China's big three state-owned airlines still dominate the country's aviation market, but low-cost carriers have started to make a real dent in their market share with the help of recent regulatory reforms.
The collective market share of China's budget airlines has risen to around 14% from less than 1% a decade ago. The planned entry of AirAsia group into the domestic market via a new joint venture looked set to boost that, but the Malaysian company's deal collapsed late last month.
While the immediate threat from AirAsia, Asia's largest discount airline group, may have faded, Air China, China Eastern Airlines and China Southern Airlines need to recognize that the market is shifting. After reporting unexpectedly positive results for the first half of 2018 thanks to the relaxation of caps on economy-class fares even in the face of rising fuel prices and the yuan's weakening against the dollar, the big 3 should use this breather to build out their own presence in the low-cost market.
Outside of China, many of Asia's large airlines have defensively set up their own discount affiliates. Jetstar, Qantas' entry, has enabled the Australian carrier to retain many fliers who might otherwise have switched to domestic LCC upstarts like Virgin Australia Airlines. It has also expanded onto international routes, enabling the company to maintain flights to destinations that could not be profitably maintained at full-service levels.
Similarly, Singapore Airlines' LCC offshoots, now consolidated under the Scoot brand, enabled it to retain many customers who had been targeted by new budget airlines without diluting the premium standing of the company's original brand. Both Singapore Airlines and Qantas have in turn used their budget offshoots as a platform to expand into new foreign markets -- including each other's.
China Eastern and China Southern have tiptoed into low-cost operations through subsidiaries, but more should be done. The scale of China's urban population and its large land mass provide ideal conditions for low-cost carriers to flourish. LCCs account for 32% of the domestic airline market on average globally; Boeing and Australian consultancy CAPA - Centre for Aviation project LCCs' market share in China will reach 35% by 2035.
LCCs have a significant cost advantage over the big 3. This is in part due to the bloated staffing at the state-owned majors, which they have not been allowed to effectively address. The big 3 are therefore at risk of losing much more business if competitive LCCs are given free rein to expand.
The Chinese authorities long held back LCC development to safeguard the positions of the big 3 and to manage the pace of aviation sector growth. Minimum fare levels were only abolished in 2013. Around the same time, the authorities began letting LCCs start flying routes between the country's busiest airports and even use them as operating hubs.
One carrier, Spring Airlines, managed to get an operating license before the regulators first got worried that LCCs could pose a threat to the big 3 and at a time when domestic traffic levels were still modest. Spring navigated around the regulatory constraints by flying mostly to secondary destinations to begin with. Spring further stayed out of the direct path of the big 3 by keeping its base at the old terminal of Hongqiao, Shanghai's former main airport, which was underused as larger carriers had shifted operations either to that airport's newer terminal or to Pudong International Airport.
Prospering on the back of the boom in domestic air travel, Spring remains the country's largest LCC, with a fleet of around 80 planes, as well as international flights and a subsidiary in Japan.
Since the Civil Aviation Authority of China began loosening the constraints that held back further LCC development in 2013, the number of such carriers has multiplied, with a few small traditional carriers converted to the LCC model.
HNA Group, China's fourth largest aviation company, has been the most enthusiastic about the LCC model. HNA's flock now includes four budget carriers, Beijing Capital Airlines, Lucky Air, Urumqi Air and West Air. HNA also organized the first international alliance of LCCs two years ago, the U-Fly Alliance, with a plan to allow passengers to book flights across their joint networks.
While AirAsia has put aside its plans for a domestic Chinese affiliate, it already services 15 cities in the country from its hubs elsewhere. Other Asian LCCs including Scoot and Jetstar have also opened flights from their hubs into China, putting pressure on the international routes of the big 3.
The big 3 have not totally ignored the trend. In 2014, China Eastern, which is based in Shanghai, converted its China United Airlines subsidiary, which has its hub in Beijing, into an LCC.
China United's fleet has since grown to 39 aircraft. Its net income surged 73% last year to 810 million yuan ($118.12 million), with a 16% net profit margin, ranking it as one of the most profitable LCCs in Asia. While its fleet represents just 6% of the China Eastern group total, its earnings amount to 13% of group net profit.
China Southern has stepped into LCC operations through its majority-owned subsidiaries Sichuan Airlines and Xiamen Airlines. Sichuan's Chengdu Airlines unit was converted into an LCC in 2014. It has since rapidly expanded its network to encompass 54 domestic destinations, mostly in western China.
Xiamen Air meanwhile set up a new LCC, Jiangxi Air, in 2015 in the city of Nanchang through a joint venture with companies owned by the government of Jiangxi Province. The LCC remains small, with just nine planes, but plans to add flights to Beijing, Shanghai and other top cities as well as eventually regional and even transcontinental flights.
Notwithstanding these forays, the big 3 though have yet to fully commit to LCC development. Partly this is out of worry that LCC operations could cannibalize their core business.
The hesitation also probably stems in part from the number of other major issues confronting management at the big 3, including digitalization, alliance development and fleet planning. Management may not have the appetite or bandwidth to handle the complexity of launching a new LCC.
This is especially true since setting up and operating an LCC requires a fundamentally different mentality and skills from running a traditional airline. LCCs require a focus on efficiency, innovation, non-ticket revenues, digital platforms, direct sales and entrepreneurial flair, not a natural fit for China's state-owned airlines.
But the big 3 need to recognize that there is significant underserved demand for budget travel in China, which LCCs are best poised to capture. The big 3 are at risk of losing business directly as well as the benefit of domestic traffic fed into their long-haul services.
They should instead exploit the advantages they hold over new LCC startups. For one, they have a clear if unstated edge in getting the best-timed takeoff slots at China's congested major airports.
Big 3-backed LCCs can also leverage the scale of their parent groups in aircraft purchasing, maintenance infrastructure, frequent flyer programs and flight connections to long-haul destinations. While demand for pilots in China outstrips domestic supply, the big 3 can leverage their ties with the military and training schools at home and abroad to get the people they need.
As with Scoot and Jetstar, fully backed LCC operations will enable the big 3 to respond to the challenge posted by Spring Air and HNA's affiliates. With new units starting from a low cost base, the big 3 should be able to serve secondary or remote destinations that lack the demand needed to make mainline flights profitable. The new LCC arms can also serve as testing grounds for innovations that can potentially be brought over to the big 3's mainline operations later.
It will be important that the new LCC units have a distinct branding identity from the big 3's mainline operations so that the two can address different market segments. As the big 3 already have airport lounges, loyalty programs and business-class sections, they need to maintain their full-service identity. This could be bolstered with retirement of some of their older planes and a renewed focus on customer service.
New big 3-backed LCCs could be a boon for secondary Chinese destinations looking for better transport connections. Travelers will be happy to have new, cheaper flights too. Aircraft manufacturers will look forward to getting more orders.
It will be a very complex and hard road ahead though for the big 3 to successfully adapt to a landscape where LCCs play a much bigger role. Those that can make the transition will likely be the winners in China's expanding aviation market.
Michel Brekelmans is managing director at SCP/Asia, a Singapore-based consulting firm that supports companies in business strategy development, organizational improvement and M&A services. He has previously worked with several Chinese and other Asian carriers.