China Eastern (670:HK), Air France, Delta, Virgin equity partnership negative for Air China (753:HK)

China Eastern Airlines (670:HK) fair value: HK$5.30
China Eastern Airlines (670:HK) 
rating: Outperform

Air China (753:HK)  fair value: HK$7.70
Air China (753:HK) rating: Outperform

31 July 2017, Global – China Eastern Airlines (670:HK) has entered into a Marketing Agreement with Air France-KLM (AFK, AF:FP) which will boost its network reach and traffic feed on China-Europe routes following CEA’s parentco’s planned 10% investment in AFK which is acquiring a 31% stake in Virgin Atlantic Airways. This new development is negative for Air China (753:HK) which currently has a huge market share lead in this route region.

EQUITY PARTNERSHIPS WILL ENHANCE THE COOPERATION BETWEEN FOUR MAJOR AIRLINES – CHINA EASTERN AIRLINES, AIR FRANCE-KLM, DELTA AIR LINES AND VIRGIN ATLANTIC AIRWAYS

China Eastern Airlines (670:HK)’s parentco China Eastern Air Holding Company (CEAHC) plans to acquire a 10% stake in Air France-KLM (AF:FP) for a cash consideration of EUR375m (or Rmb2.5B) as part of Air France-KLM’s equity-raising exercise to fund its investment in a 31% stake in Virgin Atlantic Airways.

Separately, Delta Air Lines (DAL:US), which owns a 3.22% stake in China Eastern Airlines as well as a 49% stake in Virgin Atlantic Airways, has also acquired a 10% stake in Air France-KLM on the same day.

China Eastern Airlines has correspondingly entered into a Marketing Agreement with Air France-KLM which targets to develop the China-Europe market by expanding the network, optimizing connecting opportunities, improving airport ground services and facilities.

China Eastern Airlines and Air France-KLM plan to share non-air resources, further upgrade their frequent flyer programme, enhance the integration of IT and further cooperation in aircraft maintenance and other business areas. The initial term of the Marketing Agreement is for 15 years.

THIS COULD THREATEN AIR CHINA’S STRONGHOLD ON CHINA-EUROPE ROUTES

This new development is negative for Air China (753:HK) as it will face a more formidable competitor airline group on China-Europe routes where Air China currently has a huge market share lead.

Currently, Air China is the most dominant carrier on the China-Europe routes with a huge lead versus the other carriers. Air China has a 25.5% market share in terms of seat capacity. Air France-KLM is the next largest with 14.7% market share.

Chart: Airline market share on China-Europe routes (1H17)

Chart: Airline market share on China-Europe routes (1H17)

In 2016, China Eastern Airlines (CEA) and Air France-KLM expanded their cooperation with jointly operated routes and codesharing. If CEA, Air France-KLM and Virgin Atlantic (since Air France-KLM and Delta are both shareholders of Virgin Atlantic) can work together to align their flight schedules to improve connection time to boost traffic feed and cross-sell their tickets more effectively as planned, they are likely to attract more passengers, especially in the premium travel market. China Eastern Airlines’ flight network covers 1,062 cities in 177 countries from Shanghai via its cooperation with SkyTeam Alliance member airlines.

Combining China Eastern Airlines, Air France-KLM and Virgin Atlantic Airways’ seat capacity will raise their combined market share on China-Europe routes to 26.8%. This is higher than Air China’s but still below Air China and Lufthansa (with whom Air China has a non-equity joint venture partnership)’s combined market share of 35.7%.

In addition, Air France-KLM, Delta Air Lines and Virgin Atlantic will deepen their cooperation and increase their market dominance on Transatlantic routes which could benefit China Eastern Airlines as well in terms of improved access to North America and Europe and feeder traffic. Air France-KLM, Delta Air Lines and Virgin Atlantic have a combined market share of 25% on Europe-North America routes.

This is likely to drive Air China and Lufthansa to deepen their cooperation in order to defend their market position versus their competitors.

AIR CHINA HAS THE LARGEST PASSENGER REVENUE EXPOSURE TO EUROPE AMONG THE CHINESE CARRIERS

Air China has the largest passenger revenue exposure to Europe among the Chinese carriers. European routes contribute 7% of Air China’s passenger revenue versus 4% for China Eastern Airlines and 3% for China Southern Airlines (1055:HK) among the Big 3 Chinese carriers. However, to put things into perspective, this exposure is still considered to be quite small compared to the other major Asian network carriers’ passenger revenue exposure to Europe – Singapore Airlines (SIA:SP) 22%, Cathay Pacific (293:HK) 20%, Korean Air (003490:KS) 15%.

Chart: Big 3 Chinese carriers passenger revenue exposure to Europe (2016)

Chart: Big 3 Chinese carriers passenger revenue exposure to Europe (2016)

Chart: Major Asian network carriers passenger revenue exposure to European routes (2016)

Chart: Major Asian network carriers passenger revenue exposure to European routes (2016)

STAR ALLIANCE IS STILL THE STRONGEST ON CHINA-EUROPE ROUTES BUT EQUITY PARTNERSHIPS COULD PROVE MORE EFFECTIVE GIVEN THEIR STRONGER COMMITMENT AND ABILITY TO ADAPT TO MARKET CHANGES MORE QUICKLY

Star Alliance still controls nearly half the capacity on China-Europe routes. The Star Alliance members have a combined market share of 48.8% while SkyTeam Alliance members have a combined market share of 33.6% on China-Europe routes.

However, the benefit of equity partnerships is to help cement the strategic partnership and quicken the pace of cooperation between China Eastern Airlines, Air France-KLM, Delta and Virgin Atlantic Airways.

Equity partnerships are becoming more common in the global airline industry in recent years and could prove more effective given their airline partners’ stronger commitment and ability to adapt to market changes more quickly compared to the traditional global airline alliances.

ASIAN CARRIERS COULD FORM MORE EQUITY PARTNERSHIPS GOING FORWARD

We expect more equity partnerships to be formed in the global and Asian airline industry as this helps to increase the airline partners’ commitment to cooperate more extensively.

China Eastern Airlines’ parentco CEAHC is likely to invest in more airlines going forward which will further enhance China Eastern Airlines’ global route network and traffic feed. This will also drive Air China and China Southern Airlines and/or their parentco as well as the other Asian airlines to do the same.

Note: Stocks with upside of more than 10% based on our fair value are assigned an Outperform rating. Stocks with downside of more than 10% based on our fair value are assigned an Underperform rating. Stocks with upside or downside of less than 10% based on our fair value are assigned an In-line rating. These are Crucial Perspective’s proprietary rating classifications and by no means serve as investment recommendations.

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Read: China Southern Airlines Initiation Research Report (10th April 2017) 

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