27-Sep-2012 9:00 AM

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

Analysis

A year after taking delivery of its first A380, China Southern Airlines has finally received permission from the Chinese government to operate the aircraft on long-haul routes, allowing China Southern to take its four aircraft off three daily loss-making short-haul flights. China Southern would only quantify the A380's losses in the first six months of 2012 as under RMB100 million (USD15.85 million).

But China Southern still has work ahead of it. Its first of two planned long-haul routes, Guangzhou-Los Angeles, will see capacity increase 77.8% once the A380 is deployed in Oct-2012. There will likely be a significant period for China Southern to spool-up profitable demand and appropriately market its sixth freedom network. Its second route, Beijing-Paris CDG, is not the outcome the carrier would have hoped for: it will have to partner with Beijing-based competitor Air China, which as the national carrier enjoys elements of protectionism. But without the cooperation China Southern would have struggled to find alternative routes.

Summary

China Southern Airlines has received permission from the Chinese government to operate its A380 aircraft on long-haul routes, allowing the airline to take its four aircraft off loss-making short-haul flights.
The A380's deployment on short-haul routes was a result of delays from China's aviation regulator, the Civil Aviation Administration of China.
China Southern will deploy its A380 on the Guangzhou-Los Angeles route, increasing seat capacity by 77.8% and marking the airline's largest net increase since it started serving Los Angeles in 1997.
The profitability of China Southern's long-haul network has been impacted by significant expansion in recent years, resulting in yield decreases.
China Southern will cooperate with Air China on A380 services between Beijing and Paris CDG, as the route would have been difficult to operate without Air China's partnership.
The A380 saga highlights China's restrictive market and constraints on growth, but trends suggest a more open market in the future.

China Southern's A380 is a clear mis-match for short-haul markets: the ratio of premium seats is too high (leaving economy class to be frequently full but business and first class to have light loads), maintenance and residual value impact from high-cycle operations is costly, and suitable routes and A380-capable airports in China are few. Deployment on short-haul routes was a result of delays from China's aviation regulator, the Civil Aviation Administration of China, although these delays are understood to have likely originated from China Southern submitting too ambitious route proposals.

Pending routes were discussed with the CAAC behind closed doors and China Southern never publicly lobbied to be granted a certain route. Executives spoke only vaguely about destinations and a timeframe to move the A380s to long-haul markets was always said to be only a few months away. This is typical Chinese practice to keep inner workings - and disagreements - out of the public eye.

China Southern is understood to have favoured key routes from Beijing that would have placed it in direct competition with Air China. Chinese carriers are typically only permitted to operate international routes where no other Chinese carrier has service, a measure designed to have a complimentary but not competitive market that is free and open, again reflective in some degrees of larger China. Asking to compete not only with another Chinese carrier, but Air China in particular, was a tall order. Although China Southern did persevere in gaining access to Paris, it was under a different scenario than originally envisioned.

China Southern received its first A380 in Oct-2011 and put it into service that month between Guangzhou and Beijing. The second A380, delivered in Dec-2011, was used to support Guangzhou-Beijing and Shanghai-Beijing, the latter later withdrawn. The third A380, delivered in Mar-2012, was used on Hong Kong-Beijing and the fourth, delivered in Sep-2012, will be initially used to re-open A380 services between Shanghai and Beijing. China Southern's fifth and final A380 is due in 1Q2013.

A380 performance on Hong Kong-Beijing weaker than Guangzhou-Beijing

China Southern gave neither an exact figure on A380 losses nor a breakdown by market, but its disclosure of losses being under RMB100 million (USD15.85 million) was seen to quell investors who anticipated higher losses. The carrier did offer commentary on its two A380 routes that Guangzhou-Beijing had an overall "small loss" while Hong Kong-Beijing Capital was "disappointing".

The losses are reflective of China Southern's position in those markets. Guangzhou is China Southern's hub and benefits from connecting domestic and international traffic, unlike Hong Kong. While China Southern has a large presence at Beijing, most services are to southern points that would entail significant backtracking if reached from Hong Kong via Beijing.

Beijing Capital International Airport system capacity (seats) by carrier: 24-Sep-2012 to 30-Sep-2012

Frequency and schedules were also factors. China Southern's single daily A380 service between Hong Kong and Beijing is its only offering between the two cities, limiting passengers who wanted other departures times and had variety to choose from. Air China has six daily flights between Hong Kong and Beijing, Cathay Pacific and Dragonair typically have nine, and Hong Kong Airlines/Express three. When considering Hong Kong Airlines and Hong Kong Express as one marketing carrier, China Southern also had the lowest capacity measured in seats.

Hong Kong to Beijing capacity by carrier (seats per week, one way): 19-Sep-2011 to 17-Mar-2013

Between Guangzhou and Beijing, in addition to China Southern's two daily A380 services, it also offers upwards of 10 other services, giving a wealth of options to complement its already strong position.

Guangzhou to Beijing capacity by carrier (seats per week, one way): 19-Sep-2011 to 17-Mar-2013

Schedules, and Hong Kong's restricted slots, also impacted China Southern between Hong Kong and Beijing, with the carrier having its sole service at relatively inconvenient times. For the first few months of the A380's operation between Hong Kong and Beijing, fares were typically the lowest in the market by 5-10% but then were increased.

China Southern A380 schedule: 24-Sep-2012 to 30-Sep-2012

Route	Departure time	Arrival time
Guangzhou-Beijing	09:00	11:55
Guangzhou-Beijing	15:00	18:15
Beijing-Guangzhou	09:30	12:45
Beijing-Guangzhou	15:30	18:45
Hong Kong-Beijing	14:25	17:50
Beijing-Hong Kong	08:45	12:20

As part of the A380's re-deployment, China Southern, according to Innovata schedules, will end A380 service between Hong Kong and Beijing on 12-Oct-2012 (the route reverts to being operated by an A330-300 and later to an A321) while Guangzhou-Beijing from 27-Oct-2012 will be reduced to one A380 service, used to support Beijing-Paris in terms of aircraft rotation and feeding the long-haul route (for its Beijing-Amsterdam services, China Southern originates the aircraft in Guangzhou).

Guangzhou-Los Angeles capacity to increase 77.8%; largest increase in 15 years

China Southern from 12-Oct-2012 will deploy its A380 on the Guangzhou-Los Angeles route, which it remarked is a "great turning point for the A380 operation". The A380's deployment will replace the current Boeing 777-200ERs used on the route and bring a 77.8% increase in seat capacity, the carrier's single largest net increase since it started serving the Californian city in 1997. Los Angeles is its only US route and one of two in North America (the other is Vancouver).

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

China Southern said it was encouraged about the A380's prospects to Los Angeles owing to its long history of operations and customer base as well as having a higher load factor and yield compared to its other international services. North American routes have lately been the most profitable long-haul routes for Asian, and Chinese in particular, carriers.

The profitability of China Southern's long-haul network has been impacted by significant expansion in recent years to Australia/New Zealand and Europe that have resulted in yield decreases. The A380's deployment to Los Angeles, with frequency increases to Vancouver, brings to North America the expansion programme China Southern has undergone in its other long-haul markets.

China Southern's Guangzhou-Los Angeles route for most of its history was operated less than daily, having been made a daily operation only in Mar-2011. Passenger load factors have generally increased, with the exception of much of 2009, owing to global economy's status then.

Route load factor data for 2012 from the US Department of Transportation (DoT) is only available through Mar-2012 and after Jan-2012 and Feb-2012 outperforming past years, there is a worryingly sharp drop in performance in Mar-2012. Load factors have been hampered by economic conditions but generally boosted by China Southern's growing connecting traffic market and its capability in marketing those services.

China Southern passenger load factor for Guangzhou-Los Angeles: Jan-2008 to Mar-2012

Being based in Guangzhou, the heart of China's - and the world's - manufacturing, cargo uplift has been important to China Southern, which also has dedicated freighter services to Los Angeles. Freight carried, measured as a percentage of total aircraft payload, typically average 12% to 16% for the entire route.

China Southern cargo uplift as percentage of total available payload for return Guangzhou-Los Angeles services: Jan-2008 to Mar-2012

Freight carried only from Guangzhou to Los Angeles, the segment that sees higher demand, has freight typically accounting for approximately 25% of available payload. Jan-2012 saw the weakest cargo performance in five years, but rebounded in Feb-2012 and Mar-2012.

China Southern cargo uplift as percentage of total available payload for Guangzhou-Los Angeles (one-way services): Jan-2008 to Mar-2012

The A380 does have more cargo capacity over the 777-200ER currently used by China Southern (151 to 184 cubic metres, according to each respective manufacturer). But the amount of space available for revenue cargo will reduce as more space will be needed for passenger luggage.

Long-term prospects in Los Angeles are good for China Southern, but short term will see pressure and greater competition on sixth freedom services

China Southern also benefits from an extensive codeshare deal with Delta Air Lines that dates back to China Southern's 1997 entry into the US market. The two are now SkyTeam carriers and China Southern has access to the domestic US market by coding on Delta services, giving it beyond access from its US gateway.

But the route's Chinese gateway - Guangzhou - poses challenges. Guangzhou's location in southern China restricts viable connections to North America that do not involve backtracking. Air China's Beijing hub in northern China offers better geography, and China Eastern's Shanghai hub also has geographic advantages over Guangzhou.

China Southern will need to heighten its push on sixth freedom traffic between North America and Asia, and Southeast Asia in particular. This will come at the expense of dominant sixth freedom carriers in the region such as Cathay Pacific and Singapore Airlines, as well as other Asian carriers.

China Southern in 2009 began its push on sixth freedom traffic, which mainly targetted the Australian market to/from Asia and Europe, but it has only been in 2012 the carrier has made a large push on marketing rather than merely relying on cheap air fares. While its potential for sixth freedom traffic - in Australia, Europe or North America - is no doubt large, it still has some way to go with improvements, both in the back end and front line. This suggests it will take some time for China Southern to spool up the extra capacity it is deploying into the market in addition to its existing challenge of needing improvement with international marketing.

It is seeking to drum up demand by offering a free Chinese and US domestic economy flight. But the price for this promotion, available through 30-Sep-2012, is relatively high: RMB7,900 (USD1,253) exclusive of taxes, which are approximately RMB2,500 (USD396). The lowest fare for Guangzhou-Los Angeles only flights is approximately RMB6,711 (USD1,064), inclusive of taxes. In comparison, flights from Hong Kong, near Guangzhou, to Los Angeles are USD1,094 on Cathay Pacific.

China Southern's promotional fare - riding on the allure of the A380 - is more a representation of what connecting fares would be than a real limited offering. Anecdotal responses suggest take up of this offer has been mediocre. Business class fares start at RMB24,900 (USD3,948) exclusive of taxes and include domestic flights but only in economy class. Business class fares between Los Angeles and Guangzhou are USD5,152 on China Southern while connecting options start at USD3,193. Business class fares from Hong Kong to Los Angeles are USD6,498 on Cathay Pacific, or with stops from USD2,473.

Air China and China Southern to cooperate on A380 services between Beijing and Paris

China Southern has work ahead of it to profitably deploy the A380 between Guangzhou and Los Angeles but in the medium and long term has a considerable growth opportunity. This contrasts to deploying an A380 between Beijing and Paris CDG in partnership with Air China, which in Sep-2012 serves the route with a daily 777-300ER and four weekly A340-300 service. The only other carrier in the market is Air France, which in Sep-2012 has double daily 777-300ER services, but will down-gauge in the northern winter schedule to a daily 777-300ER and three weekly 777-200ER service. Beijing-Paris CDG sees the fourth largest amount of seat capacity between China and Europe.

Top 10 routes between China and Europe ranked on seat capacity: 24-Sep-2012 to 30-Sep-2012

Rank	Origin		Destination		Total seats
1	PVG	Shanghai Pudong Airport	CDG	Paris Charles De Gaulle Airport	17,109
2	PVG	Shanghai Pudong Airport	FRA	Frankfurt Airport	15,442
3	FRA	Frankfurt Airport	PEK	Beijing Capital International Airport	15,078
4	CDG	Paris Charles De Gaulle Airport	PEK	Beijing Capital International Airport	14,203
5	PEK	Beijing Capital International Airport	SVO	Moscow Sheremetyevo Airport	13,828
6	PVG	Shanghai Pudong Airport	LHR	London Heathrow Airport	9536
7	PVG	Shanghai Pudong Airport	SVO	Moscow Sheremetyevo Airport	8248
8	PEK	Beijing Capital International Airport	LHR	London Heathrow Airport	8232
9	MUC	Munich Airport	PEK	Beijing Capital International Airport	8148
10	FCO	Rome Fiumicino Airport	PEK	Beijing Capital International Airport	6204

CAAC approval of the cooperation between Air China and China Southern was disclosed in Aug-2012, although China Southern said it was still negotiating what the cooperation will entail. The broad element is a codeshare between Air China and China Southern but remaining to be worked out are how much Air China will withdraw from the route (the two would want to offer more than daily service), profit split and level of cooperation with partner airlines.

Air China is a member of Star Alliance and China Southern is in SkyTeam. Air France, based at Paris CDG, is also in SkyTeam and could present China Southern with good feed opportunities. As of Sep-2012, an implementation date has not been announced and Air China has not adjusted its schedules. The fluidity of the situation and sparse information when initially announced suggests this cooperation was imposed, leaving neither party pleased but the balance tilted in favour of China Southern. Without cooperating with Air China it would not have been able to enter the Beijing-Paris route, and in the route's place it would have had to select a secondary one.

Although China Southern has spoken of using the A380 to London Heathrow (it started services there in Jun-2012) and Sydney, London sees major competition and is low-yielding while deploying an A380 to Sydney in the short term would result in over-capacity. China Southern has pegged using two A380s for Guangzhou-Los Angeles and two for Beijing-Paris CDG with its fifth and final A380 - due in 1Q2013 - an operational spare. But China Southern would be wise to boost utilisation of its niche fleet; a return Sydney service could be operated with one A380.

And so Air China and China Southern must navigate this new and unprecedented type of partnership in the Chinese market, figuring out what it means and how to measure outcome objectives. If China Southern's single daily A380 service between Beijing and Paris entirely replaces Air China's capacity, overall Chinese carrier capacity would rise only 1% a week; if China Southern's A380 replaces Air China's 777-300ER service and Air China keeps its four weekly A340 flights, Chinese capacity would see a 31% increase; and if, in a tall order, China Southern's daily A380 supplemented Air China's 777-300ER and the A340 service was withdrawn, Chinese capacity would increase 72%.

Beijing Capital to Paris Charles De Gaulle capacity by carrier (seats per week, one way): 19-Sep-2011 to 17-Mar-2013

A380 saga highlights China's restrictive market and constraints on growth

There is no fault or incapability with the A380; operations from Emirates and Singapore Airlines, amongst others, make that clear. As with any asset, the challenge is finding suitable markets. While some carriers are quietly concerned markets envisioned for the A380 when ordered have since seen significant changes, China Southern's struggle is not the markets but access to them. It is a larger problem facing the Chinese industry.

Competition is carefully managed and direct overlap internationally is rare. It is worthwhile to ponder what market conditions and restraints on competition China Southern envisioned when ordering its A380s in 2005. Hainan Airlines will certainly use China Southern's A380 route approval experience when considering if it will take the A380s ordered by sister carrier Hong Kong Airlines.

Amongst other justifications, this hand on competition allows growth and improvement - from the passenger and balance sheet perspective - without the fare wars that have plagued other markets and even seen carriers collapse. The downside to a stable Chinese market is that it is stunted.

Two trends support a more open market. First, Chinese carriers have received the memo about service and each new aircraft type that enters the fleet is better than its predecessor, as China Southern's A380 shows. Second, other carriers are circling, although China seeks a level playing field by restricting some air service agreements. A more open market is due to reward lean carriers and those making smart decisions. LCC Spring Airlines is a model of efficiency, and China Southern has admitted to a "huge gap" between the efficiency of itself and part subsidiary Xiamen Airlines. For market progression, a warmer welcome to China Southern's A380 would have been a good start.