GDP Growth in China

The Aerospace & Defense Forum Los Angeles Chapter- August 16, 2013

AVIATION BUSINESS IN CHINA – SOME OBSERVATIONS AND LESSONS LEARNED

DAVID CONRAD 16 AUGUST 2013

GDP Growth In China

Rapid Growth Of 10%+ Per Year Is Past – GDP Growth In 2013 Is Expected To Be In 7.5% Range

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Economic Picture Economy maintain steady growth – 2013 target 7.5% Changing economy from export driven to consumption based China aviation market 2012 pgpassenger traffic increased 11.9% over 2011 Through June 2013 passenger traffic 14.6% year-over-year growth Chinese airlines 2011 - Added 148 new aircraft to bring fleet total to 1,745 aircraft 2012/13 - CAAC restricted new aircraft to 150 aircraft per year In 2013 China had 183 airports – goal is 260 airports by 2020 Goal - One airpp()ort/100 km catchment (advanced areas) and one airport/300 km catchment (western China) Handle 1.54B passengers per year by 2020 Add 50 new airports 2012 to 2016 including 2nd Beijing airport 1.5Trillion RMB ($250B USD) in investment

Chinese Economy Driving Significant Aviation And Infrastructure Growth

Chinese Air Traffic Growth

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The Airline Fleets In China

China Aircraft Installed Base Forecast 2011 - 2020

22,260,260

TWIN AISLE 12.8% 1,727

12%

SINGLE AISLE 75% 79.3%

REGIONAL

2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

Slower Growth Rate Than Other Forecasts Based On Constraints In Infrastructure And Capacity (CAAC Mandated Restrictions)

Source：AvWeek/CAMRO Database

The China MRO Market China MRO Spend Forecast 2011 - 2020 $5.92B $5.21B 3.25% 24.3% 27.6% CAGR

$3.1B 10.94% 26.4% CAGR 71.6% 68.5% 69.4%

2011 2016 2020

Regional Single Aisle Twin Aisle

China’s Share Of Total Global MRO Spend Will Increase From 5.6% To 7.6% In This Decade

Source：AvWeek/CAMRO Database

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China MRO Market Segments China MRO Spend Forecast 2011 - 2020

Engine Components Engine Components Engine Components 28.5% 40.3% 34.8% 38.6% 37.3% 44.3% 10.94% 3325%.25% CAGR CAGR Heavy Line 7.9% Line Line 15.7% 11.9% Heavy 10.2% 6.3% Mods Heavy Mods Mods 7.1% 6.8% 3.6% 6.7% 2011 MRO Spend - $3.1B2016 MRO Spend - $5.21B 2020 MRO Spend - $5.91B

• Modifications / Engines MRO clear winners – real growth and as percent of market • Modifications – 25.3% CAGR 2011 to 2016 and 4.8% CAGR 2016 to 2020 • Engines – 15.5% CAGR 2011 to 2016 and 5% CAGR 2016 to 2020 • Heavy Maintenance overall solid growth (6.2% CAGR 2011 to 2016 and 5.2% CAGR 2016 to 2020) - declines as percent of market • Component Maintenance overall solid growth in total spend (8.8% CAGR 2011 to 2016 and 2.1% CAGR 2016 to 2020) - declines as percent of market

Source：AvWeek/CAMRO Database

Aviation Market Picture Capacity constraints to the aviation market today Lack of airport capacity – number and size to handle volume Air traffic control issues – flight delays, capacity issues Airlines encouraged to buy wide-body aircraft to replace single aisle aircraft on busy domestic routes to carry more passengers Large fleet growth plans by airlines 2011 - Added 148 new aircraft to bring fleet total to 1,745 aircraft 2012/13 - CAAC restricted new aircraft to 150 aircraft per year Forecast skilled personnel shortages over the next twenty years Pilots - China 72,700 new pilots Mechanics - China 108,300 new mechanics Issues with business models of airlines today Main carriers very inefficient – high movement of staff, poor service focus Limited LCC situation (<10%) – sustain high prices to consumers

Today’s Aviation Market Constraints – Infrastructure, People And Economics

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Aviation Market Picture

Airlines in Asia-Pacific especially China carry 4X (in $USD) component inventory / aircraft vs. airlines in Americas/Europe Cultural thinking – assured operations/safety/control of destiny Future potential market opportunities for asset management Risk – if stock is released to market impact to spares sales globally

Why Look At Political Picture Politics define all business decisions in China External – The Party and the government Party / government guide economic development of China - including development of aviation Policy for CAAC, Customs, others set by central government - interpretation / implementation is left to local branches Majority of Chinese airlines are state-owned enterprises Government is always “elephant in the room” when discussing partnerships or JV’s (especially with state-owned-enterprises) Any joint venture approved by Ministry of Commerce and Industry Intern al – com panies / a irlin es / MR O’ s How project is perceived / criticized by those not involved will guide actions / behavior of people involved – second-guessing Really more complex – simplification helps explain core issue

If You Don’t Understand The Politics – You Won’t Understand What Is Happening To Your Project

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The Political Picture 12th Five Year Plan (2011-2015) Aeronautics sector - one of seven strategic "rising" industries "We must build an industrial platform for domestically made trunk and regional aircraft, general aviation aircraft and helicopters." Airport construction / expansion with emphasis on general aviation Reform of airspace management system to increase efficiency of allocation/utilization of airspace resources National Development and Reform Commission (NDRC) “Building world-class MRO providers in China is not only a must for a strong civil aviation nation, but also a symbol of the maturity of Chinese civil aviation” NDRC expectations for the MRO industry 2010-2020 – three (3) large maintenance clusters 2020-2030 – two world-class MRO providers competitive on global scale

Party / Government Committed To Domestic OEM / MRO Capability And Infrastructure

The Political Picture Under the 12th Fifth Year Plan CAAC will: Add over 50 airports (next five years) - total more than 220 airports Reform airspace management system to increase efficiency Address anticipated shortage of airspace and pilots - structural issues that will slow down growth rate of domestic airlines More important (CAAC’s view) - transformation of outdated business models used by Chinese carriers “Growth quality more important than growth rate” Out of China’s 43 carriers today, 35 are state-controlled CAAC has pledged to support private participation in sector May 2013 - lifte d ban (s ince 2007) on setti ng up new a ir lines – issued directive to study LCC business model “We would support and help as long as they meet our conditions”

CAAC Leadership/Control Driving Growth – Infrastructure, Business Models, New Airlines

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The Political Picture CAAC Minister Li JiaXiang (the former chairman of Air China) “By 2030, China is set to achieve the historical transformation from a big aviation nation into a strong aviation nation” “A strong aviation country is to become one of the leading aviation powers among the nati ons whi ch means th e avi ati on i nd ust ry plays a strategic role in the country's economic development, as well as has a great safety record, huge contribution, high quality operation, international competitive capability and strong influential power.” “Chinese carriers can’t catch up with the growing trend of accelerating international air transport liberalization because of their collective weak international competitiveness. “Domestic airlines should focus on operating base to avoid scattered capacity allocation and disorderly competition which is a reason why Chinese carriers’ international competitiveness is undermined.”

CAAC Committed To Meet The Will Of The Chinese Government

The Political Picture Gap between government policies and Western business practices Central government defines overall policy – how it is implemented is up to local/regional offices Policies support China’s overall economic objectives – not aligned with or take into consideration Western business practices or issues Major impacts – CAAC, Customs, business licenses (tied to economic development) and taxes

BUSINESS AGENCY PRACTICES POLICIES

TBidThGTo Bridge The Gap •Communicate •Educate •Relationships •Local Partners •Time

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Political Picture -Conclusions A few conclusions about politics and China’s aviation market Government will firmly control aviation development for foreseeable future – engine of economic growth Government set very clear direction for aviation development and has politi cal will t o mak e it h appen Politics part of every decision - look from Chinese perspective to understand decisions - who is involved, their role/position, and more importantly who is not involved and why Gaps between policy, policy implementation and business practices will impact businesses Business models in China will evolve – will not be the same as in other global regions (have (“have Chinese Characteristics” ) Business in China is complex – many bureaucracies involved Committed local partner can provide understanding of events, policy, politics and deal with bureaucracy

Business With “Chinese Characteristics”

China Market Trends/Issues Large growth rate of market and the scale of growth Fleet growth - driven by newer technology/new platforms Fleet age is important – 15 years or less Market structure / dynamics evolving - creates opportunities Government policy Airlines growth strategies Market evolution (as Americas/Europe have evolved) Safety and quality have been and will be top criteria – consequences of incidents/accidents are severe Airlines will reduce outsourcinggpp,,p for support, services, repairs as in-country capabilities increase Self-capability/self-reliance more important than cost – will change over time as airlines evolve to be more competitive

Dynamic Evolving Market Driven Today By Goal Of Self-Reliance

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China Market Trends/Issues Government expectations driving airline strategy changes Pax market - #1 In-bound, #1 Domestic and #4 Out-bound by 2015 Share of air freight carried by Chinese carriers at least 35% MRO migration from other regions of the world creating competition for scarce resources MRO market in China becoming more crowded at airframe and component level creating pricing irrationality Expect shake-out and consolidation of weaker players Tug of war for aftermarket will continue to accelerate Airframe OEM’s entering market – some initial acceptance (Sichuan, China Southern) Equipment OEM’s – control tech data, life cycle support contracts Airline-backed MRO’s expanding - support airlines and gain 3rd party revenue

Increasing Levels Of Competition In Market – Airlines and MRO’s

China Market Trends/Issues Labor issues impacting the market Mandated wage increases to balance the social environment Shortage of trained/skilled workers – pilots and mechanics Competition for workers increasing – drive up costs/labor rates Management challenges – skills, generational issues Economic issues impacting the market Monetary policy - RMB Exchange rates, constraints on liquidity Government investment/policy – what industries, how much FDI Infrastructure issues – CAAC / Customs / Licenses / Land Central policy – regional interpretation leading to uneven practices Lag time to understand/accept global business practices Challenges with land (local governments/ownership) and getting business licenses – source of local government revenues

Structural Challenges Impact Market Growth And Direction

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Chinese Airlines –A Byzantine Map

Complex Inter-Locking Relationships Between Airlines In China

Chinese Airline Strategy Industry consolidation in 2002 started focus on hub structure Air China most aggressive – controls the northern region Beijing Hub - ~ 50% of passengers through Beijing / international Chengdu Hub in 2007 – flights to 62 cities in China Acquired Shenzhen Airlines (2010) – expand into southern China Hub in Dalian (NE) - new subsidiary Dalian Airlines China Southern – major player in south-central markets Guangzhou Hub – more than 50% market share Second hub at Beijing – grew domestic traffic / A380 Issue Put in unfavorable position by Air China with T3 completion China Southern looking to second Beijing airport Urumqi Hub – economic development / access CIS, Russia, Europe Chongqing Hub (SW) - compete with Chengdu China Northern acquisition (2002) - CZ biggest airline in Dalian

Air China/China Southern Overlapping Hub Strategies – Irrational Competition

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Chinese Airline Strategy China Eastern last to embrace hubs – focus on relationships with different airlines under brand Shanghai Hub (PuDong / HongQiao) – nearly 50% market share Shanghai Airlines merger (2010) - defend Shanghai market Kunming as regional hub for southwest, Xi’an as regional hub for northwest and Shenyang as regional hub for northeast CAAC – “No Chinese carrier can successfully operate two domestic hubs” (success means at least a 45% market share) Air China – Beijing 42% traffic share (transfer traffic 20%) China Eastern – PuDong 38% traffic share (transfer traffic 17%) China Southern - Guangzhou 52% traffic share (transfer traffic 8%) Flaw in hub strategy - eagerness of “Big Three” to maintain their home hubs and expand into each other’s hub cities However hub development extended market reach of “Big Three” and triggered their international expansion Hub Strategies Driving Domestic Growth – Flaw Is Quality Of Growth

Chinese Airline Strategy Air China leader in international expansion Cathay Pacific share exchange - hubs support the other Star Alliance addressed weak international route structure and added new routes in Asia and Europe High speed rail drove China Southern international expansion New routes to Australia Urumqi - gateway to central Asia, new Europe routes Increased SkyTeam cooperation (Air France-KLM) Leverage A380 fleet - Beijing hub (Political Issue) China Eastern expansion enhanced by Shanghai merger Shanghai 2010 Expo promoted international presence Joined SkyTeam in 2011 may reshape competitive picture in China CAAC - Chinese airlines must address out-of-date business models to compete effectively (“Disorderly competition”)

Airlines Being Pushed To Focus On International Market

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Chinese Airline Issues Infrastructure issues Airport facilities can not support fleets – remote parking common Military controls all air space in China - only allots 20% to civil use Flight delays are frequent (25+%) and a source of trouble Air rage rising – result of delays and demand for compensation On the ground – damage equipment, block runways, physical assaults In the air – assault on flight crews CAAC – delays 7% due to military control, 21% weather, 26% air traffic delays and 42% airline management Even when flights take off passengers increasingly violent due to perceived poor service As a consequence of industry consolidation (2002) Chinese airlines are not a homogeneous business Example: China Southern – 5 branches and 14 subsidiaries Very few functions are centralized – especially purchasing so costs are higher

Many Business Challenges With Chinese Airlines

Crowded China MRO Market

CHINA ASIA-PACIFIC • Established MRO’s - GAMECO, AIRFRAME AIRFRAME AMECO, TAECO, STARCO • 300 + 3rd party Chinese component repair stations • New China MRO ’ s – Grand China, Grand China Air China Technic Technic GMF ST Aero Guangzhou STARCO ST Aero STAECOTAECO STA - CAN EGAT LHTP BOEING AMECO- HAECO SIAEC • Boeing/Airbus entering market PVG GAMECO

Hangda STARCO HAECO • Equipment OEM’s – Goodrich, TALSCO ST Aero Various OEM’s HS-XMN AMECO - Europe Zodiac, Spirit, Honeywell, IAI Andawell SIAEC HW-XMN Various OEM’s Haite GAMECO Various OEM’s -US Liebherr - SHA Hamilton Sundstrand Thales-PEK - Singapore Zodiac GR-TJN Spirit Taikoo • APAC MRO’s – HAECO, EGAT, Feng Rong Huarui Huatai SIAEC, ST Aero, LHTP Flightparts LHT - SZN XinLi SRT • ItInternati onal lMRO’ MRO’s – SRT, CHINA AF/KLM ASIA-PACIFIC COMPONENTS COMPONENTS AF/KLM, IAI

Structure / dynamics of Chinese MRO market will continue to evolve • Expanding fleets / global migration of MRO offers opportunities • Near term - continued growth in number of players in market • Long term - consolidation/shakeout (market saturation / some players fail)

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China Business/Cultural Issues Relationship is everything in terms of doing business in China This means a customer has to know your company and you well enough to trust your word and be confident of support Trust/friendship means more than words in a contract – friends have an obligation to each other Creating trust Visit every two/three months will not work – long term approach Established connections – school, previous work Dinners/drinking and behavior per local customs is a must – “in vino veritas” Strong preference for “local business” rather than an overseas business – self-reliance and investing in the country Chinese airline versus “Foreign” airline Hong Kong is not “local” for the China market

“We Are Friends First – Then We Do Business”

China Business/Cultural Issues International perceptions and history are challenge Long memory – foreign control of China in early 1900’s International suppliers perceived as high priced (basis in history) With a partner - cost is perceived as even higher Saying “No” – uncomfortable for Chinese to say no or tell someone that something can’t be done (especially foreigner) Likely you will hear “I’ll try” Don’t assume will happen – means “no” or “no way it can be done” Politics will be a part of any and all transactions Control of business will be an issue / consideration of partner Interests of government need to be satisfied (especially with SOE) Solutions have to have value for China (strategic aims), the airlines (safety, operational performance and cost), the partner (strategic aims, growth and profit) and Company (growth and profit) – think in this order Foreign Companies Need To Be Aware of Cultural Sensitivities

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China Business/Cultural Issues Chinese companies very aggressively negotiate any possible contract to maximize their advantage/value Get most possible at lowest cost - exclusive long term deal if value Justified by value of market long term Contract negotiation and closure Chinese companies love it when the President/CEO comes in to “close the deal” – opportunity to re-open everything Once contract signed likely asked for “out of scope” – expectation of “friend helping friend” Disputes handled very differently in China Western approach of legal action to resolve disputes won’t work Chinese approach - use relationships (someone with respect of both parties) to reach a harmonious conclusion Serious consequences result if you withhold payments due

Contracts Viewed Very Differently In China

China Business/Cultural Issues Logistics of getting material into/out of China is challenge – customs, costs, time Government supports labor unions in companies (incl. JV’s) Not union in “Western” sense – focus is employee welfare Funded by business – part of budget Employee promotions guided by Party and union Intellectual Property China wants to be equal in aviation/aerospace – IP is part of this Your partner will learn from your IP – old IP will cause issues Chinese companies will claim derivative IP - acceptable in China Corruption – recent headlines (GSK, Rio Tinto) It happens – hundreds of years of history Hard to find and hard to control, especially local employees China will detain employees as part of investigation

Food For Thought If You Have A Business In China

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China Business/Cultural Issues Most airlines part of a larger airlines group (Air China, China Southern, etc.) - when part needed, first go to “Big Brother” Airlines driven by safety, quality and operational performance Will not leave their fate in hands of others - control own destiny Concept of pools/shared hardware is hard to accept for Chinese operators What happens if they need something from pool at the same time another airline (priority, quantity, availability) Chinese airlines do not want to pay money for parts until they use parts (pools) Then willing to pay exchange/ repair fee Initial acceptance of offerings such as FHS at major carriers Small scale to date – Sichuan, China Southern Not sure of future impact – airlines taking “wait and see”

Chinese Airlines Not Ready For Common Western Practices

Formula For Winning In China Studies show successes by “Western” companies in China over last ten to fifteen years all have certain characteristics Take fight to the market - patient investment, develop products / services to fit customer culture and create brand First, build a winning portfoliof – offerff what the customer wants, not just what you have or think they want Second, cut costs – the customer may not want high cost/best capability when he can get what he needs for lower cost Third, improve access to markets/customers – joint ventures / partnerships with Chinese companies and upgrade service packages so new entrants find it harder to get into market Fourth, “create the right business model” – adapt how you do business to the demands of the customer. What works elsewhere most likely will not work in China Fifth, consistent, long-term focus on market / customers –they must be confident you will be there and not just for a quick dollar

In Summary – “Adapt Or Die”

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Summary

Rapid GDP growth in China of 10%+ per year is past – 2013 GDP growth expected to be in 7.5% range Shift from export-driven to consumption/innovation economy Growing middle class (“Chinese dream”) – engine of aviation growth

Aviation growth in China will continue for foreseeable future driven by increasing passenger / cargo demand – airline fleets and MRO

This growth is not without constraints – systems capacity, airspace issues, infrastructure and people shortages

Investments are being made by the government and by companies to address constraints but the process will take time – construction, system reforms and development of skilled personnel

Politics part of every business decision - if you don’t understand the politics, you won’t understand what is happening to your project External – what is best for the Party/China Internal – won’t always win on merits of business opportunity

Summary Development of self-reliance is national policy Aircraft design/manufacture/build – COMAC C919/ARJ21 Airframe/component MRO – three hubs/clusters, two “world-class” Aircraft leasing – BOC, ICBC, others Aviation market is getting crowded – OEM’sMRO s, MRO’ s and others from around the world are jumping into China – will stabilize / shakeout over time Airline structure and business practices are dynamic and evolving – reach self-reliance first, then adopt “new practices” to become more competitive Take into consideration cultural issues to do business in China Relationship is everything – friends first / then we do business History / perceptions – “Western” control of China Contracts – viewed very differently by Chinese Business issues – logistics, unions, IP and corruption Aviation and business practices in China still evolving

Keys to success – a winning portfolio, low costs, market/customer access, right business model and long term focus