26-Dec-2012 7:30 PM

Chinese carriers in for the long haul but face stumbling blocks along the way

Analysis

There is no doubt that Chinese carriers will be a force to be reckoned with. They are working with the world's largest population and when travel propensity increases this will quickly make China the biggest market; they have the potential to maintain a low cost base; and they have favourable geography - through hubs in each corner of the country they will be able to route traffic efficiently, their sixth-freedom operations posing a threat to existing hubs in Asia and the Middle East. Realising all of this remains a question of when, how and with whom.

Long-haul aircraft deliveries are scheduled to pick up around the middle of the decade and ensure expansion (the short-term deliveries are mostly single-aisle equipment). The key will be to ensure profitable expansion. Service delivery and international marketing still lags noticeably. Functional non-Chinese-language websites can be a novelty.

The following is an extract from the special China edition of Airline Leader, CAPA's management journal for CEOs. Click on the side panel on this page to obtain full access to the soft copy.

China Southern embarks on international expansion strategy

No carrier represents China's international airline ambitions - and challenges - better than China Southern. The Guangzhou-based carrier in 2009 set out to expand the share of international services to 30% of its system capacity. This includes multiplying its Australian services from seven a week in 2009 to 55 times weekly in 2015. In doing so, China Southern has lit the fire under China's potential to act also as a major sixth freedom force - not only opening Australia-London connecting services but branding the offering as the "Canton Route" (which Qantas for decades has called the "Kangaroo Route"). It now offers "a new shortcut from Europe to Australia".

Gains often do not come without pain, and China Southern showed plenty at its 1H2012 results. While its competitors grew international RPKs 7-10% with flat or modest yield growth, China Southern's international network grew by 27% and yields dropped 7% - although that includes cushioning fuel surcharges at the lowest level of China's major airlines.

The carrier's handful of A380s, the pride of the fleet, were restricted to domestic and Hong Kong routes with low utilisation rates, accumulating USD16 million losses in six months. So it was a substantial reversal when the carrier, at its results briefing, requested that analysts not "worry too much about China Southern's international expansion".

China Southern international vs domestic capacity share by ASKS

China Southern international capacity (seats) by region

Chinese airlines on a learning curve when it comes to alliances

Friends will be needed and the Chinese carriers are beginning to partner, but this is in its infancy and the carriers are learning international relations. Attitudes to global alliances are pragmatic (for example Air China's Star allegiance and equity partnership with oneworld's Cathay Pacific). China can masterfully plan big projects and expansive international air networks are no exception - but the smaller components, not even at the detail level, are typically not handled so well and can limit cohesiveness. The biggest question for international route development - an open market - shows no signs of progression.

China's airlines and airports are big. Their size is surprising for many observers. Beijing Capital Airport is expected to overtake Atlanta in 2012 as the world's busiest for passenger movements. Shanghai Pudong and Guangzhou in Oct-2012 were the 14th and 15th largest airports, ahead of New York JFK and Amsterdam while nudging Singapore and Dallas/Fort Worth. China Southern and China Eastern rank in the top 10 largest airlines by seat capacity as the eighth and ninth largest, respectively, while Air China is a few places away at 13th largest.

But these rankings are mostly reflective of China's large domestic market. Ranked on international seat capacity only, Shanghai Pudong and Beijing Capital are the 23rd and 27th largest while Guangzhou is 68th largest, based on Innovata data. For international seats, China Eastern is the 30th largest, Air China 36th and China Southern 39th (explaining the latter's international focus to allow it to catch up). Not unrelated, their international yields are the lowest type for the Big 3 - Air China, China Eastern and China Southern - which break out yields by domestic, regional (Hong Kong, Macau and Taiwan) and international.

Regional yields are typically the highest, driven by exceptional demand for still relatively new cross-Strait flights to Taiwan, where capacity is deeply regulated. China Southern's regional network is comprised almost entirely of Taiwan services since it has no flights to Macau, and its Hong Kong capacity is half that of Air China and China Eastern. With no Macau and Hong Kong services to weigh the average down, its regional yield becomes the highest of the Big 3 whereas elsewhere it typically lags Air China and China Eastern.

Domestic yields sit in the middle, but international yields across the board are easily the weakest category for the Big 3 - 27% lower than domestic for Air China and 24% lower for China Southern, although only 5% lower for China Eastern, partially reflecting the financial community's strength in its hub in Shanghai. Lower international yields are partially supported by the lower operating cost of long-haul services than short-haul domestic, but boosting international prices must be, and is, firmly on the agenda.

China constrained by 'one route, one airline' policy

China has a de facto "one route, one airline" policy that restricts international routes to being served by one mainland carrier.

The exceptions are regional international routes to Hong Kong and Taiwan, as well as for Air China, the state-preferred carrier that has been able to launch flights from Shanghai to Frankfurt, Milan, Paris and Sydney. Shanghai-based China Eastern serves those routes (except Milan) but has not been able to operate long-haul routes from Beijing alongside Air China.

Hong Kong too had an effective one route, one airline policy until, ironically, Beijing pressed for it to be lifted so Dragonair - in which it owned a stake - could serve more routes. Dragonair was granted ex-Hong Kong rights in 2002, but Beijing shows no interest lifting the policy at home for carriers besides Air China. The domestic market has competition, but it is carefully regulated: Spring Airlines had to wait many years to enter the Beijing-Shanghai trunk route.

Opening the international floodgates is anathema to the civil aviation authority's (CAAC) current goals for China's major airlines. The strategy is to consolidate their position by boosting fortress hubs, developing better international transfer traffic and, most importantly, being able to compete with foreign carriers before increasing competition with each other.

This is a logical progression but it bears dangers, with echoes of India's prolonged protection of Air India, which led only to supporting extended inefficiency while the world changed around it. In a fast changing global market, isolation risks being left behind. And, with China's unprecedented expansion rates, infrastructure is a constraining issue too. The country's key business hubs of Beijing and Shanghai are nearly at capacity, limiting growth opportunities.

In 1H2012 Air China grew its Beijing capacity by only 2.7%. Limits on home-hub expansion in turn restrict the ability to develop international transfer traffic, a goal also slowed by economies in the doldrums and weak international marketing. As for not competing with each other, that also has the undesired spinoff of restricting Chinese carriers from reversing their national under-representation in international markets.

Between China and the United States for example, US carriers comprise 60% of direct seats and Chinese carriers 40%. Between Shanghai and Los Angeles, American Airlines and United each have a daily service while on the Chinese side there is only China Eastern's single daily flight.

Air China international vs domestic capacity share by ASKS

Air China international capacity (seats) by region

Until major economies pick up and inbound marketing improves, Chinese carriers will struggle to find viable un-served long-haul routes - despite there often being strong demand: Asiana and Korean Air are doing well on transfer traffic from China to North America while foreign carriers, typically with larger aircraft, do well to other corners of the world. This has led Hainan Airlines to purchase a 48% stake in France's short-haul carrier Aigle Azur, which Hainan would then use to link France and China, thus bypassing the one route, one airline policy.

Regulatory hurdles prolong deployment of A380 on long-haul routes

A larger pressing issue is with China Southern's A380 fleet. The carrier's Guangzhou hub is the third largest airport on the mainland but its business traffic is less valuable than at the financial hub of Shanghai or the hub of Beijing, home to government and state-owned enterprise traffic.

China Southern took delivery of its first of five A380s in Oct-2011, but it was not until Jul-2012 that Beijing's approvals for long-haul service came through. Until that point China Southern was only able to operate its A380s on domestic and Hong Kong routes, losing an amount in 1H2012 that the carrier would only quantify as "under RMB100" million (USD16 million).

While it seems there were spool-up regulatory matters on the Chinese side, route approvals were also prolonging the A380's long-haul development. Murmurs from China Southern indicated a preference for using the aircraft on flagship routes including Beijing to Paris and New York - both of which fall squarely in Air China's territory. Official and repeated statements from the carrier said approval was always just a short while away.

The first international route granted for Southern's A380 was Guangzhou-Los Angeles, which the carrier has served since 1997 with Boeing 777-200s. Even though the carrier has built up the route to a daily offering, the A380's replacement of the 777-200 will lead to a challenging 78% increase in capacity, after years of modest growth.

With Guangzhou at the foot of China, north China/Asia connections to North America via Guangzhou are too circuitous to be fully competitive. Southern China and Southeast Asia connections on paper work out better, but China Southern will be competing with well-experienced, and protective, sixth freedom carriers with far greater marketing prowess and more established brands.

The second route the CAAC granted China Southern's A380, Beijing-Paris, presents its own challenges. Air China, most likely under direction from the CAAC, will withdraw from the route in favour of China Southern, but the two will cooperate, including Air China codesharing on China Southern's service, despite the two being competitors and members of different alliances (Star for Air China, SkyTeam for China Southern).

Another example of Beijing's casual approach to global alliances, the tangle of partner codeshares must be worked out as well as the relationship between China Southern's new Paris route and its existing joint venture with Air France on its previously sole Paris service, from Guangzhou. Despite the announcement coming in Aug-2012, almost a year after the A380's delivery, the carriers said they were still working out the details. As of Oct-2012, no launch date had been set.

Ordering the world's largest passenger aircraft ahead of determining route viability reflects the larger management dilemma in China of ensuring long-term goals receive adequate planning (a bigger problem than elsewhere). Executive decisions on matters not in the short term can be pressing to achieve, partially a result of carriers having so many day-to-day concerns to deal with in a vast bureaucracy that ensures the most immediate issue, no matter what the importance, is the first one decided. Some equate this focus to the game Whac-A-Mole (an arcade game that involves suppressing heads that pop up randomly).

Second-tier cities feature strongly on long-haul services

North America and Europe have been the traditional, long-haul markets for Chinese carriers, but recently Australia has joined the ranks too, most notably for China Southern. For the Big 3, destinations are largely first-tier cities served no more than daily, although China Southern serves some destinations (Amsterdam and soon Paris) daily from both Beijing and Guangzhou. It has made a push too for double daily services to Melbourne and Sydney, but only in peak seasons. Point-to-point and connecting traffic within China is a staple, and increasingly sixth freedom traffic is important too. China Southern has been well tutored by SkyTeam partner KLM in this regard.

Outside the Big 3, long-haul routes have, owing to the one airline, one route policy, leaned more towards carriers serving second tier international cities from main Chinese cities, such as Hainan Airlines' Beijing-Seattle service. Recently there have been the additions of first tier international city service from second tier Chinese cities, including Sichuan Airlines' Chengdu-Shenyang-Vancouver and pending Chengdu-Melbourne service (and Hainan's short-lived Shenzhen-Sydney service). Secondary city air services have followed state-led initiatives to grow domestic regions, as well as allowing carriers - such as Sichuan Airlines - to acquire widebody aircraft.

Chinese airlines' services are typically vast outbound markets. While they would like a better balance, international recognition of secondary cities - let alone airlines - can be low, adding to inbound marketing woes experienced by larger carriers.

Xiamen Airlines will enter long-haul markets with its forthcoming first widebodies, Boeing 787s, and hopes a recent brand refresh and joining of SkyTeam will help it make the large steps needed for international recognition; it is almost entirely a domestic carrier, with only 5% of its seat capacity used outside mainland China. For secondary Chinese cities and carriers, the need for feed and efficient construction of itineraries is important, one reason Hainan's Shenzhen-Sydney service was perhaps premature.

Foreign airlines focus on serving China's secondary cities

Foreign carriers are instead leading the charge in serving secondary cities, with routes including Finnair's between Helsinki and Chongqing, KLM's between Amsterdam and Xiamen and Lufthansa's from Frankfurt to Qingdao and Dalian. These rely on extensive feed at the European point; accompanying codeshares with the local Chinese partners usually follow.

China's carriers are better defined on short-haul international services, where they concentrate, as might be expected, around geographic convenience. Air China and China Eastern, with bases a few hours from Japan, account for approximately 20% and 23% of total China-Japan services, respectively. China Southern, with a primary hub in southern Guangzhou, represents only 11% of capacity. China Southern is stronger than Air China or China Eastern in Southeast Asia, with 14% of total capacity compared with 5% and 12% for Air China and China Eastern, respectively. Air China has a niche in northern destinations: Mongolia and Siberia.

Short-haul international services, similar to domestic flights, still hug China's populous and wealthy east coast. More inland hubs present growth into new regions as well as establishing more transfer traffic.

The largest gain so far is from China Southern at Urumqi, in the far western corner of China. The city, capital of the Xinjiang autonomous region, is closer to Kazakhstan than Beijing and is well positioned as a hub for the growing - and high-yielding, resource-rich - west Asia, CIS and Russia region. Although China Southern inherited Urumqi's basic proposition when the carrier merged with China Xinjiang Airlines, the more significant route development has been in the past two years.

From Urumqi, China Southern serves all of the countries in the region, most of them less than daily, although that is changing. China Southern is also growing its domestic network from Urumqi, but for destinations not served directly it can funnel traffic to Beijing, which it connects with upwards of six daily flights from Beijing and five from Guangzhou.

Secondary hub development low on the agenda

Opportunity abounds for secondary hub development, but the challenge is making it a priority. China Southern has not had a critical hub such as Beijing or Shanghai to work with; and China Eastern's evolution in recent years has been distracted by its merger with Shanghai Airlines. Chengdu, Chongqing and Kunming have potential to be developed into a hub for South Asia as well as potential traffic opportunities to the Middle East - with a partner there.

China Eastern in Aug-2012 became Etihad's 37th codeshare partner, a relationship that is starting off with small steps: China Eastern will place its code on Etihad's Abu Dhabi-Shanghai service. China Eastern's only service to the Middle East is twice-weekly flights on Shanghai Airlines from a hub in Kunming to Dubai, a short drive down the road from - but not at - Etihad's Abu Dhabi hub. China Eastern is interested in expanding the partnership but the SkyTeam member has a number of other initiatives it is looking at too.

China Eastern international vs domestic capacity share by ASKS

China Eastern international capacity (seats) by region

As the global alliance paradigm shifts, it is an attractive exercise to contemplate the city-pair openings that could be realised through a deeper partnership, including having China Eastern deploy capacity into Abu Dhabi and connect with Etihad's schedule, just as some of Etihad's other partners - including airberlin and Virgin Australia - have done so closely.

China Eastern is interested in accessing Saudi Arabia as well as Africa, which Air China and China Southern are also flirting with. But the potential does not end there since China Eastern, only a few hours away from aggressive China Southern, plots a conservative approach to long-haul capacity, including to Europe - a market that is one of Etihad's specialties.

Not all of China's airlines are as bullish as China Southern

The Guangzhou-based carrier may be expanding rapidly, but as its competitors quietly note, it is doing so into competitive markets that are hardly shining beacons of profitability. It has the Chinese outbound market to work with, but so too do well-equipped sixth freedom carriers such as Cathay Pacific and Singapore Airlines, along with South Korea's and Japan's flags.

China Southern's advantage will be one of cost and domestic feed, able to usurp existing traffic flows with lower fares. Hence the remarks from a Singapore Airlines manager that China Southern sees "the Australian market, somewhat unrealistically, as an abundant utopia of low hanging fruit".

China Eastern shares few of the long-haul ambitions of China Southern, an outlook that could be based more on a justification for its current position than a fundamental strategy: its long-haul fleet consists of five A340-600s and a small but growing number of A330s, making its long-haul capacity the lowest of the Big 3 (Air China has more seats to Europe than China Eastern to all long-haul destinations). That was not planned to be the case, with a tranche of 787s due by the 2008 Beijing Olympics intended to open more services, in particular to North America. With delivery delays and, more importantly, performance shortfalls, China Eastern determined it would operate the 787 from Shanghai to America's east coast, eventually cancelling its order in 2011.

In its place are 15 A330s, including 12 longer-range -200s that China Eastern intends to deploy mostly to Europe to bulk up existing routes. An order in 2012 for 20 777-300ERs will be delivered from 2014 and allow replacement of the five A340-600s and then expansion, including to the overdue markets of America's east coast. Going double daily in existing markets - Los Angeles and New York - will be a priority.

It is North America that is capturing the attention of China Eastern, and Air China too. Europe is seen as too competitive, irrespective of the current economic situation. Foreign carriers can take traffic flows to Europe, but north Asia-North America sees fewer operators and fewer chances of traffic diversion. Air China is also looking at double daily operations and then expansion to smaller cities with 787s. The Chinese carriers are lightly represented in North America, each serving at most four destinations. Their regional competitors are ahead: All Nippon Airways' strategy is to open more North American cities (it serves seven) while Korean Air is already in 12.

Air China is beginning to experiment with long-haul expansion from its other hubs, examining a Frankfurt service from its western hub in Chengdu. China Eastern is showing no interest (it is limited on capacity - and has Shanghai's power) while China Southern reaches Istanbul and Moscow from Urumqi.

China yet to tap into full potential of Africa and Latin American aviation markets

Aviation's growth markets of Africa and Latin America have been relatively untouched by Chinese carriers, with the exception of Hainan's service to Luanda via Dubai. Africans are working in China and vice versa and investment is flowing well, despite some cultural issues.

Ethiopian Airlines and Kenya Airways are placing a large focus on Chinese routes, leveraging hubs that suitably connect across Africa. Air Seychelles, reinvigorated under an Etihad stake and seconded management, will use its Mahé hub to link Africa with China, initially Johannesburg with Beijing, a route it estimates to have plenty of demand, even with existing South African Airways and possibly pending Air China traffic. The bigger opportunity is feed from across Africa, which is achievable with partners and negotiations - not insurmountable tasks.

Latin America is harder. Most airlines are aware of the need to link the emerging markets of Latin America and Asia. The only direct options are on Aeromexico (but even then to far northern Latin America), but almost every airline that serves both regions is jockeying to be a connecting provider one day. The US airlines see transfer traffic potential but visa and security issues make growth difficult for through passengers. Unlike other countries, the US does not offer international airside connections, requiring all passengers to clear US immigration irrespective of final destination. For Chinese nationals, that means having to secure a difficult US visa in addition to a visa for their final destination.

Visas are shaping European traffic flows. The UK is of interest to the Chinese, but securing a Schengen visa grants access to all Schengen countries, enabling the continental grand tour of the types Chinese travellers prefer. British Airways has expressed interest in partnering with China Eastern or China Southern (BA's oneworld has no mainland member), but restrictive visa conditions and the circuitous nature of Heathrow connections from the east have not generated great interest.

Hainan and Spring use foreign AOCs to overcome route restrictions

The one route, one airline policy has proved too much of a barrier for private carriers Hainan and Spring, which plan to use foreign AOCs to access China. In addition to Hainan Airlines' 48% stake in France's Aigle Azur, Spring is preparing to launch a Japanese subsidiary, replicating the pan-Asian models of AirAsia, Jetstar and Tiger.

Spring currently serves a number of secondary Japanese airports from its Shanghai base. The LCC sees opportunities to have a role in non-Chinese traffic while also using its initial Japanese subsidiary to open routes from Japan to China that it cannot serve on its Chinese AOC or faces too much bureaucracy to do so. (Chinese carriers are advantaged if they establish a branch office in cities they serve.)

Hainan will probably adopt this tactic even more actively, either through new partnerships or over the long-term seeing short-haul operations go long-haul. Hainan has a stake in Ghana's Africa World Airlines and has applied to establish a domestic carrier in Saudi Arabia under that country's newly liberalised aviation regime.

Hainan international vs domestic capacity share by ASKS

Hainan Airlines international capacity (seats) by region

What remains to be proven is China's reception to circumscribing route allocation, which could make these joint ventures costly affairs if blocked or China subsequently lifts the designation restrictions.

Marketing and product improvements pivotal to international ambitions

Chinese airline capacity increases will not achieve their full potential unless there are significant improvements in marketing and product. International marketing efforts are limited, or disconnected from relevant themes. There are exceptions: Air China partnered with a foreign agency to shed its image in Sweden as a carrier flying only to China. Its Japanese network was promoted in sushi restaurants and Bangkok routes in Thai restaurants; "checking in" on Facebook offered opportunities to win Air China tickets to these destinations.

It was innovative but small scale, and there are hesitations to working with foreign suppliers and paying their fees if the Chinese (often mistakenly) think they can do a comparable job. The attitude can be pervasive, going up to the level of fledging in-flight entertainment and interior start-ups in China. Heavy metal ambitions such as COMAC's C919 - go even higher. Some think this attitude mirrors that of Russia, which eventually came around to recognising that international firms in these specialist activities were widely used for a reason.

Online buying is hard too. Chinese carriers' booking websites can be clunky, not showing price until the last step. It is not uncommon for the same flights to be found on a multitude of online travel agencies for a fraction of the price shown on the airline's own site, a feature of the wider industry some years ago.

Information is also problematic: too little and the airline does not appear reputable; too much and inevitable "Chinglish" translations slip through, as well as over-emphasis of services new to Chinese carriers but taken for granted internationally (through check-in), making the airline's marketing seem amateurish.

Even marketing of the airline in general - and not flights or fares - poses challenges. There are genuine language issues; to a non-Mandarin reading passenger, the most visible element on a Spring Airlines fuselage is China-SSS.com, the carrier's website, so named because that perplexing combination is easier for non-English speaking Chinese passengers to remember than a traditional domain such as springairlines.com. But the always-innovative carrier has identified this as something to address as it expands internationally. For Xiamen Airlines, obvious marketing tactics may not work: the carrier does more flying entirely outside of its namesake city than to or from it.

Some argue that with the right partners feeding flights, brand work can be put on the backburner. But this can only delay China's aspirations to play on the world stage and international markets are meanwhile becoming more complex.

Despite shortcomings, some significant product enhancement has occurred

The good news is that for passengers who do gain awareness and are able to book tickets, the actual journey is becoming better. Each new generation of aircraft, especially long-haul, is a sharp improvement and even often rivals international standards. In-flight entertainment has become the third largest area of expenditure for Chinese carriers, according to Air China, and China Southern has hired Australian flight attendants to provide better service to international passengers. Small steps but important ones.

There are still plenty of shortcomings and the Chinese carriers are surprisingly open about this. "There is much room for improvement," China Southern CEO Tan Wangeng said in a briefing in 2012. "But we're still nurturing this travel market so it takes some time."

With better service, demand will increase, but so too Mr Tan said would prices, beginning to boost those lacklustre international yields. "Airfares should always live up to the service quality so right now, while we are improving, our airfares are relatively lower. But as time goes by our price will go up a little as our service quality improves to catch up with those big names in the world aviation industry."

Xiamen Airlines has a similar message: "Although there is room for improvement in our services, Xiamen Airlines is committed to each passenger to provide a warm, comfortable, attentive service."

Chinese airlines still have a way to go before they become major global forces. When they do, they will greatly influence the shape of the industry of the future.

There are numerous policy and operational settings to get right before that will happen and, as in many other activities, getting the small details right will be key in this increasingly consumer-driven marketplace. No-one doubts however that the time is getting very close.