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How Chinese can brace for impending turbulence

October 2019

How Chinese airlines can brace for impending turbulence

The coming years could prove challenging for Chinese airlines, which are already battling economic losses. They should focus on five opportunities.

Steve Saxon, Qiao Xie, Zhi Wei Sok, and Zi Chen

Chinese airlines have grown rapidly. From contributed almost all of these losses (Exhibit 2009 to 2018, demand grew at 14 percent 1). Looking ahead, it’s only going to become year-on-year,1 fuelled by strong domes- more difficult for the airlines to succeed: ca- tic travel and outbound tourism that came pacity growth is on track to outpace natural with the growing Chinese middle class. By demand growth, and impending regulatory 2018, was the world’s second-largest changes will increase competition domesti- domestic market and largest outbound tour- cally and globally. ism market. Over this period, the “Big Three” To manage these pressures, Chinese carriers carriers—, China Eastern, and China should take five actions: improve productivity Southern—managed the single largest ca- and closely monitor costs, pursue ancillary pacity addition ever seen, all while improving (non-ticket) revenue opportunities, differ- safety and customer experience. entiate their products, secure spots in main Despite a favorable regulatory environment, hubs and increase the number of connecting Chinese airlines did not return the cost of flights they offer, and consolidate. By acting capital for this expansion. In fact, from 2009 now, incumbent Chinese airlines can brace 1 As measured by revenue to the end of 2018, they accumulated $29 themselves for the coming turbulence. passenger kilometres (RPK). billion in economic losses. The Big Three

How Chinese airlines can brace for impending turbulence 1 Exhibit 1 In the last decade, many Chinese airlines sustained economic losses, but the big three topped the list

Cumulative economic profit for global airlines, 2009-18 USD billions

Global carriers Chinese carriers

6.0 Cut-off for .01 (2.1) Cut-off for 4.0 top quintile bottom quintile

2.0

0

-2.0

-4.0

-6.0

-8.0

-10.0

-12.0

-14.0

$340 bn -$420 bn -$1350 bn Top 28 airlines 82 airlines Bottom 28 airlines

Source: McKinsey value chain analysis

2 How Chinese airlines can brace for impending turbulence Turbulence ahead: excess capacity, intensified competition, and pricing pressures

Chinese carriers seem set for a bumpy ride However, the Chinese airline industry shows from the economy. Chinese GDP per capita no signs of slowing its capacity growth. growth has been projected to drop from 6.3 Based on known aircraft orders, Chinese percent in 2019 to 5.4 percent in 2023; this carriers continue to add capacity at about 10 economic slowdown in China, coupled with percent year-on-year. With supply growing a similar slowdown globally, will likely have faster than demand, carriers will feel pres- a negative impact on demand and sured to drop prices to stimulate demand consumer spending. As such, we expect for the excess seats. To exacerbate the growth to decelerate in the Chinese travel yield pressure,2 incumbent carriers will face 2 A key measure of airline profitability, yield is market to 8 percent year-on-year from the increased competition from low-cost carri- the amount of revenue 11 percent year-on-year it experienced from ers (LCCs), foreign carriers, and each other, earned per passenger mile. 2013 to 2018 (Exhibit 2). driven by recent—and anticipated—easing of regulations.

Exhibit 2 Looking forward, supply is likely to grow faster than demand in China

Demand Capacity Demand/ca Demand Capacity X% projection1 Projection2 pacity ratio China airline market demand/supply analysis (domestic, outbound/inbound), 2013-23F # of passengers/seats, Millions +10% p.a +10% p.a +8% p.a 1,236 1,135 +11% p.a 1,035 943 923 875 833 813 781 753 713 694 636 640 531 579 580 485 463 509 387 414

2013 14 15 16 17 18 19F 20F 21F 22F 2023F 80% 78% 80% 80% 81% 82% 83% 82% 79% 77% 72%

1 Based on Euromonitor, IATA and GDP growth prediction 2 Based on aircraft order, assuming rented /owned ratio remains unchanged Source: PaxIs, Euromonitor, IATA, OAG, Fleet Analyzer

How Chinese airlines can brace for impending turbulence 3 From 2008 to 2017, the Civil Aviation Admin- stance to encourage more competition. It has istration of China’s (CAAC) position on new already removed regulated pricing on 375 entrants, including LCCs, seesawed. In 2014, domestic routes and will open up a further the CAAC loosened regulations for starting 302 routes, including the major business new airlines. This led to the proliferation of route from to , for market- start-up carriers, including Jiuyuan Airlines, based pricing. It is also easing its restriction , and . Later, in of one carrier per long-haul route. 2016, CAAC retightened control over new Most notably, restraints on airport terminals carriers by restricting license issuance, and slot capacity that have hindered growth limiting slots allocated to new entrants, and will ease. Chief among these is the new holding back approvals for new aircraft pur- Beijing Daxing airport, which opened at the chases. Ultimately, these moves benefitted end of September 2019. Daxing is expected the Big Three. to serve 72 million passengers per year by CAAC has also historically prevented direct 2025 and 100 million passengers per year competition on international routes by by 2040, doubling capacity in Beijing. All of restricting traffic rights on these routes to a the Big Three and the fourth-place Hainan single Chinese carrier. The market used to Airlines are set to compete with large-scale have price limits (fares were allowed to float hubs in the Beijing market. between 25 percent above and 45 percent The combination of excess capacity, intensi- below the standard regulated price). Tightly fied competition, and pricing pressures may controlled rules on ancillaries deterred prod- result in increasing economic losses if Chi- uct innovation and hampered LCC growth. nese carriers continue a business-as-usual Today, the CAAC is cautiously relaxing its approach.

4 How Chinese airlines can brace for impending turbulence Five ways Chinese airlines can manage compounding pressures

It’s not too late for incumbent Chinese CASK) was low compared with global peers’ airlines to change course. Five actions can apart from two cost categories—labor and help them effectively navigate the coming aircraft ownership (Exhibit 3). In 2018, the turbulence. Big Three’s staff CASK was slightly higher than , despite enjoying Improve productivity and tightly much lower labor rates in China. And air- manage costs craft ownership costs 60 percent more for Chinese carriers than for those in the United As of 2018, Chinese carriers’ overall unit States. cost (the cost per available seat-kilometer, or

Exhibit 3 Compared with peers around the world, Chinese carriers’ overall unit cost is generally low

Unadjusted CASK by cost category, 2018 Aircraft ownership Staff Maintenance Others USD cent Airport and enroute Fuel Marketing & sales 8.3 0.7 0.3 6.7 6.7 6.6 6.4 1.2 1.2 0.9 1.0 2.7 1.4 1.5 1.3 1.0 4.6 0.7 1.2 1.2 1.3 1.3 0.7 2.0 1.0 0.4 2.0 2.0 0.3 2.0 2.0 1.5 0.2 0.4 0.4 1.8 0.4 0.2 0.2 0.2 0.1 0.3 0.1 0.2 0.5 0.5 0.5 0.4 Air China China Eastern China Southern Spring Singapore US average

SOURCE: The Airline Analyst; annual reports

How Chinese airlines can brace for impending turbulence 5 The comparison with —the tions, Chinese carriers have already begun leading LCC in China—is also illustrative. As to implement digital tools such as electronic a newer entrant, Spring has many unit costs, flight bag for pilots—an electronic device that including pilot and staff salaries, that are aids in flight-management tasks. Carriers higher than the Big Three carriers’. However, can explore additional opportunities around because of Spring’s more efficient opera- automating crew scheduling, maintenance tions, it has a 30 percent lower unit cost. management systems, fuel calculation, and weight- and balance checks. Finally, innova- One cause of large Chinese incumbents' tive digitization in cabin services can both high cost of labor is the complex holding and reduce cost and improve customer service. organizational structures that they’ve built up Delta Airlines, for example, is equipping over the years. For example, the Big Three its first A220-100 with the new wireless carriers have many regional branches that IFE system to improve on-board customer are set up as distinct entities. This separa- experiences while saving cost. The wireless tion has led to both significantly higher labor streaming technology enables the reduction costs and lower productivity (measured by of about one pound of wiring per seat when the passenger-to-staff ratio) when compared installed on an aircraft. 3 with industry peers. The Big Three carriers on average served only about 1300 passen- To pursue these digital improvements, Chi- gers per employee in 2017, while each em- nese carriers must attract the right talent. ployee with Hainan, another Chinese airline, This has historically been challenging for served about 2900 passengers each. state-owned enterprises, which have not been able to attract top digital talent due Moving forward, carriers need to reevaluate to relatively lower salaries and stodgy work their structures and streamline their oper- cultures. They should experiment with work- ating models. This change will not be easy arounds such as setting up market-based due to legacy structures and local interests. digital companies. However, carriers should further central- ize control over their subsidiaries, increase shared functions, and make more efficient Promote ancillaries and direct use of pilots and cabin crew through better sales coordination across subsidiaries. Such efforts As more routes are subject to market-based will also help increase aircraft utilization. pricing, Chinese carriers must further de- Chinese carriers can also make better use of velop their pricing and revenue-management their assets by, for example, equipping each capabilities. This will mean more fare buck- aircraft with more seats, which can support ets, more dynamically managed. And Chinese lower costs and fares for consumers. Air Chi- carriers can lead a shift to fully dynamic na has already reconfigured its 738s pricing through New Distribution Capability, with 176 seats, compared to 171 seats for the a new International Air Transport Association average Chinese carrier. In this competitive program aimed at facilitating more-efficient market, every seat counts. distribution systems for airlines.4 Beyond better cost management, the next Chinese carriers also trail behind global wave of productivity will come from digitiza- peers in ancillary revenues per passenger. 3 Source: https://news. delta.com/3-ways- tion. Opportunities abound in ground opera- Historically, this lag has been due to CAAC’s delta-flight-products- tions, flight operations, and cabin services. restrictions on ancillary offerings and pricing. revolutionizing-aircraft- interiors. , for example, adopted However, the agency is loosening its regula- 4 Source: https://www. mobile solutions to improve its aircraft tions. iata.org/whatwedo/ mechanics’ productivity through better airline-distribution/ndc/ Recent relaxations in regulations allow Pages/default.aspx information and data flow. In flight opera-

6 How Chinese airlines can brace for impending turbulence Chinese airlines to charge for seat selection more impact in reducing the negatives than, on both international and select domes- for example, improving product design. tic flights. Carriers should unbundle these Chinese carriers should start with the largest components of their products and explore negative of the airline experience: delays. differential pricing for seats. Carriers should Among countries globally, China has the most also push to capture more on-board sales of flight delays.5 This issue is largely outside the ancillary products, for which, unlike food and carriers’ immediate control and stems from beverages, there are no regulatory restric- factors such as airspace restrictions and tions. Again, digital capabilities can help air- conservative air traffic control rules. How- lines create fully functional apps and mobile ever, carriers can improve how they handle websites to allow pre- and in-flight orders. delays with their customers. Airlines should also continue to engage regu- Today, the situation is dire. Delays are fre- lators on other ancillary-related initiatives quently not announced until passengers are that are still restricted, such as enforcing at the gate, even when the airline knows the baggage fees and charging for seat selection incoming flight is late. Many delays are only on remaining domestic flights. announced on a handwritten poster at the Finally, airlines should increase direct sales. departure gate. Airline staff manage rebook- To accomplish this, airlines should increase ing, meal vouchers, and hotel accommoda- incentives for buying through their online tion manually, which results in long lines of channels, including their app and website. weary passengers. Compared to global carriers, Chinese carri- Improvements in this area hinge upon in- ers have a high share of ticket sales through vestments in digital capabilities. Analytics mobile and web channels, but a low share can better predict delays, and automated through their self-run channels. The online systems are capable of managing passenger travel agency (OTA) is king in China. While accommodation. Rebooking, meal vouchers, OTAs can help customers package multiple and hotels can all be dispensed through apps products in a single journey, airlines should and mobile websites. Our customer satisfac- aspire to own more customer relation- tion research in the US market shows that ships themselves. Direct sales reduce the a well-handled delay can actually create a likelihood that customers will shop among more positive customer experience than an competitors, increase an airline’s ability to on-time flight. generate ancillary sales, and reduce distribu- tion costs. Secure their presence in main 5 In August 2019, the top hubs, while building a strong 10 Chinese airports’ on- Differentiate the product, starting time performance (OTP) connecting network was 67 percent and 76 with how delays are handled percent in the US. Among While Chinese carriers have hubs, they are 1200 airports, Beijing Today, the Big Three Chinese carriers are nothing like US hubs. The market share of the Capital International quite similar. The onboard service is compa- Airport (PEK) ranked largest airline within each of China’s 15 larg- 903, Shanghai Pudong rable, they use the same airports, and many est airports averages 33 percent, significant- Airport (PVG) ranked planes even have exactly the same business- 999, Shanghai Hongqiao ly lower than the US average of 52 percent International Airport class seats. (SHA) ranked 1100, and in its 15 largest airports. With the opening of Baiyun In- To brace themselves for lower-cost competi- Beijing Daxing and four carriers competing in ternational Airport (CAN) ranked 937. tion, Chinese carriers will need to sharpen the Beijing market, better managing con- Source: https://www. their product proposition to boost customer nections will be more important than ever for oag.com/august- satisfaction and loyalty. Our experience with Chinese airlines. 2019-airlines-on-time- performance carriers around the world reveals that there’s

How Chinese airlines can brace for impending turbulence 7 Carriers should seek to develop a stronger flights that are strategically important but connecting network with more privileged unprofitable, carriers should improve loads origin-and-destination pairs (O&Ds). The by capturing more connecting traffic and current state highlights significant opportu- reducing capacity with new long-range, nar- nities for improvement: the Big Three carriers row-body aircraft. Carriers can also explore have only around 20 percent of passengers cost-effective code-share partnerships with connecting in their hubs, while their global other carriers to support these opportunities. peers have captured a much larger share. Delta Airlines leads the pack: 74 percent of Consolidate—both domestically passengers in its main hub, Atlanta, take and internationally connecting flights.6 Of course, Beijing is a larger city than Atlanta, with more local pas- Despite individual efforts, the Chinese airline sengers, but many seats on Chinese carriers market will eventually require capacity con- still go unfilled; strategic use of connecting solidation. Since government deregulation O&Ds can fill these seats. in 2014, the growth of smaller players and new entrants has led to increased market Chinese carriers can benefit from design- fragmentation in China, with the Big Three’s ing their schedules with improved banks of capacity share decreasing from 54 percent connecting flights, aiming for short con- to 46 percent. This fragmentation contrasts necting times on key O&Ds. They could also starkly against other geographies that have work with their hub airports to improve the higher levels of consolidation. The US airlines connecting experience, which is currently a market, for example, went through a long source of frustration for customers. For ex- process of consolidation; today, around ample, China requires even international-to- 60 percent of US capacity is concentrated international connecting passengers to pass among American Airlines, Delta Airlines, and immigration, and in some cases to reclaim , the top three carriers. Only baggage. Some customers have to check 12 US airlines operate internationally, com- in for connecting flights twice; most inter- pared with 29 Chinese carriers. As in the US, national carriers would provide all boarding consolidation in the Chinese market will likely passes at the first check-in. Transfer desks take time and will require regulatory support. and channels for transfer passengers don’t exist in many Chinese airports, and, where Chinese carriers have already started build- they do, they are often closed. ing global partnerships through network joint ventures (JVs): China Eastern has JVs with While pursuing these opportunities, Chinese and Airlines, Air China with carriers need to balance network presence , China Southern with and profitability on international routes. KLM. Such partnerships help the airlines Local and national governments encourage expand their networks, and Chinese carriers Chinese carriers to expand internationally. should continue building global cooperation. The pace of international expansion has ac- celerated with the introduction of One Belt, Chinese carriers can be more proactive in One Road policies. Local governments are international consolidation as well. Today, some have either taken or been the recipi- 6 Source: Paxis by IATA. especially keen to achieve international con- nectivity, which has led to the launch of niche ent of foreign airline minority investment. For 7 Delta owns 3.22% of China Eastern, Delta and routes such as to Seattle and example, Delta owns 3.22 percent of China China Eastern both own to Helsinki. Even with subsidies, Eastern, which in turn owns 10.3 percent of 10% of Air France KLM respectively. these routes are hard to make profitable. For Air France KLM overall.7 Such minority equity

8 How Chinese airlines can brace for impending turbulence stakes help cement the JVs. But beyond pas- sive minority stakes, Chinese carriers could seek more control in international airlines. Such activities could be financially advanta- geous and help improve Chinese carriers' standing in the international market, aligning with One Belt, One Road initiatives.

We are at an inflection point in the Chinese aviation market. The next few years may be challenging, with excess supply and looser regulations leading to greater competition. But by pursuing the five measures above, Chinese carriers will be better equipped to steer through the turbulence.

Steve Saxon is a partner in McKinsey’s Shenzhen office and leads the company’s airline practice in . Qiao Xie is an associate partner in the Beijing office, Zhi Wei Sok is a consultant in the Singapore office, and Zi Chen is a researcher in the Shanghai office.

How Chinese airlines can brace for impending turbulence 9 How Chinese airlines can brace for impending turbulence October 2019 Copyright © McKinsey & Company Designed by GCO NewMedia www.mckinseychina.com