Why Price Competition Is ‘Killing’ Chinese Airlines

Shares of Chinese airlines lost ground on Tuesday following a disappointing earnings report from China Southern Airlines, Asia’s largest airline by passenger numbers, which highlighted challenges facing the aviation sector in the world’s second biggest economy.

China Southern Airlines
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China Southern Airlines

Dwindling demand for domestic travel, intensifying local competition and higher fuel prices are threatening the profitability of the country’s airline industry, say analysts.

China Southern – which kicked off the reporting season for the sector – saw an 85 percent decline in profits over the January-June period, setting the trend for disappointing earrings out of rivals Air China and China Eastern Airlines .

Shares of the three Hong Kong-listed mainland carriers have been under pressure this year - down 12 -17 percent since the start of 2012, underperforming the broader market.

Competition in the sector is being driven by overcapacity, says Patrick Xu, Transportation Analyst at Barclays, which is hampering the ability of carriers to raise ticket prices to meet rising fuel costs. China Southern’s 15 percent rise in fuel costs in the first-half, for example, was matched by just a 3 percent increase in passenger yields.

According to Xu, the trend of rising supply is set to continue, with carriers expected to see acceleration in aircraft deliveries over the next two years, as a result of orders placed back in 2010-2011, when the outlook for demand was brighter.

"Demand and supply are going in the wrong direction – we’re seeing weakness in the yield, or ticket price, as a result of price competition. (This) is killing the Chinese airlines,” Xu told CNBC.

Growth in Chinese domestic travel is set to rise just 12 percent year on year in 2012, according to Xu, compared with a rise of 20 percent last year. He says demand is falling in both the leisure and business travel segments, as a result of the slowing economy.

On top of the challenging dynamics in the airline sector, Chinese carriers are also grappling with the impact of a weakening yuan – which has fallen 1 percent against the U.S. dollar this year, compared to a gain of 4.5 percent last year.

The airlines hold a lot of U.S. dollar denominated debt on their balance sheets, which means that a fluctuation in the currency directly impacts their profitability.

“Depreciation in the yuan hurts them (the airlines) very much because most of their borrowings - for purchases of aircraft for example - are denominated in U.S. dollars,” Xu said.

Xu, who has an underweight position on China Southern, says its shares, which are trading at 0.8 times book value, do not look attractive yet.

He adds that the Guangzhou-based airline faces competition from Air China, which has 30 percent of its fleet based in nearby Shenzhen. It also has to reckon with the full force of Cathay Pacific out of Hong Kong. This Xu says “will undermine the long-term growth potential of its hub volume, especially on the long-haul international routes.”