How Chinese airlines 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, China 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—Air China, 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 airline 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 air travel 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 Beijing to Shanghai, for market- start-up carriers, including Jiuyuan Airlines, based pricing. It is also easing its restriction Loong Air, and Donghai Airlines. 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 Singapore Airlines, 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 Spring Airlines—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.