AirAsia (China) adds partners but lack of Henan govt stake raises risk of other entrants

AirAsia (AIRA:MK) Fair Value: M$3.40
Rating: Outperform

26 September 2017, China – Last night, AirAsia Bhd (AIRA:MK) announced new partners for its proposed Zhengzhou-based LCC JV, AirAsia (China). The addition of Plato Capital Limited (PLC:SP) will increase AirAsia’s management influence in this joint venture airline as AirAsia Group Founders each have a 6.33% indirect stake in Plato Capital. AirAsia will still have a working relationship with the Henan Government Working Group under the original MoU signed in May 2017 but the absence of a direct equity stake  by the Henan provincial government or its related entity in this joint venture (in contrast with Cargolux’s Henan Cargo Airlines JV shareholding structure) could raise the risk of other low cost carriers acquiring licenses to operate from the Zhengzhou base in time to come. The shareholding structure of the joint venture airline, AirAsia (China) has yet to be finalised but we believe AirAsia’s direct stake will be capped at 25% under China’s foreign airline ownership laws.

AirAsia Bhd (AIRA:MK) has entered into a non-binding Term Sheet with China Everbright Group, Plato Capital Limited and Oxley Capital Limited to establish AirAsia (China), a low-cost carrier (LCC) to be based in the Henan provincial capital of Zhengzhou. The addition of Plato Capital Limited (PLC:SP) will essentially increase AirAsia’s management influence in this joint venture airline as AirAsia Group Founders each have a 6.33% indirect stake in Plato Capital.

The Term Sheet is valid for a period of 12 months from 25 September 2017 for the Parties to discuss and negotiate definitive agreements for the proposed joint venture airline. The Term Sheet is non-legally binding, save for provisions in relation to confidentiality, publicity and exclusivity.

ABSENCE OF HENAN PROVINCIAL GOVERNMENT’S EQUITY STAKE IN AIRASIA (CHINA) RAISES THE RISK OF OTHER LCCS GAINING LICENSES TO OPERATE FROM THE ZHENGZHOU BASE IN TIME TO COME

It is interesting to note that while AirAsia Berhad will continue to have a working relationship with Henan Government Working Group as part of their previously signed Memorandum of Understanding (MoU), together with China Everbright Group on 14th May 2017, Henan Government Working Group was not mentioned as one of the parties in discussions for the equity stakes in this joint venture airline in the Term Sheet announced yesterday.

This contrasts with Cargolux’s Henan Cargo Airlines joint venture which was just granted final approval on 12th June 2017 and is essentially supported by the Henan provincial government. Henan Cargo Airlines is a cargo airline that will operate out of Zhengzhou under a Chinese Air Operator’s Certificate (AOC). 75% of the joint venture will be owned by Henan provincial government companies: Henan Civil Aviation Development and Investment Co. (HNCA), Henan Airport Group and Xinggang Investment Group which represent the Zhengzhou economic zone. The remaining 25% will be taken owned by Cargolux.

A crucial difference lies in the shareholding structure of AirAsia Bhd (AIRA:MK) and Caroglux. The Henan Civil Aviation Development and Investment Co. (HNCA) owns a 35% stake in Cargolux while AirAsia Bhd (AIRA:MK) has no significant shareholding by a Chinese state or provincial company. See our previous report below for more details.

Zhengzhou Airport flying high with Henan Cargo Airlines, Cargolux/Emirates partnership and AirAsia China JV

Having the Henan provincial government’s participation with a direct equity stake in AirAsia (China) would have been hugely beneficial for the airline’s future growth. We would not rule out the possibility that other low cost carriers will be granted licenses to establish their hub in Zhengzhou after learning from AirAsia (China)’s lessons and success, potentially with similar support from the Henan provincial government in time to come which is the key risk for AirAsia.   

AIRASIA’S DIRECT EQUITY STAKE IS LIKELY TO BE CAPPED AT 25% BUT ITS EFFECTIVE INFLUENCE COULD BE GREATER VIA PLATO CAPITAL

The shareholding structure of the joint venture airline, AirAsia (China) has yet to be finalised but we believe that AirAsia’s direct stake will be capped at 25% under China’s foreign airline ownership laws. This is similar to the Henan Cargo Airlines joint venture that was granted final approval on 12th June 2017

AirAsia Bhd (AIRA:MK) has historically sought the highest stake that is allowed based on regulatory requirements in its overseas joint venture airlines and is therefore likely to want a bigger stake and might arguably be adding greater value than Cargolux to its respective China joint venture through the proposed establishment of an aviation ecosystem, including a dedicated low cost carrier (LCC) terminal, an aviation academy and aircraft maintenance, repair & overhaul (MRO) facilities as well as possessing one of the world’s strongest airline brand.

Roping in Plato Capital Limited (PLC:SP) will essentially increase AirAsia’s management influence in this joint venture airline as AirAsia Group CEO Tan Sri Dr. Anthony Francis Fernandes and AirAsia Berhad Executive Chairman Datuk Kamarudin bin Meranun each have a 6.33% indirect stake in Plato Capital.

Chart: Potential shareholding structure of AirAsia (China)

Chart: Potential shareholding structure of AirAsia (China)

AIRASIA (CHINA) LCC MODEL WELL-SUITED FOR HENAN

China, currently ranked Number 2, is expected to overtake the United States as the largest aviation market by 2024. Low cost carrier (LCC) market penetration remains low in China and the North Asia region at 9%-10% market share compared to 56% in ASEAN, 40% in Western Europe and 32% in the United States. 

While Henan province has a lower per capita income relative to the wealthier Chinese provinces, it has an estimated population of around 100 million. Henan province’s population is easily the 3rd largest and possibly the largest in China depending on the demographic methodology used.

Henan’s less developed economy dependent on agriculture and vulnerability to flooding has also historically led to a huge population of Henan migrant workers employed in other provinces. 

Thus AirAsia (China)’s low fare, no frills and high flight frequency LCC business model is well positioned to tap into Henan’s passenger market.

Due to Zhengzhou’s strategic location in central China, AirAsia (China) will be able to cover all the cities in China using its narrowbody aircraft fleet and the average flight time from Zhengzhou to the major cities in China is less than 3 hours. We expect AirAsia (China) to operate the Airbus A320ceo or A320neo aircraft but do not rule out the possibility of the Comac C919 aircraft or its variant if it generates further political goodwill.

STRATEGIC LOCATION WITH ACCESS TO LARGE TRAVEL CATCHMENT AREA – ZHENGZHOU IS RANKED THE 15th BUSIEST PASSENGER AIRPORT IN CHINA

Zhengzhou Xinzheng International Airport’s passenger throughput grew 18% CAGR in the past 10 years, ahead of the 12% CAGR growth pace of the Chinese airports industry.

This has raised Zhengzhou Xinzheng International Airport’s ranking to the 15th busiest passenger airport in China in 2016 from 22nd position ten years ago in 2006. Zhengzhou Xinzheng International Airport handled 40.5 million passengers in 2016, implying 2.0% market share of the Chinese airports industry’s total passenger throughput. 

Chart: Zhengzhou Airport passenger throughput growth (2001 to 2016)

Chart: Zhengzhou Airport passenger throughput growth (2001 to 2016)

Chart: Top 50 passenger airports in China (2016)

Chart: Top 50 passenger airports in China (2016)

Given Henan’s lower average per capita income relative to the more developed cities in China, AirAsia (China) is well positioned to help stimulate travel demand given its low cost structure and attractive airfares. Due to Zhengzhou’s strategic location in central China, AirAsia (China) will be able to cover most cities in China with its narrowbody aircraft fleet’s flying range. 

The initial target passenger market could include migrant workers, visiting friends & relatives (VFR) traffic as well as leisure travellers as AirAsia (China) improves the affordability of air travel for people in the Henan area. Once more flight frequencies are in place, AirAsia (China) could also attract passengers travelling on business, particularly those working in private and small & medium enterprises. We expect AirAsia (China) to boost international traffic between Zhengzhou and Asia.

ZHENGZHOU AIRPORT NEEDS TO BROADEN ITS DIRECT FLIGHTS NETWORK REACH IN ORDER TO DEVELOP INTO A SIGNIFICANT AEROTROPOLIS 

The Henan government is targeting to develop Zhengzhou into an Aerotropolis – an industrial, commercial and logistics zone five times the size of Manhattan with Zhengzhou Airport at the centre of the Aerotropolis. Although Zhengzhou Airport has many airline customers, it has significantly fewer destinations compared to its stronger neighbours Chengdu and Chongqing airports. 

To this end, Zhengzhou Airport will need to significantly broaden its direct flights network reach as it serves predominantly domestic flights at present (96%). International flights account for only 4% of the total capacity to/from Zhengzhou Airport. In contrast, neighbouring airports Chengdu and Chongqing have a larger international route exposure and handle larger passenger and cargo volumes than Zhengzhou Airport. 

Zhengzhou Airport has 46 airline customers but is connected to only 68 domestic and 20 international destinations. In comparison, Chengdu Airport has 61 airline customers and serves 111 domestic and 54 international destinations. Chongqing Airport has 49 airline customers (only 3 airlines more than Zhengzhou Airport) and serves 105 domestic and 31 destinations (55% more destinations than Zhengzhou Airport).

AirAsia (China)’s largest growth opportunity will be China-Asia routes. International routes are likely to face less competition than domestic routes and will enable AirAsia (China) to leverage on the AirAsia Group’s international branding and wide network in Asia.

Chart: Zhengzhou airport route exposure (1H17)

Chart: Zhengzhou airport route exposure (1H17)

Chart: Airline market share at Zhengzhou Airport (1H17)

Chart: Airline market share at Zhengzhou Airport (1H17)

GROWTH OPPORTUNITIES & RISKS

Low cost carrier market penetration remains relatively low in China and therefore offers large untapped domestic and international markets for AirAsia (AIRA:MK). However, the key challenges are the large incumbent airlines which also operate young aircraft fleets and have fairly competitive cost structures. These airlines also have deep pockets and access to cheap financing which enable them to withstand the impact of yield pressure. AirAsia (AIRA:MK) also needs to adapt to vastly different cultures and regulatory framework. In addition, AirAsia Group management resources may be spread too thinly given its large number of geographically spread-out joint venture airlines.   

Another key constraint to growth is air traffic congestion. Greater access to the airspace for commercial use is needed to improve the operating efficiency and on-time performance of the Chinese passenger and cargo airline industry. In addition, start-up airlines typically take at least 2 to 3 years before they turn profitable. As such, more government incentives and/or subsidies will be required to help AirAsia (China) in its initial phase of expansion.

AirAsia (AIRA:MK) plans to invest in building a dedicated low cost carrier terminal at Zhengzhou Airport. It will also establish an aviation academy to train pilots, engineers and crew and an aircraft maintenance, repair and overhaul (MRO) facility. This will help tackle the pilot shortage issue and reduce the MRO-related costs of operating in China, enabling AirAsia (China) to be more cost competitive. 

AIRASIA (CHINA)’S EXPANSION WILL NEGATIVELY IMPACT THE FOLLOWING LISTED AIRLINES

  • China Southern Airlines (1055:HK) is the dominant carrier with 24% market share at Zhengzhou Airport and 40% share including its subsidiary and associate airlines. 
  • Hainan Airlines (600221:CH) has a market share of 7% at Zhengzhou Airport and 28% share including its subsidiary and associate airlines. 
  • China Eastern Airlines (670:HK) and its 100%-owned Shanghai Airlines have a market share of 10% at Zhengzhou.

The neighbouring airports Chengdu and Chongqing may also be negatively impacted if more international passenger and cargo flights are launched to/from Zhengzhou Airport, increasing the competition for traffic among the three airports.

  • Air China (753:HK) has the largest market share at Chengdu Airport and Chongqing Airport at 27% and 19% respectively among all the carriers.

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