV and SkyTeam partner Air France codeshare on the Beijing-Paris service. A wet-lease to Air China – and likely subsequent deployment of the aircraft to Paris – would see it compete with Air France. SkyTeam has voiced its concerns on the A380 matter, saying it seeks clarity on what Air China and China Southern wish to do.

The carriers say the matter has now received the blessing of alliances – which likely concurred reluctantly, with alliances not wanting to upset the Chinese authorities and perhaps jeopardise a more important and larger future.

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Cooperation with Air China would also give China Southern greater network and marketing exposure, whereas a wet-lease would give China Southern no network or marketing exposure and would also be something of a loss of pride if it could not operate its own A380s, the flagship of the fleet that generated it considerable positive publicity. The incentive, if any, for Air China to operate the A380 is not clear. (Air China has no A380s of its own on order.)

China Southern says it has undisclosed plans if the cooperation with Air China cannot go through, but these are likely to be less valuable scenarios as viable routes from Guangzhou – China Southern's main hub where it has more freedom of operation – are few, and key long-haul routes from other Chinese cities are already taken. This dilemma was the driving force behind Hainan Airlines' stake in France's Aigle Azur, which can serve Beijing-Paris as a proxy for Hainan on Aigle's French AOC.

See related article: HNA, of Hainan Airlines, takes 48% stake of France's Aigle Azur, giving backdoor European access

China Southern top 10 bases/hubs stations by available seats: 1-Apr-2013 to 7-Apr-2013

Whatever the outcome of the proposed Air China cooperation that would utilise about two A380s, China Southern would still be left with at least three A380s. About 1.5 frames are used on the Guangzhou-Los Angeles service, so China Southern would need to find at least one, and ideally two, medium/long-haul route to utilise the aircraft.

Increasing Guangzhou-Los Angeles to double daily would be too ambitious after the route already saw a 78% increase in capacity when it was up-gauged from a 777-200 to the A380.

See related article: China Southern to finally commence long-haul A380 services, but operation still faces challenges

China Southern Guangzhou-Los Angeles scheduled capacity (return seats per week): 2008 to 2012

China Southern is strongly promoting Australia-Europe sixth freedom connections via Guangzhou, but serving a European or Australian point from Guangzhou with the A380 would also be overly ambitious (not impossible but unlikely to be profitable). Most of China Southern's European and Australian routes are served with A330-200s. China Southern serves London less than daily, even in the northern summer season. China Southern also faces some demand shortage when serving Australian cities with more than one flight a day, although this is a fast growing market.

Given its long-haul network focus, greater growth can occur through frequency rather than capacity changes. China Southern has mooted, in response to questions about uncertain international markets, that it could keep the A380s flying domestic routes, but this has been unprofitable and unlikely to be a long term solution.

China Southern has understandably kept the aircraft on domestic services until a more sustainable network was available; the carrier was willing to take short-term pain for the right long-term solution. But it is becoming increasingly clear the options for a long-term solution have already presented themselves. The issue now needs to be forced, and will likely be resolved directly or indirectly through the government, which will need to decide whether to make a decision based on what is best for the country (Air China and China Southern, as well as China Eastern, are state-owned) or let politics weigh in: Air China as the national flag carrier curries considerable favour and could have the government agree to what it wants.

China Southern is defensive about its A380 performance, working towards becoming a network operation

As the A380 saga and associated losses have dragged on, it has attracted greater attention, which has become a source of frustration for Mr Tan, who proclaimed to analysts, "We didn't expect so many questions about the A380. I still don't understand why."

Mr Tan tried to argue that load factors on the A380 are high – and, according to the carrier's metrics, higher than on other aircraft for comparative routes. At one point Mr Tan suggested straight-up financial figures were not the sole measurement of the A380's success, saying the aircraft is a "brand", an argument that has some validity. China Southern has heavily marketed the A380, including with a special logo, which has helped to set the carrier apart from competitors, especially as it seeks a larger international profile and has ramped up international services after lagging behind Air China and China Eastern in international flights. China Southern's domestic yields have also lagged behind competitors but are now catching up and excelling.

As questions mount on how China Southern was permitted by Beijing to order the A380 without having access to suitable routes, Mr Tan said: "With or without the A380, we would rather have the A380." But Beijing also has some questions to answer if it is prepared to allow the carrier to suffer continued losses for lack of access to key routes.

Attention may now be on what China Southern will do with its remaining 3.5 aircraft not used between Guangzhou and Los Angeles, but there are also concerns about that long-haul route too; its profitability is still far from guaranteed. Mr Tan said he recently had statistics pulled up about the service on one day and 55% of passengers on the service were connecting. While such a figure is comparable to large sixth freedom carriers like Cathay Pacific and Singapore Airlines, China Southern is still evolving into a formidable opponent.

On that flight, 53 passengers – accounting for around 10-15% of total loading – originated in Manila. The Philippines is hungry for services to the United States as Philippine Airlines is unable to expand its capacity until it regains FAA Category One status. Once it does, this market could soften for China Southern, highlighting the sometimes volatile nature of securing traffic sources for sixth freedom operations.

See related article: Philippine Airlines Group to step up competition against Cebu Pacific with new long-haul LCC

China Southern balances long-term objectives with short-term profitability, building sixth freedom operations

The challenge for China Southern and other Chinese carriers is balancing the long-term objective of being significant international carriers, including in sixth freedom markets, with the short-term profitability objectives. A larger future tomorrow means building the network today, but doing so challenges short-term financials. As Mr Tan conceded of Chinese carriers: "If you wish to make a profit from long-haul routes, it's still very difficult."

China Southern and others are operating loss-making routes, but with the vision they will, one day, be profitable. They are not, as a Singapore Airlines manager once said, "profit-neutral", evidenced by China Southern's push to minimise losses rather than deploy aircraft where it might attract the greatest amount of attention.

China Southern says it has re-timed 80 flights to facilitate better international connections, which in 2012 numbered approximately 370,000 – a significant increase from the 30,000 in 2009. Some routes see transfer rates upwards of 70%. Australian, European, Japanese and Korean routes see about 50% of passengers transfer to China Southern's domestic network. Of China Southern's Australian routes, its more developed services to Melbourne and Sydney are "very good" according to Mr Tan but others require more effort. China Southern had closed reservations for its new Perth service, leading the industry to believe it would be shut down, but later re-opened the flight, saying it was committed to the Perth market.

On the larger subject of route profitability, Mr Tan asked analysts not to consider route-by-route analysis as "we have to rely on the network". The suggestion was that passengers on one loss-making sector feeding into a profitable sector made a positive gain. It is a valid point for some carriers and has been used in Europe to justify loss-making short-haul services as they feed profitable long-haul services. (A distinguished former Cathay Pacific network planner once said, only partly tongue in cheek, of the then-highly profitable carrier that it did not have a single route that made money.) But in China the profitability flow is in reverse: international services have high losses to feed passengers on either more loss-making international services or short domestic routes which can seldom recoup the cost of the international segment. Holistic perceptions are also asked for in other matters, such as the Chinese Government arguing loss-making airports have a net benefit to the economy of the region they serve.

While international waits for its day, domestic rises, leading to higher profits; but rising costs are a worry

China Southern's is now a massive airline, whose core market remains domestic. This again grew in 2012 and helped lead to a 17% increase in operating profit and slight gain in operating margin from 4.8% in 2011 to 5.1% in 2012.

China Southern financial highlights for 12 months ended 31-Dec-2012:

  • Revenue: CNY99,514 million (USD15,767 million), +10.1% year-on-year;
    • Passenger: CNY89,544 million (USD14,187 million), +9.9%;
    • Cargo: CNY6556 million (USD1039 million), +13.8%;
  • Operating costs: CNY95,877 million (USD15,191 million), +10.1%;
    • Fuel: CNY37,401 million (USD5926 million), +14.5%;
  • Operating profit: CNY5099 million (USD4353 million), +17.1%;
  • Net profit: CNY2619 million (USD415 million), -48.7%;
  • Passenger numbers: 86.5 million, +7.2%;
    • Domestic: 77.6 million, +6.5%;
    • Hong Kong, Macau and Taiwan: 1.9 million, +9.2%;
    • International: 6.9 million, +15.7%;
  • Passenger load factor: 79.9%, -1.1 ppt;
    • Domestic: 81.4%, -1.3 ppt;
    • Hong Kong, Macau and Taiwan: 73.2%, -2.5 ppts;
    • International: 75.0%, +1.1 ppt;
  • Cargo volume: 1.2 million tonnes, +8.5%;
    • Domestic: 890,380, +3.9%;
    • Hong Kong, Macau and Taiwan: 15,660, +22.6%;
    • International: 325,820, +22.7%;
  • Yield: CNY0.66 (USD 10.5 cents), -1.5%;
    • Domestic: CNY0.69 (USD 10.9 cents), +1.5%;
    • Hong Kong, Macau and Taiwan: CNY0.84 (USD 13.3 cents), -4.5%;
    • International: 0.53 (USD 8.4 cents), -5.4%;
  • Total assets: CNY142,454 million (USD22,571 million), +10.1%;
  • Total liabilities: CNY102,720 million (USD16,275 million), +12.1%.

2013 will show large growth as China Southern plans a net increase in fleet of 67 aircraft, bringing its total to 558 aircraft, the largest fleet in Asia. This gain is larger than the 47 net increase in 2012 and the 22 net increase in 2011.

Domestic yields show only moderate growth while international sags, the result of capacity – mainly long-haul – still being absorbed. Worryingly, regional yields to Hong Kong, Macau and Taiwan are down, a combination of China Southern's short-lived A380 Beijing-Hong Kong operation requiring ticket price discounting, as well as the cross-Strait market to Taiwan seeing lower fares as the market continues to expand. That expansion, however, is occurring mainly through new city-pairs lacking demand, requiring fare discounting.

China Southern monthly traffic: 2011-2013

The biggest worry – more so than the A380 – is cost base creep. Staff costs, the second-largest item, saw a 13.8% increase. Driving this is some increase in headcount but mainly staff requiring salary increases, as is occurring across China, even forcing some manufacturing to move offshore. The third largest charge, landing and navigation, will increase in 2013 as Chinese carriers will no longer receive discounts on landing charges. Even catering is increasing beyond the growth rate as China Southern seeks to deliver better quality meals in order to woo customers.

A long-term positive, even dominating, outcome in global markets is in sight for China Southern and its peers. But getting there will require more work than the carrier has so far achieved as Asia's largest.

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