23-May-2017 2:12 PM

AirAsia China: establishing the model for JVs in China's complex aviation market

Analysis

The AirAsia Group plans to establish AirAsia China, a cross border JV, with non airline Chinese partners. The startup will be based in one of China's secondary cities: Zhengzhou, which is not a major point of demand and already has above average LCC representation. But Zhengzhou is eagerly building an aviation hub, and this is critical for AirAsia China to receive government backing for this first in foreign airline JVs of this nature.

Launching in a major Chinese city was not going to happen - from a slot and protectionism view - but Zhengzhou is a start. AirAsia Group CEO Tony Fernandes called AirAsia China "the last piece of the puzzle for AirAsia", but AirAsia's full China aspiration and entering major markets may take more than five, possibly 10, years to materialise.

AirAsia has the distinction of becoming the first pan Asian LCC group to have a China unit. But the announcement of AirAsia China provides a greater reflection on the state of Chinese aviation - layered regulators, hub ambitions, home grown aircraft - and thus is a global case study for how to succeed in Chinese aviation.

As some airlines struggle with mere slots and codeshares, AirAsia will set up a local airline with a foreign (but geographically accurate) brand. AirAsia China will be one of more than a dozen global JV airlines, but the nuances of China mean that AirAsia's announcement is one of the most profound - from a partnership perspective.

AirAsia China announcement in summary:

This section provides a summary of the AirAsia China announcement. Selected themes are explored in more detail in subsequent sections

AirAsia China ownership structure

AirAsia, China Everbright Group and Henan Government Working Group have signed an MoU to establish an LCC JV: AirAsia China. The prospective shareholding has not been disclosed. Henan province is home to Zhengzhou, where AirAsia China plans to be based, while Everbright is a state owned financial enterprise.

**AirAsia China does not have a local airline partner**

As important a feature is who AirAsia's local partner is not: an existing airline. Over the past five years there has been a wave of startup airlines in China. China has preferred those airlines to have affiliation - through ownership or strategic cooperation - with an existing Chinese airline. There are various reasons for this, such as being able to leverage another airline's safety experience and not making the pool of airline groups too wide. Some startups have intentional affiliation: there are a number of new airlines affiliated with the HNA Group, which wants to grow its footprint.

There have also been some startups without a local airline partner, and AirAsia China will be one of those. AirAsia has been put off JVs with other airlines since the failure of AirAsia Japan, which was co-owned with All Nippon Airways. It has since pursued a new joint venture project in Japan and a new project in Vietnam with non airline partners.

AirAsia believes that partnering with other airlines to create a new airline inhibits AirAsia's ability to implement best practices. Although China has a lower operating cost environment than Japan, there are still many operational inefficiencies that incumbent airlines may not be willing to tackle.

China's startup moratorium is, as expected, loose

With considerable media attention, in autumn 2016 China announced restrictions on startup airlines. This was seen to end the startup wave and slow down the conversion of cargo and small regional airlines into bigger players.

That an entirely new airline - AirAsia China - plans to launch, and believes it has government backing, indicates no surprise that this regulation, like others, is hardly as firm as it sounds, and has considerable flexibility or loopholes for those with enough influence.

AirAsia China is the first foreign passenger airline JV

With its new JV in China, AirAsia will have the distinction of being the first foreign airline to establish a local passenger airline. AirAsia will promote itself scoring another notch against the Jetstar Group, a long time rival, even though there are now new and growing LCC groups like Lion and VietJet. AirAsia is not the first foreign airline to partake in Chinese aviation: Lufthansa was a significant investor in the all freight operator Jade Cargo, which launched services in 2006 but then shut down in 2011. Singapore Airlines was also an initial investor in another all freight operator, Great Wall Airlines, which launched in 2006 but was merged into China Cargo Airlines in 2011.

Several foreign airline groups have been keen to set up a passenger airline JV in China for more than a decade, including AirAsia. With AirAsia having finally signed an MOU to establish its long desired Chinese affiliate, the question becomes whether this signals an overall opening up of China to other potential foreign airline JVs - assuming AirAsia China actually succeeds at launching.

AirAsia China to be based in Zhengzhou

It would have been ideal of course for AirAsia to be based in a first tier city (such as Beijing or Shanghai) or a prominent second tier city (such as Hangzhou). But that was almost certainly never going to happen from a protectionism and slot point of view. Zhengzhou is China's 12th largest airport based on available domestic seat capacity in May-2017 (for system capacity, including international, it is 13th largest). It holds 2.4% of China's available domestic seats. The largest airport, Beijing Capital, accounts for 6.7% - so Zhengzhou is about a third the size of Beijing Capital and about half the size of Guangzhou and Shenzhen (second and third largest).

AirAsia China's flights will likely have to be underpinned by generous subsidies; a saying goes that where, in Chinese aviation, there are slots, there are no profits, but where there are profits, there are no slots.

The AirAsia Group serves more than a dozen Chinese cities, but none of its affiliates serves Zhengzhou (yet). As CAPA highlighted in an early 2016 analysis report - AirAsia is the largest LCC brand in the Chinese international market. At the time, the AirAsia and AirAsia X groups had already exceeded 100,000 weekly seats to and from China, and more than 30 routes.

Zhengzhou has wanted an LCC

Zhengzhou has considered a local LCC as being important for its aviation hub. News reports in 2014 said that Zhengzhou and various local companies were in discussions with Japan's Peach Aviation LCC to establish a unit at Zhengzhou. (Peach's shareholders include a Hong Kong firm.) The discussions also mooted the opportunity for Zhengzhou to launch an LCC without Peach's brand or capital, but with strategic support.

Improving China-Malaysia relations

The AirAsia China announcement underscores improving relations between China and Malaysia, which fell out over the Malaysia Airlines flight MH370 that disappeared en route to Beijing.

Besides improved government relations, Chinese visitors are again going to Malaysia - some of their own independent accord, some because there are no longer influences or blocks on travel agents to promote/sell Malaysia.

Digital airline and smart airport

AirAsia China intends to be a digital airline working with smart airports. This meshes well with the government's push for airlines to be more digital oriented, partially as China advances a digital economy. State owned airlines have made rapid gains in direct online distribution and have established separate e-companies to facilitate new business growth. Airports are seeking best practices to be more efficient.

AirAsia is studying the C919

AirAsia flags that it is studying the C919, the locally manufactured narrowbody jet that Comac ultimately wants to pit against the A320 and 737 families.

This follows the C919's high profile first flight in May-2017. AirAsia's mention of the C919 should be seen as political: AirAsia China is spruiking its local ties to come. Even if operating a split A320/C919 fleet is financially unsound, the political goodwill should be worthwhile for AirAsia. However, AirAsia should avoid making any C919 acquisition promises in order to secure approval.

A broad announcement encompassing what China considers to be value

The JV agreement was obviously carefully worked in detail. Rarely has a new airline announcement been so broad: detailing local training (pilots, crew and engineers) and ground based businesses (MRO); establishing a low cost terminal (still nascent in China); studying the national aircraft, and playing into China's aviation themes of a digital airline and smart airport.

This was a well crafted announcement. AirAsia knows China is not looking merely for a company to move passengers around, but also to contribute to the broader aviation ecosystem, and from the start AirAsia China is sending the right signals.

Announced in Beijing

AirAsia China was announced in Beijing, some 663km from its proposed base at Zhengzhou. The announcement was alongside a Beijing summit, but was critically held in the epicentre of China's power, nationally and for aviation. Beijing is where AirAsia China will either be approved or rejected.

AirAsia has a low profile in Northeast Asia

CAPA, in Aug-2016, commented on AirAsia's aspirations across Northeast Asia, where it is not as prolific as it is in Southeast Asia. CAPA observed of AirAsia's quest for a China unit:

The question for local Chinese AirAsia units is not if, but how and where. There are no foreign-affiliated passenger airlines in China. There have been foreign cargo JV airlines (with market exits) but China does not protect cargo as much as the passenger segment.

AirAsia is the largest non-greater China airline group in China. This accomplishment did not eventuate without very close relations to Chinese authorities. As significant as AirAsia's growth has been, it is a leap multitudes greater to go from serving China with healthy access to having an airline in China flying under a foreign (albeit neutral) brand.

There is the question of geography. AirAsia would likely look for a local government to take part in the JV and, more importantly - advocate on its behalf at government levels. A smaller, lower-profile city may be easier to set up base in, but also has a smaller market (although this is "small" by Chinese standards). More lucrative markets will be even more challenging to enter.

There is no LCC dominating the entire China market

China's LCC market is young, but may seem crowded with incumbents and startups. Yet no single (or two) LCCs dominate in the way that Southwest and JetBlue are present in the US, or Ryanair and EasyJet are in Europe.

Spring Airlines is arguably China's pre-eminent LCC, yet it is still very much a Shanghai airline. Spring does not even fly to Beijing. Spring's Shanghai Hongqiao (SHA) and Shanghai Pudong (PVG) bases dominate, with no other bases coming close in size.

Spring Airlines' top 10 hubs/bases/stations/focus cities ranked on available seat capacity: week commencing 15-May-2017

In comparison, JetBlue and Ryanair have strong home markets but also a number of other bases where the airline has a significant presence.

JetBlue Airways top 10 hubs/bases/stations/focus cities ranked on available seat capacity: week commencing 15-May-2017

Ryanair top 10 hubs/bases/stations/focus cities ranked on available seat capacity: week commencing 15-May-2017

The reason for this characteristic is protectionism. The government controls aircraft imports and Spring has not been allowed to grow as quickly as it would like, even though it has the commercial rationale and operational sustainability. With Spring being limited on the number of aircraft it can take a year, it has focused on its home market.

Spring wants a strong presence in its home, and Shanghai is also one of China's highest yielding cities. Putting aircraft elsewhere - if allowed (there is protectionism with routes and slot allocation) - would likely mean that Spring would take lower yields while losing Shanghai market share, which is already below ideal.

Private Chinese airlines have a difficult time growing fleet

AirAsia China's growth in China will be moderate, since aircraft imports are controlled by the government and subject to protectionism. AirAsia's Malaysia unit accumulated a larger fleet in 10 years than Spring Airlines did. This is despite AirAsia's Malaysia market being a fraction the size of China.

In the US market, which is larger than China's but with a narrowing gap, JetBlue reached 150 aircraft in its first 10 years.

Fleet growth of selected LCCs in first 10 years of their operation

Likely limits on AirAsia China's growth rate could impact the new airline's ability to achieve economies of scale and profitability. This is a major concern for AirAsia investors, who have understandably been frustrated with the group's lack of profitability outside Malaysia and Thailand.

Zhengzhou has been seeking an LCC

Zhengzhou is an ambitious Chinese city seeking to put an intermodal hub - rail, road air - at the centre of its development. Geographically, Zhengzhou has a favourable position linking all parts of China. It has also become a major electronics manufacturing hub for Apple products. The release of new iPhones has driven the setting up of nonstop freighter services from Zhengzhou to Los Angeles, carrying the new devices.

Henan province, of which Zhengzhou is the capital, invested in the freight operator Cargolux. Henan tried to woo Boeing to establish a completion centre, which will instead be placed in Zhoushan, 287km southeast of Shanghai.

Zhengzhou planned to work with the Japanese LCC Peach Aviation to establish a local LCC, but the plan fell through for many reasons, including the souring of Japan-China relations.

Zhengzhou already has 22% LCC market share

AirAsia's decision to pick Zhengzhou was largely based on where it could find the partners and local government support to get it approved. Based on market opportunity, there is a strong reason not to select Zhengzhou: it is already one of China's major LCC hubs.

Zhengzhou is the fifth largest airport in China for LCC seat capacity. Zhengzhou has almost as much LCC seat capacity as Beijing Nanyuan - home to the China Eastern LCC subsidiary China United. (Beijing Capital airport has only 37,000 weekly LCC seats in May-2017, making it the 33rd largest LCC hub.)

Zhengzhou has more LCC seats than in Guangzhou. However, with 125,000 weekly LCC seats it is not as many as the combined Shanghai Hongqiao and Shanghai Pudong size of 239,000 weekly seats (which is larger than the 158,000 weekly seats at Kunming, the single largest airport in China for LCC capacity).

Chinese airports ranked on LCC seat capacity: week commencing 15-May-2017

Rank	Airline	IATA	ICAO	Total
1	Kunming Changshui International Airport	KMG	ZPPP	157,796
2	Shanghai Pudong International Airport	PVG	ZSPD	147,926
3	Chongqing Jiangbei International Airport	CKG	ZUCK	129,184
4	Beijing Nanyuan Airport	NAY	ZBNY	125,262
5	Zhengzhou Xinzheng International Airport	CGO	ZHCC	124,660
6	Guangzhou Baiyun International Airport	CAN	ZGGG	113,474
7	Chengdu Shuangliu International Airport	CTU	ZUUU	108,186
8	Shanghai Hongqiao International Airport	SHA	ZSSS	90,864
9	Hangzhou Xiaoshan International Airport	HGH	ZSHC	87,213
10	Shijiazhuang Zhengding International Airport	SJW	ZBSJ	85,648

At Zhengzhou the LCCs already have 22% domestic market share (international capacity is negligible). Two HNA LCC units - Lucky Air and West Air - have bases at Zhengzhou. West Air is the third largest airline presence at Zhengzhou (9% of seats), while Lucky Air is fifth largest (6%). Together they are smaller than the largest airline presence - China Southern with 23%. However, including the full service capacity of Hainan Airlines, the HNA Group has a 24% share of capacity, ahead of China Southern.

Zhengzhou is West Air's largest base after its home base of Chongqing. West Air has 89,000 weekly seats at Chongqing and 48,000 at Zhengzhou. Zhengzhou is also the largest base for Lucky Air after its home base of Kunming, but Kunming is more prominent for Lucky Air, with 115,000 weekly seats, while it has 33,000 at Zhengzhou.

Zhengzhou walks a difficult course - supporting AirAsia in addition to China Southern and two HNA LCC units. Airports typically host a few airlines with hubs, but this instance will be different, since AirAsia China will be regarded as foreign, and more of a threat.

Zhengzhou airport domestic seat capacity by airline: week commencing 15-May-2017

China's LCC market share is low

LCCs account for approximately 9% of capacity in the domestic China market, according to CAPA and OAG data. This is higher than the 7% observed in 2016, but this market share gain is more reflective of airlines transitioning to the LCC model (with varying levels of LCC business characteristics) than it is reflective of LCCs growing faster and making market share gains.

The 9% figure varies across the country. The LCC penetration rate is 10% in Shanghai, home to Spring Airlines, which displays very clear LCC characteristics and has long been China's LCC leader.

A 9% China wide LCC market share figure may sound similar to Shanghai's 10% figure, but if the LCC market share figure excluded airlines that are LCC more in name than by having an actual low cost base, the China wide LCC market share figure would be lower, and there would be a wider gap with the Shanghai market share figure, reflecting Spring's achievements.

In Jun-2016 CAPA looked at the nuances of the LCC market share in Northeast Asia. Northeast Asia lags other regions:

LCC share of available seats within a region: 05-Jun-2016 to 11-Jun-2016

LCCs have a significantly lower share of capacity in Northeast Asian domestic markets, particularly China, compared to Southeast Asia:

LCC share of available seats within selected Northeast and Southeast Asian domestic markets: 05-Jun-2016 to 11-Jun-2016

Some international market pairings involving China have a high LCC market share figure, for example China-Malaysia, but this is often due to LCCs in the foreign country.

In the China-Malaysia example, LCCs have 65% of the market - the second highest within Asia after the 66% observed between Indonesia and Malaysia. The high China-Malaysia LCC market share is due mainly to AirAsia and AirAsia X.

LCC share of available seats within the 20 largest international Northeast and Southeast Asian markets: 05-Jun-2016 to 11-Jun-2016

CAPA observed in Jun-2016 that substantial gains in the Northeast Asian LCC market share figure will occur only when LCCs make stronger market share gains in domestic China, which is such a large market that it heavily shapes the average Northeast Asian figure.

Under a series of what-if scenarios calculated by CAPA, if the Hong Kong-Taiwan LCC market were to be 20% instead of 2% the total Northeast Asian LCC penetration rate would increase by only 1ppt to 12%. A 20% LCC rate is far-fetched, given the restricted traffic rights and improbability of an existing airline converting some of its capacity in the market to a low cost platform.

Likewise, if the China-Korea market grew from LCCs having 9% to 40% the total Northeast Asian LCC penetration rate would also grow only 1ppt. Such an achievement comes into focus once the Korea-China air service agreement is liberalised.

It is the large domestic markets that define any top-level statistics. LCCs account for 17% of the Japanese domestic market, and were their share to double to 30%, Northeast Asia's LCC penetration rate would grow from the present 11% to 19% under such a what-if scenario. If the same 30% were to be achieved in the domestic China market (currently 7%), Northeast Asia's total market about a quarter - 24% - of seats would be flown by LCCs.

Growth in other market pairs in Northeast Asia can add up, but significant region-wide improvements will not arrive until there is growth in mainland China.

AirAsia is reaping the benefits of long CAAC/China partnership

The opportunity to launch in China, even in an uncertain regulatory regime, is one worth pursuing.

There will be some concerns from AirAsia investors, who have been uneasy that AirAsia is overstretched and should bed down its existing units before launching new ones. However, the inevitable slow growth forced on AirAsia China by regulators could provide some relief to these investors as it limits the risk of overexpansion. And the benefit of being first mover could well outweigh downside concerns.

AirAsia has reached this point by successfully working with the CAAC and other Chinese parties. It has been a long partnership.

China is starved of experience and best practices. Growth has been frantic, which has often precluded strategic growth. As the sector has started to think much more about smart growth and improving practices, the anti-corruption and austerity campaigns have made it exceptionally difficult - near impossible - for leaders to travel overseas and learn new concepts and practices, bring them back, then adapt and improve on them for other countries to learn from China.

Regulators and stakeholders are eager to learn, improve and lead. AirAsia has spent much time walking regulators through the fundamentals of its businesses, and why it is more efficient and presents better growth - which rings very well in China. It has helped that AirAsia is also bringing visitors to China - a traffic flow often ignored in the larger China outbound story, but China is actively courting inbound growth. AirAsia's Asian heritage, culturally and linguistically, has helped too.

AirAsia has found a partner in Everbright and the local airport and government. Although Everbright has been lauded as a state owned enterprise, every company in China has strong enough government links. The question now is to what extent AirAsia China can leverage its partners' government ties to overcome what will certainly be fierce protectionism on some fronts. There is a warning in connections gone awry from 9 Air, the Guangzhou based LCC that has not been able to grow as quickly as it planned.

China may be the final piece of AirAsia's puzzle, even though it will take time for this unit to be significant and fulfil AirAsia's ambitions. In the longer term, Zhengzhou may be only a small part of the AirAsia China story, but in China's massive and expanding market, having a foothold of this nature could prove a very sound investment.