China's Big 3 airlines shaken out of status quo by a cooling Chinese economy

But China leads in one important area. The Chinese market is profitable - terrifically so; however the cost is in highly regulated competition, expensive fares, unmet demand and an industry that overall remains inefficient, despite extensive government-driven consolidation.

Chinese carriers handled 292 million passengers in 2011, 93% of them domestic, and the CAAC expects this to increase to 450 million in 2015, 700 million in 2020 and then 1.5 billion in 2030. On current trends, the domestic Chinese market is expected to double in size about every eight years. As expansive as the market may seem today, it is still in its infancy - and very much in its formidable years as networks seek to grow but also respond to a burgeoning high-speed rail network.

China's domestic airline market is still highly profitable

Even for the Big 3, Air China, China Eastern and China Southern, which are most exposed to the international market, the domestic market is the source of profits (and sometimes subsidies to loss-making international routes). Weakening domestic demand contributed to lower 1H2012 profits while hints of a stimulus towards the end of the year, after China's once-a-decade leadership transition, lifts outlooks.

Air China, China Eastern and China Southern revenue source*

Source: CAPA - Centre for Aviation and Airlines Reports
*For 1H2012 in RMB million
**excludes HK, Macau and Taiwan

Many foreign carriers would be jealous of average yields at the Big 3, which in 1H2012 for the domestic market were between RMB65 cents-RMB74 cents (USD10.4-USD11.8 cents) per RPK. Historically, Beijing based Air China has the highest yields, followed by China Eastern and then China Southern, which some ascribe to - but are unable to explain the provenance of - China Southern currying weaker market perception by having lower quality. On the back of China Eastern's domestic yields weakening and China Southern's increasing, China Southern in 1H2012 had a higher domestic yield than China Eastern.

Outside the Big 3, financial information is less transparent, but carriers are generally profitable, including privately owned Hainan Airlines and LCC, Spring. Breakdowns by units - for example Air China includes Air Macau and Shenzhen Airlines; Hainan includes Tianjin Airlines, among others - are not given. Even Cathay Pacific does not disclose operating or financial differences about its mainline operation and Dragonair unit (the Big 3, like Cathay, are listed on the Hong Kong stock exchange).

Domestic yields and resulting profits are high as a result of strong demand and carefully controlled supply. The Chinese Government approves aircraft purchases and dispenses them on arrival, thereby effectively controlling how much each airline can grow. Privately owned carriers such as Spring say they cannot grow as much as they would like to. Hainan is understood to be trying to use its Hong Kong Airlines subsidiary to place aircraft orders - including for the A380 - that would otherwise take too long for Beijing to approve, if at all (hence the irony when Hainan Airlines in mid-2012, responding to weakening performance at Hong Kong Airlines, suggested the subsidiary might not take delivery of its A380).

A further important ingredient of balanced supply and demand is the CAAC's domestic fare regulation. It has set a price of RMB75 cents (USD12.0 cents) per one-way kilometre, with carriers allowed to charge upwards of 25% more or 45% less, giving a range of USD6.6-15.0 cents per kilometre. As evidenced by the Big 3's domestic yields, average fares fall slightly under the target price.

Air China, China Eastern and China Southern yield summary: 1H2012 vs 1H2011*

Source: CAPA - Centre for Aviation and Airline Reports
*per passenger km in RMB

Deregulation could promote greater efficiency

The CAAC in 2012 quietly suggested it would end domestic fare regulation, something it has already done internationally. Deregulation would likely have a greater impact in the long-term than short-term, as Chinese carriers could fully hone revenue management practices, which would benefit their international markets. With domestic load factors - previously relatively low - hovering around 80%, stimulation opportunities would not be great, except perhaps for quieter periods.

Fare deregulation could deliver to the domestic market the behaviour passengers are coming to expect from foreign low-cost carriers that set rock-bottom launch fares or special sale fares. Critically, Spring Airlines, the only notable domestic LCC, would gain experience with this - as would full-service carriers, who will one day have to contend with greater domestic LCC competition.

Larger long-term shifts in consumer behaviour would occur once airlines were able to stimulate demand far in advance. Outside the main holiday periods, domestic tickets are typically booked close to travel: almost all about a month out, many only a week before departure. Greater indications about demand ahead of departure would allow airlines to improve their revenue management, but a far greater impact on the bottom-line would come from curtailing the bloated cost bases of the legacy carriers. There is still much to be achieved towards becoming more entrepreneurial and to taking the initiative in selling rather than largely waiting for demand to find seats.

Efficiency efforts are sorely needed. In 1H2012 wages, salaries and benefits increased significantly: 16% at Air China, 6% at China Eastern and 22% at China Southern. Alarmingly, the carriers say it was salary rises - not more staff - driving the increase, a feature consistent with the experience in other Chinese sectors such as manufacturing.

Given their history, China's airline achievements are unprecedented. It was only in 1987 that the aviation regulatory authority, the CAAC, divested itself of commercial air transport responsibilities by breaking up the then-CAAC airline into six carriers, most simply named for their geography, illustrating the methodology behind the future strategy: Air China, China Eastern, China Northern, China Northwest, China Southern and China Southwest.

Airline consolidation heralds the rise of China's Big 3

After a frantic and often chaotic period of quasi-deregulation in the mid 1990s, consolidation arrived in 2001, well ahead of most other markets. The CAAC announced it would merge the nine carriers it controlled into three groups, the modern Air China, China Eastern and China Southern. Some airlines left over from the 2001 consolidation - Shandong Airlines, Shanghai Airlines, Shenzhen Airlines, Sichuan Airlines, Wuhan Airlines and China Post Airlines - feared being overwhelmed and formed an alliance, China Sky Aviation Enterprises Group (somewhat a revival of the 1990s' New Star Aviation Alliance).

The carriers sought to cooperate while remaining independent, but the alliance has gradually disintegrated as some of the carriers have since aligned to one of the Big 3 - usually with the not always gentle guiding hand of Beijing. Shanghai-based China Eastern in 2009 merged with Shanghai Airlines under a move orchestrated to make the two more competitive with Air China and China Southern rather than with each other. Shandong and Shenzhen Airlines are now partly owned by Air China, Sichuan Airlines is partly owned by China Southern and Wuhan Airlines has been absorbed into China Eastern.

This was all part of China's strategy to have the Big 3 plus Hainan Airlines, but the mid-2000s saw another abrupt shift in direction as the CAAC opened the market to domestic carriers, which most prominently created Juneyao and Spring Airlines (a child of the large and longstanding travel agency group). The market has since re-closed, except for new carriers formed as part of a joint venture with an existing airline. Air China has created Tibet Airlines and is working on a carrier for Inner Mongolia, while HNA is looking to establish Fuzhou Airlines.

The Big 3 develop footholds in each corner of the country

The consolidation of the past decade created the Big 3's triangular hub network, which seeks to give each of them a stronghold in a different corner of the country. Originally conceived as a nationalist unifying effort, consolidation's greater implication is allowing the carriers to begin to construct powerful connecting, including sixth-freedom, networks.

At first the Big 3 were effectively restricted to using these hubs at their home base, but eventually, as the airlines grew, it became obvious that if they were all to grow into strong units they would need to be able to make their own commercial route decisions.

Air China's main hub in Beijing (northeast) is now complemented by Chengdu (central west) and Shanghai (east), with considerable capacity also in Guangzhou (southeast). There is overlap with China Southern, based in Guangzhou with hubs in Beijing, Chongqing (close to Chengdu) and Urumqi (far west). China Eastern's spread is more compact, based in Shanghai (central east coast) with hubs in Kunming (southwest) and Xian (east).

Networks are largely hub-and-spoke and development outside of the main base is gradually occurring. So far China Southern is most developed outside its home owing to its sizeable international network from Urumqi. Air China is turning its attention to growth at Chengdu.

Liberalisation in 2005 was partially successful, Spring and Juneyao the strongest survivors

When the CAAC opened the market to new and private entrants in 2005, results were mixed. East Star collapsed, Okay Airways launched as an LCC but dropped the model within eight months and United Eagle sold a stake to Sichuan Airlines. There was probably inadequate management within the carriers but it was the regulatory limitations designed to protect incumbents that really damaged them.

The two carriers which have done well, Juneyao and Spring Airlines, present something of a future glimpse into Chinese aviation.

Juneyao was established in 2005, at which point it was the first notable carrier to keep its Chinese name rather than provide an English translation ("juneyao" means "auspicious", tapping into China's favouritism for all things implying success). Owned by the Juneyao Group, a self-styled "enterprise group … in the modern service industry", it is a full-service carrier without the legacy costs dragging down the Big 3, and by its own calculation enjoys yield premiums. On the cost side it is much more focused, with attention to such practices as fast turnarounds. Though these are increasingly the norm elsewhere, China's major carriers still have a long way to go.

Based in Shanghai with a new fleet of A320s, the local market has found Juneyao a fresher version of China's legacy carriers with a few extra perks such as more legroom and higher-quality food.

The carrier notes its target base is premium leisure traffic, which Shanghai's comparatively wealthy population can sustain, but no doubt parts of the business market find it attractive too and Juneyao wants to downplay success; achieving too much in the Chinese economy - especially at the expense of a state-owned enterprise - is an invitation for Beijing to interfere.

Juneyao has a 9% seat capacity share of the domestic Shanghai market and is not a deep rival to the legacies. It has first-class service but is faced with dwindling slots at Shanghai's airports. With a primary base at Shanghai Hongqiao, future growth will be tilted towards Shanghai Pudong. Frequencies are much lower than the Big 3 and its all-Airbus narrowbody fleet of approximately 25 is small to the hundreds of jets at the Big 3, including popular A330s used on trunk routes. Juneyao will begin to introduce larger-capacity A321s so it can grow in the face of slot constraints, and, subject to Beijing's blessing, its own widebody aircraft could be a possibility.

Juneyao is expanding internationally to popular tourist destinations in northeast and southeast Asia and is considering new domestic bases in what will be a test of whether other regions have the disposable income levels to generate as much success as it has found in Shanghai.

Spring Airlines, also a new entrant, is towards the same end of the spectrum as Juneyao, and China's only LCC of substantial size. Also based at Shanghai, the carrier has a 10% share of the domestic market and has opened domestic bases in Shenyang and Shijiazhuang, although these have yet to achieve considerable scale. Spring has approximately 30 A320s with a goal of 50-60 by 2015. Famously lean (staff share hotel rooms on business trips and shun restaurants for cup noodles), Spring has also been agile and lately hybridising, offering a loyalty programme as well as its Spring Plus product that seats passengers in the front rows of economy with extra legroom and meals. Elsewhere its service is a la carte, although checked luggage is included in fares.

Spring is owned by Spring Travel, China's largest private travel agency, and has been profitable since its launch, even in 2008 when the Big 3 posted losses. Its strong financial performance has continued since. Both Spring and Juneyao are planning IPOs.

HNA/Hainan Airlines also attempts to capitalise on 2005 market opening

The HNA Group, which owns Hainan Airlines, also used the 2005 market opening to launch new carrier Lucky Air. The group is large and sometimes opaque; it has recently made some corporate structure changes and is mulling others, although few seem likely to increase transparency.

Hainan's subsidiary carriers, as well as those from the Big 3, raise the matter of global marketing alliance alignment.

The Big 3 are already aligned, although not always conventionally (with Air China for example closely allied to oneworld's Cathay Pacific, linked by cross-shareholdings; also codesharing with China Southern's A380 services to Europe). Shanghai Airlines and Xiamen are to enter SkyTeam and Shenzhen will join Star.

While that leaves the majority of Chinese carriers unaligned, they are largely affiliated with the Big 3 or with Hainan. Codeshares between the Big 3 and affiliates are common, perhaps reducing the need for the smaller carriers to ponder joining an alliance. If they did, they are all but guaranteed to follow their part-owner, as Shenzhen (partially owned by Air China) and Xiamen (China Southern has a stake) are doing.

Hainan's possible entry into oneworld has meanwhile been complicated by Cathay Pacific - understandably - wanting to protect its territory and by Beijing's lack of interest in expanding Hainan's reach.

High Speed Rail impacts China's airlines - but not as much as projected

Chinese High-Speed Rail (HSR) Network as of Feb-2012

Souce: World Bank Office, Beijing

With negligible multi-modal coordination at government level, China has developed a massive high-speed rail (HSR) network in a typically incredible short time. While undertaking its extraordinary aviation investment in airlines and airports, dotting the countryside with London Heathrow-equivalents to be served by an aircraft backlog valued at the GDP of a small island nation, China is also pouring billions into constructing what will be the world's largest high-speed rail network with tracks covering 8000km in 2010, doubling to 16,000km by 2020.

The sheer scale of the HSR system promised a clash and likely cannibalisation among duelling modes of state-backed transport. This sense of conflict was only heightened when headlines announced airlines were entirely cancelling routes following HSR's entry, such as the Changsha-Guangzhou route, dropped five days after the new line connected the two cities. China Southern estimated that a quarter of its domestic network would be affected by the rail network. And the opening of the Shanghai-Beijing rail link in mid-2011 generated large airline discounts on the country's busiest air route - since stabilised.

But some perspective is in order. In Nov-2012, Chinese air carriers operated approximately 1070 unique city-pairs. HSR's competitive threat is primarily on air services less than 800km. Given available domestic ASKs less than 800km account for 14% of airline system capacity in Nov-2012, the potential for HSR cannibalisation of air services is even lower than that figure.

Some city pair routes of less than 800km, such as Urumqi-Korla (269km), will not see HSR service at all. Others like Chongqing-Xian (560km) will each have an HSR presence but on different routes that do not, for now, connect. Those city-pair examples are out in western China, which is experiencing less HSR development than the eastern coast, where there is the greatest concentration of air traffic. Even on the east coast cannibalisation is not a given. Beijing-Qingdao at 538km is squarely under HSR's dominating stage-length territory, but the two cities will not be directly linked, requiring a transfer and longer journey length (about 650km).

High Speed Rail continues to face more setbacks

The core planned HSR network is referred to as "four vertical, four horizontal", following China's preference for symmetry, especially numerically, in strategy nomenclature. Four major east-west routes and four north-south routes are planned, conjuring an image of China crisscrossed with HSR tracks. But the cute strategy names can come at the expense of details, and the four vertical routes are closer to being two wavy paths, giving more thorough HSR coverage on the coastal area than inland. HSR networks, to be developed late in the decade, including Guangzhou-Kunming, Guangzhou-Guiyang and Chengdu-Xian, could fill some gaps.

Another handicap for HSR is that tracks will not always be along the most direct path - although neither are air traffic control corridors - especially in China. This underscores the need for Beijing to push the military to overhaul its management of the skies. There are negating factors for HSR, too.

Following a Jul-2011 train collision that killed 40, China has cut HSR's maximum speed from 350km/h to 300km/h, further reducing the competitive nexus between HSR and air travel, as well as delaying some expansion projects. Restoration of the 350km/h service is still an uncertain move: reports suggest that higher speed was above international recommendations.

More and more HSR stations are being built outside the city centre; from some stops on the Beijing-Shanghai route, the nearest city can only be seen in the distance. New airports are being constructed even further away from city centres as those conurbations grow rapidly - but with an emphasis on having a fast rail connection into town. China's expansive state security apparatus is also diminishing HSR's no-hassle bragging rights: briefcases and large handbags must go through x-ray machines even on the subway in some Chinese cities. A Madrid-Barcelona or Tokyo-Osaka rail passenger encounters no such formalities.

Delays on the existing HSR expansion timetable seem inevitable. The 16,000km-of-track-by-2020 goal was previously to be achieved by 2015. The current economic slowdown may not help, and, like China's airport construction boom, there are questions of how much public spending and debt-financing China can take.

There is also the question of whether Japan's HSR pricing experience can be replicated in China; shinkansen fares quadrupled as profitability demands became higher - and are now increasingly challenged as LCCs introduce lower fares. China only needs to look across the Taiwan Strait where Taiwan's HSR network announced in 2012 its first profit after five years of operation - but even after the USD193 million profit, the Taiwan High Speed Rail Co still has USD2.2 billion of accumulated losses.

HSR's effect on airline yields is difficult to assess

While airlines at first slashed prices to counter initial HSR consumer enthusiasm, HSR prices increased and then decreased after the 2011 collision - which shook the market's confidence in the new mode. After that, airlines were able in many cases to increase prices again. Any long-term increase in HSR fares will lose the price advantage and nudge some passengers towards the air travel alternative.

As Japan gives birth to a number of LCCs able to transport passengers far cheaper, they are not only lower priced than legacy carriers on medium and long routes, but also cheaper than the shinkansen on short routes.

The long-term outcome in China will not be clear for some time, but in the near future there will be impacts, although not as substantial as some Chinese airline CEOs have publicly suggested - perhaps in a bid to drum up support for their cause. As well as China Southern's suggestion that 25% of its network would be affected, China Eastern claimed exposure in about 60% of its domestic operations. Recently and more quietly, however, China Eastern expects that the bulk of damage has already been done.

Seven per cent of Air China's domestic ASKs are on routes less than 800km, while for China Eastern it is 16%, China Southern 14%, Hainan 8% and Shanghai Airlines 12%. Of China's smaller carriers, Shenzhen is less exposed to routes less than 800km, which comprise 7% of its total ASKs, but Shandong and Xiamen are greater exposed, with sub-800km routes comprising 31% and 27% of ASKs, respectively.

The most rational outlook may be that of CAAC leader Li Jiaxiang, who claims 50% of flights under 500km in length and about 20% of flights between 800km and 1000km could become unprofitable due to HSR.

Chinese carriers' distribution of domestic ASKs: Nov-2012

Source: CAPA - Centre for Aviation and OAG

Further expansion of the HSR network will undoubtedly make redundant some air routes (and the CAAC would be abreast of these developments), but there will be no equivalent to a London-Paris link undermining air services overnight. For that to occur in China a step-change in HSR technology must occur, and talk of that is faint. Even now, not all active lines run at 300km/h; many are 200-250km/h and some new lines will be in that range too.

Beijing-Shanghai (Hongqiao & Pudong) available seats: Jan-2002 to Dec-2012

Source: CAPA - Centre for Aviation and OAG
The trunk Beijing-Shanghai route (1075km) has increased seat capacity since HSR's entry. Growth has slowed, but this started around 2008 when slots became severely limited.

More coordination is needed between rail and air services

Air transport in China is occurring on a more compact continuum, and the airline-HSR relationship is no exception (to China's advantage, it has the world's experience to glean from). Europe's airlines spent considerable time competing with HSR before electing to cooperate, creating inter-modal journeys. China Eastern in May-2012 - nine years after the country's first HSR line opened - commenced operations of air-rail tickets in partnership with the Shanghai Railway Bureau.

A single ticket includes flights to/from Shanghai Hongqiao and Pudong with a rail sector to the cities of Changzhou, Ningbo, Suzhou and Wuxi. Hainan Airlines struck a similar agreement with Yuehai Railway, which runs the HSR between Haikou and Sanya in Hainan province. A Hainan Airlines ticket to Haikou can include a rail connection to Sanya.

China Eastern is particularly pleased with early results and both carriers target expansion, but it will be a slow process. China Eastern says it must negotiate with each regional railway bureau and then link up systems. Dealing with non-commercially driven state bureaucrats can be complex. Hainan says it took a year to negotiate and implement the deal. China has the potential advantage that new airports and HSR are being planned together and will frequently overlap, although the meshing between airline and railway operator may not be as smooth.

Despite hurdles to be expected of vast bureaucracies, these partnerships are clearly the way forward, giving greater network access. Across the Straits, China Airlines partners with Taiwan's HSR company, but far greater air-rail partnerships can be found in Europe. Deutsche Bahn is the leader of inter-modal connections. The German rail operator offers codeshares with more than 70 airlines covering 16 domestic airports to its entire network of 500 routes over 34,000km of track. SNCF and Thalys are also in this space but to a lesser extent.

15 largest domestic Chinese routes (ASKS): Nov-2012

Source: CAPA - Centre for Aviation and OAG
The 15 largest domestic Chinese routes collectively account for 19.3% of system capacity and are understood to account for an even higher share of profits. The shortest route, at 1075km (Beijing-Shanghai), is not within HSR's main threat radius

Air-rail partnerships can be one way to overcome the HSR challenge; another is adding more international flights. There is potential for foreign airlines too, as connectivity into an expansive rail system becomes available. Chinese carriers are also expanding into markets where rail links will take many years to cover, such as the west of the country.

Airlines target growth in China's west

The trend of airlines growing faster in the west is a combination of slot restrictions at eastern airports and HSR seeking new markets. The growth is facilitated by China's current Five-Year Plan, which calls for economic development in the west and once-stagnating northeast, thus increasing air demand.

Domestic growth at China Eastern is being driven by routes to northern and western regions, including Lanzhou to Beijing, Chengdu to Jiuzhai and Xian to Jiuzhai. China Eastern's marketing is targeting these areas, with a "Three regions in southern China" campaign focusing on Yunnan, Hainan and Jiangnan, while a "Journey to the West" campaign promotes Xian. Additional growth has been to Lhasa in Tibet as well as inner Mongolia, two markets where Air China has been expanding. In 1H2012 Air China received 198 slots at its main base of Beijing but also grew by 44 slots a week at Chengdu.

This growth shift will be gradual; China Southern derives 40% of revenues from flights at Beijing, Guangzhou, Shanghai and Shenzhen. China Eastern's sales strategy is "growing strong in Shanghai, doing well in eastern China and keeping up in western China". Overall, capacity growth in the west is expected to be 10%. The Big 3 in 1H2012 collectively grew domestic capacity by 5.8%.

This westward push is, of course, relative. Chengdu and Chongqing are less than half the distance to China's far western border; Xian is only a third of the way there. That is reflective of the dense east coast but also great opportunities for further air expansion to the real west. So will China's transport system be a game of cat and mouse, airlines finding new markets but eventually surrendering them to HSR? Perhaps in the very, very long-term, yes.

For HSR overlap to pose a greater threat to short-haul air routes, HSR's network of four horizontal and four vertical routes would need diagonal connections between them and more vertical lines in the central and west, a proposition that may require the planned network to double. To tackle longer routes, HSR speeds would need to be increased significantly.

So the reality is that the domestic airline network is largely shielded from HSR - and for smart carriers, even actually offers opportunities.

China's domestic airline market faces more significant challenges in short term

China's airlines face more significant challenges: congested airspace, inefficiency, shortage of manpower skills and external curbs on growth.

Carriers such as Juneyao and Spring offer a pleasant glimpse into a future of efficiency and low-cost operations that stimulate far greater demand. China will not claim the title of world's largest domestic market by supporting the status quo.

The sooner Beijing loosens the reins, domestically and internationally, the faster China's airline fleet will become a world force.