China’s Big Three Report Earnings

Madhu Unnikrishnan

April 5th, 2020 at 12:19 PM EDT

  • They don’t say much. Transparency isn’t their thing. But China’s Big Three airlines — all reporting their 2019 financial results last week  —did at least have a few words to say about how they’re recovering from the Covid-19 shock.

    The pandemic started in Wuhan, China, first infecting people in December. By early January, the World Health Organization was warning about a “pneumonia of unknown cause.” On Jan. 13th, Skift Airline Weekly inconspicuously noted that public health officials were monitoring a SARS-related virus outbreak in Wuhan. Only in late January, just as Chinese New Year travel was getting underway, did the virus lead to drastic reductions in air travel. February became a lost month for Chinese carriers, flying largely empty planes during what’s typically their busiest and most profitable time of the year.

    Between Jan. 23 and the middle of March, Chinese traffic had dropped 80% y/y, according to IATA. For international travel to and from China, the drop exceeded 90%. In total, nearly 500k domestic and international flights to and from China were cancelled.

    But Chinese cases of the illness subsided in March, just as they grew explosively elsewhere in the world. Planes and people gradually returned to the air, domestically anyway. And while life and business aren’t back to normal yet in China, things are at least trending that way. China Southern said last week its own operations are on the path back to normal, adding its expectation that the impact of the epidemic is “short-term and generally controllable… [the] most difficult and arduous stage has passed.” China Eastern was slightly more specific, mentioning some of the steps it took in response to the demand shock. It adjusted schedules, negotiated cost concessions with suppliers, suspended aircraft deliveries, froze capital spending, and prioritized cash preservation. Air China mentioned some of that as well, while otherwise stating just vague platitudes like having “spared no effort in prevention and control of the epidemic.”

    In fairness, China’s airlines were indeed critical in the battle to contain the virus, transporting doctors and medical supplies, most importantly. The carriers haven’t yet reported their March traffic numbers. And as April begins, international travel remains highly restricted, in part to prevent new infections arriving from abroad. Beijing now has a “one-one-one” policy, allowing just one flight a week by one carrier for each single route. Load factors cannot exceed 75%. There are no restrictions on cargo though.
  • How is China’s government supporting its airline industry during the Covid crisis? Like many other governments around the world, it’s relaxing airport slot rules and waiving lots of taxes and fees. It’s also subsidizing international flights. To prevent Hainan Airlines from imploding, Hainan’s municipal government grabbed a controlling ownership stake. The industry likely received other forms of undisclosed financial support.

    That said, Beijing hasn’t yet engaged in anything similar to the massive fiscal stimulus it enacted after the global financial crisis a decade ago, which helped lift economic growth worldwide but also left China with massive debts. Hainan Airlines hasn’t yet reported its full-year 2019 results. Nor for that matter, have the smaller private sector-backed airlines Juneyao and Spring, both based in Shanghai. Stayed tuned for their numbers in the coming weeks.    
  • Air China, as mentioned, did report, and its financial statements showed a $1b-plus net profit for 2019, and an operating margin of close to 9%. That’s similar to what it earned in 2017 and 2018, again distinguishing itself as the most profitable of China’s Big Three. Last year featured both ups and downs. As with its peers, many of Air China’s efforts focused on improving areas like brand management, product improvement, revenue management, outfitting planes with Wi-Fi, frequent flier plan development, cultivating sixth-freedom traffic, e-commerce, corporate contracts, ancillary revenues, airline partnerships, fleet renewal, environmental stewardship, and best practices in cost management.

    The macroeconomic environment was challenging, with China’s GDP growth slowing to 6% amid deteriorating economic relations with the U.S. This badly hurt Air China’s cargo revenues, so much so that it wound up selling its entire 51% stake in Air China cargo. More damagingly still was Air China’s heavy exposure to the embattled Hong Kong market, along with its large 30% ownership stake in hard-hit Cathay Pacific.

    Premium revenue on Hong Kong, Taiwan, and Macao routes, in fact, shrank 11% last year. There were other headaches too, including the grounding of Air China’s 16 B737-MAX 8s. The opening of a new Beijing airport created new competition in its most important market. The busy China-Japan market saw a surge in new capacity as carriers diverted planes from the depressed Korea-Japan market. Air China felt compelled to withdraw capacity from the highly competitive Australian market. The cross-Strait Taiwan market remained depressed for political reasons. Reliable high-speed rail competition is a reality in many key domestic markets.

    Frustrating air traffic congestion is another reality. China’s currency weakened as the year progressed, putting upward pressure on airline costs. Air China’s B787s experienced engine problems. Major Chinese carriers were forced to order Chinese-built regional jets. And despite the fact that China’s domestic RPK traffic grew a robust 8% in 2019, Air China itself grew mainline ASK capacity just 2%, reflecting diminished opportunities. Then how did it prevent profit margins from dropping.

    A big reason for that was a 7% y/y decline in fuel costs for the year. Shenzhen Airlines, a subsidiary, contributed $168m in net profits. The Air China group as a whole, with about 700 planes, is enjoying the benefits of scale. It now has 63m members in its Phoenix Miles loyalty plan. It’s now starting to take A350-900s, outfitted with a new premium economy class product. Soon Chengdu, its second-most-important hub after Beijing, will get a new airport of its own. Helpfully in these times of distress, Air China has just 20 widebodies currently on order, all A350s.

    Longterm, it still believes outbound demand from China will grow strongly. And it plans to restore all of its international routes as soon as feasible. It even still mentions plans to launch new routes this year like Chongqing-San Francisco and Hangzhou-Tokyo. We’ll see about that. But it does have important overseas alliance partnerships intact, with carriers like United, Lufthansa, Air Canada, and Air New Zealand. Cathay Pacific remains a close joint venture partner as well, and perhaps an eventual merger candidate.

    As usual, all Chinese carriers did poorly in the final quarter of 2019, an offpeak period of the year. Air China did manage to break even at the operating level, with the help of government subsidies that all Chinese carriers receive. Without these subsidies, its income statement shows, Q4 operating margin would have been negative 3% (and positive 6% rather than 9% for the full year). The Hong Kong demand shock, as well as its cargo woes, led to a 2% y/y drop in quarterly revenues. But operating costs declined by a similar amount.

    Once again, Air China was the slowest growing of the Big Three, increasing Q4 ASKs just 4%. Domestically, they grew 5%. Internationally they grew just 3%. Hong Kong, Taiwan, and Macao routes saw a 7% decline. All eyes now turn to the summer season, which Chinese carriers hope will see further revival of domestic traffic. In one note of encouragement, Air China did say it would continue paying dividends despite the Covid shock.
  • If Air China is the perennial profit champ among China’s Big Three, China Eastern is often the opposite. Again in 2019, it posted the worst results of the bunch, earning just a 3% operating margin. Part of its chronic underperformance stems from the heavy competition in its chief market Shanghai, though pressures eased somewhat after swapping ownership stakes with rival Juneyao Airlines. China Eastern now holds 15% of its shares. Net results for the year were hurt by $143m in forex losses, though this was significantly lower than its 2018 forex losses.

    As for Q4 figures alone, they were bloody. Operating margin was negative 12%, or a gruesome negative 19% if the nearly $1b in government subsidies it received are excluded. Despite its difficulties making money, China Eastern pursued double-digit expansion anyway, growing ASKs 10% for the year and 9% for Q4 alone. Offsetting large reductions in flying to Hong Kong was an aggressive 13% increase in international routes. Like Air China, China Eastern has heavy Hong Kong exposure, idled MAX jets, and cargo distress, though cargo represents just 3% of the latter’s total revenues. As bad as Q4 margins were, they improved a bit y/y as cheaper fuel kept operating costs flat; revenues rose 2%.

    It might be a profit laggard, but don’t accuse China Eastern of strategic lethargy. For starters, it’s alone among the Big Three to own a low-cost unit. China United, formerly based at Beijing’s tiny Nanyuan airport, is now competing from the new Daxing airport, where it hopes to expand abroad. China Eastern is building a mainline hub at Daxing too, hoping to improve a traditionally weak position in the nation’s capital.

    It’s been most aggressive on the alliance front too. It has joint ventures with Air France/KLM, Qantas, and soon Japan Airlines. It actually owns 10% of Air France/KLM. Conversely, it sold 4% of itself to Delta, another critical partner. It did lose Jet Airways as a codeshare partner. But it’s forming new codeshare relationships with others like Air Europa and LATAM. It has close relationships with the online travel retailer and the theme park Disneyland Shanghai.

    At home in Shanghai, connecting traffic grew by double digits last year. It wants to challenge Air China in Chengdu when the city’s new airport opens later this year. It wants to be the top player at Qingdao’s new airport. Last year, China Eastern carried 130m passengers while growing its Eastern Miles plan membership to 43m. Just this January, it switched from a mileage based accrual program to one based on revenues. Xian and Kunming are its two largest hubs outside of Shanghai and Beijing. It recently began offering new branded fares. More B787s, A350s, and A320 NEOs are on the way.
  • China Southern, the largest of the Big Three by passenger volumes, showed a negative 6% operating margin for the offpeak fourth quarter, or negative 10% excluding subsidies. Revenues rose 8% y/y on 7% more ASK capacity, a sign of healthy demand. Operating costs rose just 6%, here again benefitting from cheaper jet fuel. The carrier still pulled out a full-year operating profit for 2019, with operating margin reaching 4%, similar to 2018’s figure. Excluding subsidies, full-year operating margin was more like 1%.

    China Southern had one big advantage relative to Air China and China Eastern last quarter: It had limited Hong Kong exposure relative to its rivals, and probably even benefited some from its unrest. That’s because Guangzhou competes for some of the same traffic in the greater Peal River Delta region. Make no mistake, the region is highly competitive, with Air China’s Shenzhen Airlines growing and Juneyao’s LCC 9 Air a major presence in China Southern’s home city Guangzhou.  Lots of ASEAN-based LCCs are also present in China’s economically dynamic southeast.

    To the north, China Southern aims to be the largest carrier at Beijing’s new airport, targeting a 40% market share by next spring. Less helpfully this year, it happens to be the largest airline in Wuhan, birthplace of Covid-19. China Southern has 49m SkyPearl members. It controls Xiamen Airlines and cooperates with Sichuan Airlines.

    The group’s fleet will top 1,000 planes by 2022 according to current plans. Ordering five A380s many years ago never made any sense. But B787-9s and A350-900s serve it well. It will eventually need replacements for its 56 A330s and 20 B777-300ERs. Narrowbody replacement is already underway with both NEOs and MAXs, though MAXs are of course still grounded — between mainline and Xiamen Airlines, the group has more than 30 MAXs already on hand.

    On the alliance front, China Southern decided to leave the SkyTeam alliance last year, unable to comfortably coexist alongside China Eastern. Rather than joining oneworld though, it’s maintaining some ties to SkyTeam members like Delta and Air France/KLM, while also forging new links to carriers like Emirates, Qatar Airways, Finnair, and British Airways. It also sold a small stake in itself to American. In the past China Southern’s value as a partner was limited by its undersized presence in Beijing and Shanghai.

    Establishing a new hub at Daxing changes the equation. Longer term, a more viable Beijing hub also positions China Southern to become as stronger player in markets like North America and Europe. Intercontinentally, Guangzhou is only advantageous for Australasia, a highly competitive market.

Cebu Pacific Reports Strong Quarter

  • In the tourist-heavy ASEAN region, Cebu Pacific of the Philippines reported another set of excellent financial results. The LCC often ranks high on the list of most profitable airlines worldwide, exercising a commanding presence in a market with just two other major competitors. One is Philippine Airlines, a perennially troubled legacy carrier. The other is AirAsia, which has until recently struggled in the Philippine market.

    Cebu serves not just inbound tourists and local business travelers but also many of the 10m Filipinos working abroad. The economy has surged in recent years, aided by Chinese investment and exports of business services like call center support. It’s still a lowish-yield market without much premium business traffic, but that’s the kind of markets where LCCs often thrive. One thing holding the economy back is Manila’s terrible main airport, characterized by poor passenger service and severe congestion.

    Cebu, however, benefits from an inability for carriers to grow there, in the same way British Airways benefits from Heathrow’s inability to accommodate traffic growth. For years, Cebu itself barely grew at all due to Manila’s shortcomings. In 2018, it even shrank ASKs a bit. That did change however, in 2019, thanks to newly arriving A321 NEOs — last year it grew ASKs 13%. Ordering A330s for longhaul service to Middle Eastern migrant markets and Australasia never quite worked as planned. But the widebodies are proving useful as growth enablers on popular intra-Asian routes from Manila, i.e. Osaka and Shanghai. New routes launched last year include Manila-Shenzhen, Cebu-Shanghai Pudong, and Manila Clark-Tokyo Narita.

    The new A321s are naturally reducing Cebu’s unit costs, helping the carrier earn a 13% operating margin in Q4 and 15% for all of 2019. Q4 revenues rose 6% y/y on 12% more ASK capacity, while operating costs rose 7%. Ancillaries are a key component of Cebu’s business model, accounting for a fifth of total revenues. And that doesn’t include the carrier’s vibrant cargo business which generates another 6%. Cebu ended the year with 75 planes, and according to its original 2020 plans, will have a fleet of 88 by 2024. A330s NEOs are coming. So are A321 XLRs. This would allow growth in the high-single digits annually.

    All plans are in tatters, however, as the Covid crisis cripples commercial aviation everywhere. As management pointed out in its earnings presentation, China will be critical to the industry’s recovery, as it accounts for 18% of total worldwide tourism (that figure was just 5% when SARS happened). Cebu entered 2020 with cash equaling about 2.5 months of revenue. It’s now asking Airbus for commercial concessions. It’s asking its government to waive certain fees. It’s cutting management pay, freezing hiring, and restricting overtime pay, among other efforts to lower labor costs. It’s also reviewing its maintenance strategy. These initiatives should save it more $100m annually. To boost its cash position, it sold and leased back some older A320s.

Garuda Struggles

  • Indonesia’s Garuda, struggling to pay debts even before the Covid crisis, is now trying to restructure some of its obligations, including $500m worth of debt it needs to repay by June. Failing that, it’s confident about receiving support from its government, which still owns a 61% ownership stake. Conditions actually improved in 2019, with operating margin reaching positive 3%, from negative 3% in 2018. A few reasons account for this improvement — lower fuel prices, an operational merger with rival Sriwijaya Air, profits at its low-cost Citilink unit, and major capacity contraction by Indonesia’s airlines, including Lion Air and AirAsia.

    Garuda didn’t provide any commentary with its results, not even any mention of the current crisis. From earlier commentary though, there’s a clear eagerness to earn more money from auxiliary businesses, like maintenance and cargo. During Q4, the carrier suffered a negative 9% operating margin as it cut ASK capacity 11%. But operating costs (down 10%) fell more than revenues (down 7%).

    Speaking to Bloomberg Television on March 19, Garuda president Irfan Setiaputra said the pandemic’s biggest impact on the carrier is the revenue it’s losing from religious pilgrimage traffic to Saudi Arabia. The busy Singapore market is another important source of lost revenues. Domestically, he said revenue declines were steep but not as bad as international. In the meantime, the Indonesian currency is rapidly depreciating, complicating efforts to preserve cash. Garuda, by the way, has just one grounded B737 MAX.

Madhu Unnikrishnan

April 5th, 2020 at 12:19 PM EDT