Chinese airlines to dominate under landmark China-UK agreement

Air China (753:HK) Fair value: HK$8.30
Air China (753:HK) Rating: Outperform

China Eastern Airlines (670:HK) Fair value: HK$5.00
China Eastern Airlines (670:HK) Rating: Outperform

China Southern Airlines (670:HK) Fair value: HK$6.30
China Southern Airlines (670:HK) Rating: Outperform

12th December 2017, China – China and the United Kingdom have concluded a landmark agreement for a 50% increase in flights between the two countries, effectively increasing the flight capacity to 150 flights per week from 100 previously. While this development is positive for the airlines in both countries, we expect the Chinese airlines to be the bigger beneficiaries given their more competitive cost structures (with 30% lower non-fuel unit costs), enabling them to offer more attractive fares to gain market share, particularly the leisure travellers.

The key challenge, however, lies in the current airport slot constraints at London Heathrow Airport and the 3 major Chinese airports in Beijing, Shanghai and Guangzhou until their infrastructure expands. As such, we expect a large part of the incremental capacity increase to come from new flights to/from the secondary cities but the travel demand on these routes tends to be smaller, more seasonal and lower-yielding. Chinese carriers with more aggressive expansion plans and deeper pockets are likely to be interested in purchasing some London Heathrow Airport’s slots from the European carriers. The UK routes contribute around 1.5%, 1.0% and 1.0% of Air China, China Eastern and China Southern Airlines’ revenue respectively based on our estimates. Air China and British Airways dominate this route with 25% and 24% market shares respectively but the airline market shares are shifting significantly, with the Chinese carriers gaining much greater dominance as this market, effectively transporting 65% of the total passenger traffic between China and the United Kingdom currently from 49% back in 2014.

BRITISH CARRIERS ARE LOSING MARKET SHARE TO THE CHINESE AIRLINES RAPIDLY

Three years ago in 2014, the market share split between the British and Chinese airlines on the China-United Kingdom routes was quite even, with the British carriers having a small lead at 51% market share versus 49% for the Chinese airlines.

However, this has changed significantly in the past three years. Currently, the Chinese airlines have garnered a 65% market share on the China-United Kingdom routes, leaving British Airways (IAG:LN) with 24% share of the market and Virgin Atlantic with the remaining 11%.

Chart: Significant shift in airline market shares on China-United Kingdom routes in the past three years (2017 versus 2014)

Chart: Significant shift in airline market shares on China-United Kingdom routes in the past three years (2017 versus 2014)

 

MORE AND MORE UK RESIDENTS ARE CHOOSING TO FLY WITH THE CHINESE AIRLINES DUE TO THEIR MORE ATTRACTIVE FARES

The airlines do not publish their travellers’ statistics based on nationality. However, we can infer from the tourism statistics that more and more UK residents are choosing to fly with the Chinese airlines.

Unlike in some of the other overseas markets, there are more UK residents visiting China than there are Chinese residents visiting the United Kingdom. This market is also more leisure travel driven and therefore price-sensitive, which works to the Chinese airlines’ advvantage. In 2016, there were 0.43 million UK visitors to Mainland China, representing a growth of 12% y/y. More than half went to China to visit their friends and relatives and a quarter of them were on business trips.

In comparison, 0.31 million Mainland Chinese visited the United Kingdom in 2016, 6% lower y/y, mainly due to weaker travel demand following the terrorist attacks in Europe. Nearly half went to the United Kingdom for holiday, another one-fifth to visit their friends and relatives and one-fifth travelled there for business.

Chart: Purpose of travel of UK visitors to Mainland China (2016)

Chart: Purpose of travel of UK visitors to Mainland China (2016)

 

Chart: Purpose of travel of Mainland Chinese visitors to United Kingdom (2016)

Chart: Purpose of travel of Mainland Chinese visitors to United Kingdom (2016)

 

With the Chinese airlines having a 56% market share in 2016, up from 49% back in 2014, this implies that more and more of the UK residents are switching from British carriers to the Chinese airlines in recent years. The Chinese airlines have successfully gained greater traction with the UK travellers given their more attractive airfares, increased flight frequencies and younger aircraft fleets. Air China’s unit cost per ASK excluding fuel is 30% lower than British Airways’. The market has also become more competitive as the number of carriers flying the China-United Kingdom route has increased from 5 airlines in 2014 to 8 airlines currently.

 

AIR CHINA HAS OVERTAKEN BRITISH AIRWAYS AS THE LARGEST CARRIER ON THE CHINA-UNITED KINGDOM ROUTE THIS YEAR BUT THE OTHER CHINESE AIRLINES ARE CATCHING UP QUICKLY

 Air China (753:HK) has the largest market share (25%) among all the carriers, overtaking British Airways (whose market share has fallen to 24%) while China Eastern (670:HK) and China Southern Airlines (1055:HK) each have 15% market share on the China-United Kingdom routes. The HNA Group of airlines, including Hainan Airlines (600221:CH), Tianjin and Beijing Capital Airlines, serve the remaining 10% of the market.

However, Air China and the British carriers will face stiffer competition going forward as the rest of the Chinese carriers are aggressively expanding on the China-UK routes. China Eastern Airlines, China Southern Airlines and HNA Group have grown their capacity by 44%, 57% and 108% y/y respectively this year. This is driving Air China and British Airways to scale back on their capacity by 7% and 19% respectively.

With the expanded bilateral air services agreement, we expect these Chinese carriers to expand further by linking more Chinese cities to the United Kingdom. Hainan Airlines already flies between Beijing and Manchester while Tianjin Airlines operates flights to London Gatwick airport from Chongqing and Xi’An while Beijing Capital Airlines flies between Qingdao and London Heathrow. However, these secondary routes tend to have thinner, more seasonal and lower-yielding traffic.

Chart: Airline market share on China-United Kingdom routes (2017)

Chart: Airline market share on China-United Kingdom routes (2017)

 

NEGATIVE IMPACT ON CATHAY PACIFIC AND EMIRATES

This expanded China-UK bilateral agreement will have a negative impact on Cathay Pacific (293:HK). Europe is the second largest route region for Cathay Pacific, contributing 20% of Cathay’s passenger traffic year-to-date and the Hong Kong-United Kingdom routes account for nearly half of this traffic.

However, Cathay Pacific owns an 18.43% stake in Air China which will help to offset some of this negative impact. This is also negative for the Middle Eastern airlines, particularly Emirates, which carry some Chinese passengers that travel between China and Europe via the Middle East due to their attractive fares and better connectivity to more European cities.

 

KEY CHALLENGE IS LONDON HEATHROW AIRPORT’S SLOT CONSTRAINTS

90% of the flights between China and United Kingdom land at London Heathrow International Airport. London Heathrow Airport is already running at 98% utilization so there will be limited incremental access for the Chinese airlines at this airport. London Heathrow Airport handled 473K aircraft movements and 76 million passengers in 2016. The new runway, which will raise the airport’s design capacity to 740K flights and 130 million passengers per annum, needs to be built for the airlines to reap greater benefits from the bilateral agreement. In the meantime, the Chinese airlines with more aggressive expansion plans and deeper pockets are likely to be interested in purchasing some London Heathrow Airport’s slots from the European carriers.

British Airways (IAG:LN) has the lion’s share, accounting for 53% of total flights out of London Heathrow Airport, followed by Lufthansa at 5% (LHA:GR), Aer Lingus, Virgin Atlantic  and American Airlines (AAL:US) at 3% each.

It will also be challenging for British Airways to expand to the major airports in China near term due to airport slot constraints in Beijing, Shanghai and Guangzhou until the infrastructure expands although this is likely to happen much sooner than the completion of London Heathrow Airport’s expansion.

Chart: Distribution of airline flights at London Heathrow Airport (2017)

Chart: Distribution of airline flights at London Heathrow Airport (2017) 

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