Flying in China Hasn't Changed Much, but Its Big Three Airlines Just Made Record Profits — 13 Charts on What's Happening in This Market

Oil prices and exchange rates sway airline profits. And, more than either of them, government subsidies do.

In 2017, flying itself changed little for Chinese travelers. On average, each passenger took three flights that year.

As in years past, two of those three tickets came from the three state-owned carriers — Air China, China Eastern and China Southern. Ticket prices rose, but only by 2%.

On-time performance swung with the seasons, as always. In July you suffered the worst on-time rate in the world; in December you enjoyed one of 90%.

All three airlines made headlines with big-ticket aircraft orders and now fly some of the youngest fleets in the world. But in the growing outbound-travel market, they lost to foreign airlines.

Meanwhile, in the 2017 annual reports the three released one after another last month, operating profit surged to 24.3 billion yuan, double the figure a year earlier. Their profit per passenger carried one kilometer matched, and in one case beat, that of the three big U.S. carriers, the ones known for running lean.

All three post record profits — the best of them, Air China, earns nearly 120 yuan per passenger

China is now the world's second-largest aviation market after the United States. Over the past decade, both international and domestic capacity to and from Chinese cities has grown sharply, with total seats climbing from 300 million in 2007 to 797 million in 2017.

Air China's operating profit last year was 11.6 billion yuan. Of the three, it is the only one confident enough to keep disclosing revenue from first- and business-class passengers: about 13.1 billion yuan last year, or 12.8% of the total.

That share trails the global level. IATA data for 2017 show that premium passengers — first and business class — made up 5.3% of international passengers worldwide but delivered 27.0% of international passenger revenue.

For the other two, the growth did not come mainly from carrying people.

China Eastern's operating profit last year was 7.2 billion yuan, 7.2 times its 2016 level and the biggest jump of the three. But the jump was not all operating improvement: the airline booked 1.7 billion yuan in investment gains from selling its logistics arm, equal to 25% of its profit.

China Southern's 2017 operating profit doubled from the year before, and its revenue growth returned to double digits for the first time in three years. Cargo drove that. As the global economy recovered in 2017, China Southern's revenue per ton of cargo carried one kilometer rose 12.1%, lifting cargo and mail revenue by 26.3%.

What barely changed from previous years is how much of the market the three control. Year after year, as the number of Chinese air passengers hits new highs, their combined share has grown too — but only by single digits.

The money from carrying people comes mainly from domestic routes, and tourism has pushed Xishuangbanna into China's ten busiest

"If you look at profitability, our forecasts also suggest that domestic flights are actually more profitable than international routes," said Andrew Lee, an analyst at Jefferies Group. "There's more to gain from focusing on the domestic market."

Domestic capacity at the three airlines grew 7.7% on average, faster than in 2016 but still short of 2015. Domestic demand, though, grew sharply against 2016, and with fares rising, domestic revenue per passenger carried one kilometer returned to year-on-year growth.

According to Variflight, Chinese airlines flew 4.288 million flights in 2017, up 10% from the year before. Among all the trips people took, Beijing, Shanghai, Guangzhou, Shenzhen and Chengdu remained the five most popular destinations.

Each of those cities is either a home base for one of the three airlines or one of their hubs, where they hold more takeoff and landing slots and keep fuller aircraft and crew resources.

Compared with previous years, China's ten busiest routes had a newcomer this year: Kunming–Xishuangbanna. One likely reason is that many tour itineraries schedule several round trips between the two cities inside a single package, which would push flight numbers up sharply.

Xishuangbanna sits at the southern tip of Yunnan province, bordering Myanmar and Laos and close to Thailand and Vietnam — a node between inland China and Southeast Asia. Its Gasa Airport ranks only 93rd nationwide by passenger throughput.

The Water-Splashing Festival held every April is a traditional holiday of Xishuangbanna's Dai people, and in recent years it has also become a popular domestic tourist draw. Figures from People's Daily Online show that during the 2017 festival, tourism bookings in Yunnan rose 30% year-on-year, with Xishuangbanna, Kunming and Ruili the top three destinations.

Because the festival runs right into the Qingming (Tomb-Sweeping) mini-break, this stretch becomes peak season for Xishuangbanna and for Yunnan as a whole. Most tourists pick packages like the "Kunming–Xishuangbanna 3-flight, 6-day tour" (three flights, six days in all) or the "Xishuangbanna–Kunming–Dali–Lijiang 4-flight, 8-day tour," and many of them include several round trips between the two cities.

Data provided by Variflight show that in the first half of 2017, flights within the province made up 83.7% of Xishuangbanna's traffic, more than half of it to and from Kunming.

44% of the planes Boeing and Airbus sold last year went to China, but the airlines themselves bought few of them

News reports keep saying the three airlines are on a plane-buying spree. Chinese companies took 44% of Boeing and Airbus's orders last year.

China Eastern, China Southern and Air China added 67, 79 and 39 new aircraft to their fleets.

On November 9 alone, during Donald Trump's visit to China, the two countries signed 15 trade agreements, one of them a purchase deal for 300 Boeing aircraft.

In fact, most of those planes are leased. The buyers were not the three airlines but China Aviation Supplies Holding Company and a number of leasing firms. CDB Leasing, a subsidiary of China Development Bank, was among the five biggest spenders at last year's Paris Air Show.

China Southern has the largest fleet in Asia and the fourth largest in the world, with 754 aircraft. Of those, 477 are leased, more than 60% of the total; China Eastern and Air China lease at similar rates.

Airlines expanding their fleets prefer leasing to buying, mainly because paying rent shifts the risk of depreciation and write-downs onto the leasing company. The cash they free up can go toward more aircraft or day-to-day operations.

A former Boeing employee told QDaily that mainstream airlines now want to run asset-light and dislike locking large sums of cash into aircraft. "An airline's biggest cost is jet fuel — that's where cash actually has to change hands," the employee said.

Last year, simply to keep their vast fleets flying, the three airlines paid more than 10 billion yuan in lease payments. That sounds like a lot, but at roughly $200 million a plane, buying those aircraft outright would have cost 880 billion yuan — 88 times the annual rent.

Cutting out ticket agents saved the three airlines 6.3 billion yuan in commissions over three years, but that gain has largely run out

For years airlines were unwilling to carry the labor and overhead of building their own sales teams, so most tickets were sold through agents. At Chinese carriers, agent-sold tickets usually accounted for 70%-80% of total ticket sales.

Ticket sellers such as Trip.com Group typically charge commission as "a percentage service fee on the face price plus a sales rebate." On a 1,000-yuan ticket, an agent would take 45 to 50 yuan.

As foreign carriers including Air France and KLM stopped paying rebates to sales agents in China, one after another from 2011, Chinese airlines began cutting their own rebate rates, from 5% to 3% and then to 1%.

After 2014, Chinese airlines also began pushing direct sales hard and squeezing agent fees. China Southern, China Eastern, Air China, Hainan Airlines and others jointly pushed back against online ticketing channels such as Trip.com Group and Qunar, promoted the slogan "cheapest on our own site" and put more tickets on their own apps.

By 2017, the three airlines' ticket agency fees had fallen by 6.3 billion yuan in three years.

But by 2017 this source of savings was largely spent. Direct sales now exceed 50% at all three, close to the rates at Delta and American Airlines. Agency fees at China Southern and Air China rose again year-on-year, and only China Eastern's kept falling — and that decline, too, has nearly reached its floor.

Oil prices rose 34% last year, costing the three airlines an extra 20 billion yuan

Jet fuel usually makes up 20%-30% of an airline's total costs, so swings in oil prices land directly on profits.

In 2017 that share topped 25% at China Southern, Air China and China Eastern alike. The ex-factory jet fuel price published by China's National Development and Reform Commission rose 25.55% over the same period, and the average price of Brent crude on international markets rose 34%, costing the three airlines an extra 20 billion yuan between them. By their own separate estimates, every 5% move in oil prices swings total costs by more than a billion yuan.

Airlines normally use financial hedging instruments, which work rather like insurance, to offset that risk. But using them requires a reasonably accurate view of where oil prices are going, and there is no guaranteed win.

China Eastern and Air China lost heavily on fuel hedges during the 2008 financial crisis, China Eastern by as much as 6.2 billion yuan. The State-owned Assets Supervision and Administration Commission had to inject 7 billion yuan into China Eastern to keep its cash flow from breaking. Out of caution, none of the three hedges fuel today.

Strip out fuel and the three airlines controlled costs fairly well over the past year. Non-fuel cost per available seat-kilometer held flat or fell at China Southern and China Eastern. Air China, mainly because aircraft maintenance spending jumped, saw the fastest cost growth of the three.

Outbound travel keeps spreading, but passengers increasingly pick foreign airlines

According to the latest figures from the UN World Tourism Organization, Chinese tourists account for more than 20% of what the world's outbound travelers spend; second-place American tourists spend half as much.

The number of Chinese traveling abroad keeps setting records. Figures from the China National Tourism Administration show the outbound market reached 129 million trips in 2017, more than 45.8 million above 2012, and China has been the world's largest source of outbound tourists for several years running.

But when Chinese travelers choose a flight abroad, domestic airlines are often not their first pick.

Among the 20 most popular international routes of 2017 tracked by Variflight, foreign carriers took a large share. On the two busiest — Shanghai Pudong to Hong Kong and Beijing Capital to Hong Kong — the Hong Kong group Cathay Pacific/Cathay Dragon held 42% and 35%, ahead of China Eastern and Air China.

Service, schedules and fares are part of it. On service, Hainan Airlines is currently the only Skytrax five-star airline in China. On busy routes to Japan, South Korea and Europe, passengers can pick five-star carriers such as Japan's ANA, South Korea's Asiana, Hong Kong's Cathay Pacific, Germany's Lufthansa and Singapore Airlines.

The other part is that after years of adding international routes, the three airlines slowed sharply last year, with capacity growth falling below 15%, less than half the peak of 2015-2016.

Even so, with capacity growth slowing while more people flew abroad, load factors on the three airlines' international routes rose 1.5%, and the fall in unit revenue narrowed markedly.

China will free up fares on more routes next, which will lift airline profits

On January 5 this year, the Civil Aviation Administration of China and the National Development and Reform Commission issued a Circular on Further Advancing the Reform of Domestic Air Passenger Transport Pricing, ruling that on domestic routes flown by five or more airlines, fares would move to "market-adjusted pricing," set by the airlines themselves.

The pricing in question is not the discounted fares travelers see day to day but the undiscounted full economy fare. Essentially, the flights back to first-tier cities after Spring Festival all sell at that price.

"Market-adjusted pricing" is the opposite of "government-guided pricing." China built its fare-setting mechanism — for those full fares — back in 2004, around a government formula that left airlines little room to move.

The policy change means more routes are escaping what amounts to a planned-economy pricing rule, and airlines can adjust prices themselves as supply and demand shift.

Statistics from China Merchants Securities show that in the 2017/2018 winter-spring season (each season runs half a year), China had 3,567 domestic routes. This round of reform added 306 to market-adjusted pricing, bringing the total freed since 2013 to 1,030 — 29% of all domestic routes. In 2015, only 10% were priced by the market.

Most popular routes will feel it.

Take Beijing–Shanghai. China Eastern, which flies the most capacity on it, charges a full economy fare of 1,230 yuan. Beijing–Nanjing and Beijing–Hangzhou, meanwhile, cost 1,850 and 2,200 yuan — and neither city is farther from Beijing in a straight line than Shanghai is.

That is because Beijing–Nanjing and Beijing–Hangzhou are already priced by the market, while Beijing–Shanghai fares remain government-controlled, worked out under a system of 0.75 yuan per passenger per kilometer.

Northeast Securities estimates that once fares are freed, revenue per passenger-kilometer will rise 99% on average. For the three airlines, assuming fares climb over six to eight years — 120% between first-tier cities and 90% between first- and second-tier cities — China Southern, Air China and China Eastern could each add up to 1.1 billion, 1.4 billion and 1.1 billion yuan a year in pre-tax profit.

But poor on-time rates at home could cancel out what higher fares bring in

In 2017 the average on-time rate for Chinese airlines nationwide was 78%, 2 percentage points better than 2016. That is only the annual average: winter flights are rarely late, while summer flights routinely run five to eight hours behind.

Variflight's Global Airport On-Time Departure Performance Report shows that in May 2017, Shanghai Pudong, Beijing Capital and Shanghai Hongqiao had delay rates of 53%, 52% and 49% — the worst three on the list.

By July, separate figures from the British aviation data company OAG put several Chinese airports and airlines among the ten worst in the world for delays, with Shenzhen Airlines worst of all: 70% of its flights that month were late. By December, delay rates at Chinese airlines had dropped to as low as 10%.

Just as cars keep to marked lanes, planes must fly marked air routes. China's airspace is controlled by the military, and only about 20% of routes are open to civil aviation. In the United States the figure is 80%.

When summer thunderstorms arrive, air traffic control and the airlines cut the routes available to flights sharply for safety, while the number of planes waiting to take off or land stays the same. Congestion follows. A captain at a Chinese airline once said that in thunderstorms the interval between departures stretches from one every five minutes to one every ten minutes, or even every half hour.

A flight also cannot leave without signatures from both the captain and the airline's dispatcher, and in bad weather the two can disagree about whether conditions meet the standard for takeoff. "After looking at the weather data, I decided it wasn't safe to fly. The dispatcher insisted it was. If I don't sign, it has to go up the chain, level by level," the captain said. That causes delays too.

High delay rates stop airports and airlines from opening new routes, which holds down passenger throughput and, in turn, is likely to hurt their results.

Under the CAAC's 2017 Flight Normalcy Assessment Indicators and Restrictive Measures, any airport whose on-time departure rate falls below 75% for two months running and ranks in the bottom three will have applications for extra passenger flights, charters and new routes suspended for three months.

China Merchants Securities Research Institute once projected that if Pudong Airport kept its on-time rate above 80%, it could qualify for a capacity increase as early as the second half of 2018 and start opening new routes.

But last month the CAAC announced that from March 27 to April 30, applications for extra flights, charters and new routes at Pudong would be suspended because its on-time rate fell short. That is the third quarter in a row Pudong has drawn the same penalty. The same has happened to China United Airlines, a China Eastern subsidiary, and to Beijing Capital Airport.

The yuan's rise was the main driver of the three airlines' growth, worth 17 billion yuan in profit last year

Buying planes, leasing planes, buying jet fuel — the international convention is to settle in dollars, and Chinese airlines also tend to raise dollar financing. In 2015, dollar debt made up 60% or more of the three airlines' total debt.

That leaves them badly exposed when the yuan swings hard. In 2015 and 2016, as the yuan fell sharply, the three booked more than 26.9 billion yuan in foreign exchange losses over the two years.

In 2017 the yuan rose 6%, reaching a nine-year high. The three airlines booked about 6.7 billion yuan in exchange gains, which pushed their overall profits up sharply.

But what rises can fall. The three are cutting their dollar debt to head off the risk.

Their dollar debt is now below 40% of the total, so the sensitivity of net profit to exchange rates keeps dropping. At Air China, for every 1% move in the yuan against the dollar, the hit to net profit has fallen from 530 million yuan in 2015 to 279 million. The three airlines' currency exposure is much smaller than it was.

Then there are the subsidies: the three airlines took 12 billion yuan from governments in a single year

Set against all the factors above, government subsidies do more to shape airline profits than any of them.

Six airports across Beijing, Shanghai, Guangzhou, Shenzhen and Chengdu handle more than a third of the country's passenger throughput, and airlines planning new routes fight first for slots there. So local governments in other second- and third-tier cities — Qingdao, Kunming, Chongqing — have tried to pull airlines in with dedicated route subsidies, hoping to build up their own aviation economies.

Last year China Eastern's operating profit was 7.2 billion yuan, of which government subsidies and cooperative-route revenue came to 4.9 billion — nearly 70% of the total. China Southern and Air China took 3 billion and 3.9 billion yuan in subsidies and cooperative-route revenue. That is what appears on the income statement. China Eastern also has about 1.4 billion yuan in route subsidies owed but not yet collected, which the income statement does not show.

China Eastern's annual report explains cooperative-route revenue as income earned under agreements to fly routes jointly with local governments, meant to support local economic development and deepen cooperation. Government subsidies cover route subsidies, hub-airport construction subsidies and tax rebates, paid out of the CAAC's development fund and local government budgets.

In 2015 and 2016, without subsidies China Eastern would have gone from profit to operating losses of 2.69 billion and 2.27 billion yuan.

A public spending disclosure from Yunnan's finance department showed that between 2015 and 2020, the province would hand airlines a cumulative 500 million yuan to open international and regional routes.

By its calculations, a single-aisle narrow-body like the 737 costs 50,000 yuan an hour to fly; a twin-aisle wide-body like the 777 costs twice that. Under the relevant rules, Yunnan considers covering up to half of operating cost — and in 2016 alone it paid out 162 million yuan.

Chongqing, Qingdao, Changsha and Chengdu run route subsidies of their own. Fares from these cities to destinations such as Los Angeles, San Francisco, Melbourne and Sydney are often 30%-50% cheaper than on flights leaving Beijing, Shanghai, Guangzhou or Shenzhen.

Even first-tier airports with plenty of traffic pay up.

Qi Yaoming, spokesman for Guangzhou Baiyun International Airport, told Southern Weekly in a 2016 interview that airport subsidies are rare — only a few airports, Beijing, Shanghai and Guangzhou among them, can afford to offer them. That year, with joint marketing from Baiyun, Finnair resumed flying from Guangzhou to Helsinki. Another foreign carrier had run the route before and dropped it as business travelers thinned out.

"We subsidized this route because we wanted to round out our European network," Qi said, adding that what Baiyun does should not really be called a subsidy — it is more a partnership. Xiamen Airlines, for its part, opened a Xiamen–Shenzhen–Seattle route because Shenzhen offered money.

But routes conjured up this way do not last well, and their load factors are not encouraging.

From 2016 on, international routes out of second- and third-tier cities began closing one after another. In September 2016 Jetstar dropped its direct flight from Wuhan to Australia's Gold Coast; a month later Lufthansa cancelled Shenyang–Frankfurt. In 2017, thin loads led United Airlines to cancel its Hangzhou and Xi'an routes to San Francisco. In short, too few travelers still choose to fly abroad from second- and third-tier Chinese cities.

Figures from the aviation operations data provider CADAS show that in the first half of 2017 the average load factor on China-U.S. routes was close to 80%. The lowest was Qingdao–San Francisco, the only China-U.S. route below 50%.

Charts by Feng Xiuxia

Cover image by Pixabay, Jason Leung on Unsplash