Ticket Price Aside, Budget Airlines and Legacy Carriers Aren't Even the Same Business

The just-ended May Day holiday was a four-day break, a rare stretch that fired up Chinese people's appetite for travel. According to Qunar, flight searches surged within an hour of the four-day holiday being officially announced — international routes spiked tenfold.

On fares, deregulation on popular routes let airlines price to demand: flights to Beijing, Shanghai, Chengdu, Kunming, and other destinations came in nearly 40% higher than last year. Over the whole holiday, even pricey first-class bookings rose 30%.

According to VariFlight, China's five busiest domestic routes over those four days all ran between Beijing, Shanghai, Guangzhou, Shenzhen, and Chengdu — routes largely carved up among the three state-owned giants: China Southern, Air China, and China Eastern.

Holiday travel booms like this have repeated for over a decade, and the three state carriers would seem to have little to worry about. But last month's 2018 annual reports showed net profit roughly halved at all three. Q1 2019 net profit grew only in the single digits year over year.

Budget carriers, meanwhile — the ones that can't even get prime slots at the biggest airports, like Spring Airlines — kept profit growth at 20% throughout 2018 and into Q1 2019.

This isn't unique to China. According to CAPA, the Centre for Aviation, budget carriers' share of the global domestic market rose from 24.7% to 32.5% between 2009 and 2018, and their share of international routes rose from 5.6% to 12.7%. Asia — Southeast Asia especially — still has the highest budget-carrier market share of any region.

On the surface, they're all airlines. But the Big Three's fortunes swing wildly with the macro economy: they turn a strong profit only when both oil prices and the exchange rate rise. Budget carriers' load factors and fares fluctuate far less — they don't even get much benefit from the load-factor flexibility that helps the Big Three in good times, and in weak times the flexibility oil prices offer outweighs any swings in load factor. So a weak economy is often a good time for budget carriers to expand.

Both fly passengers. But by business logic, they aren't the same business.

The first difference between legacy and budget carriers: the planes

Commercial airlines fall into two types: full-service carriers — the "legacy" airlines — and low-cost carriers, or budget airlines.

The world's first budget airline was Southwest Airlines, founded in the United States in 1971. By flying nothing but smaller Boeing 737s and enforcing tighter cost control, it could sell cheaper tickets and pull in passengers — a move that touched off a revolution in air transport. Europe's Ryanair, Asia's AirAsia, and other budget carriers followed.

China's budget carriers today fall into two categories: independent ones, such as Spring Airlines and Juneyao Airlines, and ones owned by the Big Three, such as China United Airlines, West Air, Lucky Air, and 9 Air. In 2018, budget carriers held just 9.7% of China's domestic market — against a 32.5% global share — leaving enormous room to grow.

For economy passengers, the most obvious differences between legacy and budget carriers are fare and service.

Take the fares currently on sale for a May 9, 2019, Shanghai-to-Guangzhou flight: Spring Airlines charges 830 yuan, while the Big Three price the same route at 1,200 to 1,500 yuan.

Beyond fare, whether a carrier serves a free meal during mealtime flights remains, in China, the clearest line between budget and legacy airlines — even though in the United States, the world's biggest aviation market, the Big Three have long since stopped serving anything beyond snacks on domestic economy flights, much like the budget carriers do.

But for how an airline actually runs, what matters most isn't a meal or a bottle of water. It's the choice of aircraft.

China's mainstream commercial jets today fall into roughly three categories:

• Wide-body jets, such as the Boeing 787 and Airbus A350, have two aisles, carry more than 250 passengers, and are built for routes of 3,000 kilometers or more — though in recent years Air China, China Southern, and China Eastern have increasingly put these larger planes on short, popular routes between major domestic cities.
• Narrow-body jets, such as the Boeing 737 and Airbus A320, have a single aisle, carry 100 to 200 passengers, and are built for short- and medium-haul routes of up to 5,000 kilometers.
• Double-decker jumbo jets, the Boeing 747 and Airbus A380, are an increasingly rare third category — both are now out of production.

Air China and China Southern fly all three. China Eastern flies the first two — no 747 or A380, but it does operate the newer long-haul wide-bodies, the 787 and A350.

Budget carriers, by contrast, generally fly a single aircraft type. Spring Airlines flies nothing but the Airbus A320. Southwest, the pioneer mentioned above, flies only the Boeing 737.

Different planes because they serve different cities

As of the end of 2018, mainland China's population stood at 1.395 billion. Beijing, Shanghai, Guangzhou, Shenzhen, and Hangzhou together held 83 million people. Those 83 million are the Big Three's core market and route network.

Take a single route: on the Shanghai–Guangzhou corridor as of June 1, 2019, there were 45 flights a day. Of those, the two budget carriers, Spring and Juneyao, ran 6; the Big Three and Hainan Airlines flew 16 solo; and legacy carriers code-sharing with regional airlines accounted for the remaining 23. Big cities and popular routes mean more passengers and higher frequency — enough to fill bigger planes.

To serve big-city passengers willing to pay more for comfort, the Big Three offer premium economy, business, and first class on different routes, along with roomier seats and better meal options.

Beyond domestic routes, budget carriers' overseas destinations are also close to home — Japan, South Korea, Southeast Asia — not far enough to require anything beyond an A320 or 737.

Meanwhile, in Yangzhou near Shanghai and Shantou near Guangzhou — both cities of around 5 million people — there's just one Spring Airlines flight a day, a two-hour trip priced between 150 and 220 yuan, and no direct train connects the two cities at all. For city pairs with fewer passengers, a narrow-body plane is clearly the better fit.

Different planes, different volatility: legacy carriers swing, budget carriers hold steady

The planes budget carriers fly aren't special in themselves — Southwest's 737s and Spring's A320s are the same models the Big Three buy by the dozen.

The difference is flying only one aircraft type, and only economy class.

A single aircraft type has real advantages. Every airport only needs to maintain one type of plane. Pilots generally train to fly just one model — let alone switching between Airbus and Boeing. (The design flaw behind the Boeing 737 MAX traces back to Boeing's push to let pilots of the old 737 fly the new one without extensive retraining.) Flying one plane type means a budget carrier doesn't need to worry, when scheduling, about which routes at which airport a given aircraft can serve — any available pilot can fly it. Legacy carriers, by contrast, have to check whether an idle pilot in a given city is even qualified for whatever aircraft type happens to be needed there. These are the logistics that determine an airline's operating efficiency.

Economy-only seating and no free meal service mean simpler catering and a galley that barely gets used. Spring Airlines, for instance, shrank the galley at the back of the plane to add seats — going from 180 to 186 — selling six more tickets a flight.

The reason legacy carriers see bigger swings in load factor and fares is their exposure to the economic cycle. Passengers who'd otherwise pay a premium fare may trade down to a cheaper one when the economy weakens — but passengers who only ever buy the cheapest ticket keep buying the cheapest ticket, as long as they're traveling at all.

Fares are also discounted by how far ahead a ticket is booked — the earlier, the cheaper. Looking back over the history of China Southern, China Eastern, and Air China, profitability has peaked only in cycles when both oil prices and the yuan's exchange rate were rising.

Take China Southern, the largest of the Big Three by revenue: from 2011 to 2018, its load factor fell from 83% to 79% before climbing back to 82%. Over the same period, budget carrier Spring Airlines expanded its fleet from 28 planes to 81, holding a load factor above 90% throughout — far more stable.

On revenue per passenger-kilometer, a key measure of an airline's earning power, China Southern's figure swung between 0.53 and 0.71 yuan, while Spring Airlines held steady around 0.38 yuan.

In China, a high load factor doesn't just mean more revenue from passengers — it also means bigger subsidies from airports and local governments.

Over the past decade-plus, Chinese cities have poured huge sums into building airports, highways, and other infrastructure — and once it's built, it has to be used. So in some third- and fourth-tier cities, local governments and airports offer route subsidies and waived landing fees to lure airlines into opening service there, not unlike the traffic subsidies internet companies once used to win users.

There's also a formal incentive: under a rule on passenger-service-fee discounts at civil airports, in force since 2008, if a plane's seat count exceeds the domestic-carrier average by 10% or more and the flight's load factor is at least 85%, the flight's passenger service fee — part of the landing charge — qualifies for a further discount. Flights with a load factor between 90% and 95% can have that fee cut by another 25%.

With policies like this in place, subsidies make up a striking share of airline profit.

In 2018, for example, China Eastern posted net profit of 2.71 billion yuan and collected 5.43 billion yuan in subsidies; Air China posted 7.34 billion yuan in net profit and 3.13 billion yuan in subsidies; China Southern posted 2.98 billion yuan in net profit and 4.45 billion yuan in subsidies; Spring Airlines posted 1.5 billion yuan in net profit and 1.141 billion yuan in subsidies.

By nature, these local-government subsidies to airlines resemble how traffic-management bureaus buy surveillance cameras — closer to a revenue-generating measure than an operating cost. Rising throughput at trunk and regional airports means more passengers arriving, which helps drive the local economy.

Take Jiangsu province: it now has nine major civil airports — Nanjing Lukou International, Wuxi Shuofang, Changzhou Benniu, Nantong Xingdong, Xuzhou Guanyin, Yangzhou Taizhou, Yancheng Nanyang, Lianyungang Baitabu, and Huai'an Lianshui — an extraordinarily high density, and all of them competing for the traffic airlines bring. Local governments and airports would rather fall behind on other subsidies or debts than be late paying out traffic subsidies to airlines.

That shows up in airline balance sheets as unusually low accounts receivable owed by government. Other subsidy-dependent industries — PPP-model environmental companies, for instance — often run into cash-flow trouble whenever government subsidies shift.

The Big Three do well only when oil prices and the exchange rate both rise

The exchange-rate effect is easy to understand: buying planes, leasing planes, and buying jet fuel are all typically settled in US dollars, so the yuan-dollar rate has an obvious effect on airline profit. In 2015 and 2016, for instance, as the yuan kept depreciating, the Big Three's combined foreign-exchange losses over those two years reached 26.9 billion yuan.

Oil's effect is more complicated.

Airline costs include jet fuel, labor, fixed assets (depreciation, aircraft leasing, maintenance), landing fees, sales, and other expenses. Of these, fuel is the biggest, at roughly 20% to 40% of an airline's costs — but changes in the oil price don't map simply onto airline profitability.

That's because oil-price swings carry a lot of information at once. High oil prices usually coincide with a strong economy, which also means stronger demand for the Big Three's pricier seats, letting them pass costs on through higher fares. Low oil prices may look like lower operating costs, but they can just as easily signal a weaker economy — and weaker demand for the Big Three.

Over the past decade, oil prices swung wildly: they fell fast after the 2008 financial crisis, then rebounded and stayed above $80 a barrel until 2015, before crashing to around $45 a barrel in 2015 and 2016. From 2017 through the first half of 2018, prices climbed back to $75 a barrel, then fell below $50 again by late 2018.

During this stretch, 2008 brought both the Beijing Olympics and a sharp oil-price crash, but the global economy was also in crisis, and the Big Three posted combined losses of 27.9 billion yuan that year. In 2009 and 2010, after the crisis, oil prices rebounded sharply, but with the economy stabilizing and the 2010 Shanghai Expo underway, the Big Three's profits quickly recovered.

From 2011 to 2013, oil prices were relatively stable, but China's economic growth slowed — GDP growth fell from 10.3% in 2010 to 7.7% in 2013 — and with the macro picture weaker, the Big Three's profits declined noticeably too.

From 2016 to 2017, oil prices gradually climbed, and in 2017 the yuan ended three straight years of depreciation against the dollar that had begun in 2014, appreciating nearly 6%. That year, the Big Three's combined net profit attributable to shareholders hit a record 19.5 billion yuan.

In 2018, oil prices started low and rose through the year, while the yuan depreciated nearly 5.2%. Even after China's civil aviation authority and the National Development and Reform Commission deregulated fares on some routes — letting any domestic route with five or more competing carriers set "market-adjusted" prices, giving airlines more room to raise fares — the Big Three's profits still shrank sharply.

In short, the Big Three earn the most when both oil prices and the exchange rate are rising. Over the past decade, when a booming economy drove up both aviation demand and oil prices at once, rising costs could be passed on to passengers — which is why 2009 and 2010 saw oil prices and airline profits climb together. The opposite happened in 2008: after the financial crisis, demand fell faster than oil prices did, so airlines posted heavy losses even as oil crashed. And in 2014 and 2015, with airline supply and demand largely unchanged, a global oil glut sent prices tumbling — costs fell for airlines, but with the yuan depreciating, the Big Three's net profit stayed depressed all the same.

By comparison, budget carriers are more like taxi companies

Unlike the Big Three, whose profitability swings with oil prices and the exchange rate, budget carriers see far less fluctuation in load factor and fares.

Take Spring Airlines: from 2011 to 2018, its fleet grew from 28 planes to 81, and its seat count grew from 5,208 to 15,066; revenue grew from 4.46 billion yuan to 13.1 billion yuan, and profit grew from 483 million yuan to 1.5 billion yuan — growth proportional to its added capacity.

Take the Shanghai–Guangzhou route again: on Ctrip, Spring Airlines' May 8, 2019, 07:15 flight was priced at 1,150 yuan and its June 1 07:15 flight at 820 yuan — a 330-yuan gap. China Southern, flying the same A320 on the route, priced its May 8 06:55 flight at 1,360 yuan and its June 1 06:55 flight at 870 yuan — a 490-yuan gap. Same plane, same route, similar departure time: Spring is cheaper, and its fares swing less too.

Over the past eight years, Spring Airlines has tripled its capacity while keeping its load factor above 90% and its fares more stable — which suggests, on one hand, that supply still lags well behind demand, and on the other, that Spring's profit is essentially per-plane profit multiplied by fleet size.

That's a world away from the volatile Big Three. It looks much more like a taxi company, where profit equals per-car profit times fleet size.

Of course, for taxi companies — and today's ride-hailing companies like Didi and UCAR — the more cars and drivers pile up, the more management difficulty rises, geometrically. Didi, for instance, has suffered a string of safety incidents. Managing an airline fleet is comparatively far easier.

Even among budget carriers, Spring and Juneyao differ.

Juneyao's routes concentrate mostly on popular corridors out of Shanghai. With Shanghai's two airports near capacity on airspace and runway slots and few new routes opening, Juneyao's growth comes from raising fares on existing routes.

Spring Airlines, by contrast, has since 2016 established new operating bases in Shijiazhuang, Yangzhou, Ningbo, and Jieyang, aiming to build out and replicate routes connecting these smaller, third-tier cities. In 2018 it opened new routes from Shijiazhuang to Guilin, Quanzhou, and Wenzhou; from Yangzhou to Nanning and Zhengzhou; from Ningbo to Nanning, Qingdao, Zhengzhou, Harbin, and Hohhot; and from Jieyang to Nanjing, Nanning, Qingdao, and Hangzhou. By the end of 2018, Spring operated 113 domestic routes, including 33 connecting two third-tier cities, 33 connecting a first-tier city with a third-tier city, and 19 connecting a second-tier city with a third-tier city — meaning roughly 75% of its domestic flights originate in third-tier cities.

And these routes face little competition from high-speed rail.

For one thing, high-speed rail itself is mostly a short- and medium-distance mode. Research from the Civil Aviation Administration of China found that high-speed rail cuts into air travel by 50% on routes under 500 kilometers, 30% on routes of 500 to 800 kilometers, 20% on routes of 800 to 1,000 kilometers, and almost not at all above 1,500 kilometers. The average high-speed rail passenger in China travels around 400 kilometers, while the average air passenger travels more than 1,400 kilometers.

For another, many second- and third-tier cities aren't directly connected by high-speed rail, or require a transfer, which stretches travel time and erases rail's fare advantage over budget carriers. Take Qingdao, in Shandong, to Ningbo, in Zhejiang: high-speed rail requires one transfer and takes roughly nine hours, with second-class seats at 600 yuan — while Spring Airlines covers it in two hours for 360 to 420 yuan. Or take Jieyang, in Guangdong, to Hangzhou, in Zhejiang: a budget flight takes two hours for 470 yuan, while high-speed rail requires a transfer and takes 17 hours for a 400-yuan second-class seat — and an ordinary train takes more than 20 hours.

First-tier cities' airspace and runways are now near capacity, leaving little room for new routes short of building an entirely new airport, as Beijing did with Daxing. Third- and fourth-tier cities, meanwhile, are rolling out household-registration incentives to accelerate the "race for residents", and flight volumes at their airports are climbing fast to match.

The chart above shows flight volume essentially flat at first-tier cities — Beijing, Shanghai, Guangzhou, Shenzhen, Hangzhou — and just as stagnant at traditional tourist-destination airports like Haikou, Kunming, Sanya, and Guilin. Meanwhile, flight volume is climbing sharply at lower-tier cities like Ningbo, Yinchuan, Jieyang, Yichang, and Yangzhou — a sign that the flow of people and goods there is picking up.

At the same time, growth in big-spending outbound tourism has slowed. In 2017, the number of private outbound trips by Chinese travelers grew just 5.7%, down sharply from 22% in 2010 and 10% in 2015. And according to calculations by Li Xunlei, chief economist at Zhongtai Securities, 1 billion people in China have still never flown, and 80% of the country's airports account for less than 10% of total passenger throughput.

Population growth in lower-tier cities also shows up in consumption. The scale of rural e-commerce grew from 200 billion yuan in 2014 to 1.2 trillion yuan in 2017 — growth that also fueled the rapid rise of Pinduoduo, built on low-priced goods.

All of which suggests that China's growth market in civil aviation over the next several years lies in its lower-tier cities.

Seen the other way around, the Big Three's slump over the past year-plus, alongside budget carriers' continued growth, reflects a broader shift in China itself — much like the rise of Pinduoduo did.

Cover image: pixabay