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For Northeast Asia’s airlines, previously slow to adapt, 2015 spells opportunity

Airline Leader

2015, the year of the sheep, may not sound the most auspicious for Northeast Asian aviation. But it is a reflective mode, offering prudent advice that should be taken sooner rather than later.

Prone to financial difficulties, sheep are urged to be conservative and live within their means. But the region's airlines will need to be more agile than they have been in the past.

As Asia's growth cools, slowing aggressive expansion would clearly be prudent. In the single largest Northeast Asian market, domestic China, the country's next five-year plan should call for slower growth. This will be a welcome relief to the main state-owned airlines. They have seen yield and load factor weakness as the centrally-planned growth was not adjusted as economic growth slowed. China Southern took 70 aircraft in 2013, but expected to take 42 in 2014, and projects fewer than 40 in 2015 and under 35 in 2016 - halving its aircraft growth in three years.

While slowing growth, the big airlines will need to display the sheep's characteristic of not being envious of others' successes. There are 20-odd airlines in China that have launched or planned to in recent years. Even if many do not succeed, that is a sizable injection of start-ups, and they will look to grow quickly. Rather than seek to preserve market share, incumbents have the alternative to establish a lean operating base to cut costs while trying to improve yields.

The task is substantial. On the cost side, the inefficiency is largely due to the constraints of government ownership. For example, workforces are bloated but rationalisation has been difficult and staff retrenchment generally impossible. China Eastern has been trying to use the effects of growth to maximise office staff productivity, only hiring employees essential for growth, such as pilots, flight attendants and engineers.

Even airline brands are subject to state influence. China Eastern, seeking a larger degree of autonomy, was able to change its logo and livery. While the result is controversial, the point is China Eastern succeeded in making the change. Air China, closer to the source of national power, has not been permitted to change its longstanding image.

There are other government policies that impede growth, such as a ban on red-eye flights, and restrictions on airspace made available for commercial flights is also at the root of much inefficiency. The woeful crowding of airspace often provokes airlines to attach to boarding passes slips of paper advising of delay possibilities and that the airline is not to blame.

Infrastructure inadequacy is also an important brake on expansion. Unable to expand rapidly enough to meet the demands of unprecedented levels of growth, China's major city airports are under stress. Shanghai was forced to cut flights over the summer period. In August-2014, what should be a peak travelling month, locally based China Eastern recorded only 0.9% group growth, compared with 8.7% growth in Aug-2013, and 10.4% in Aug-2012.

In contrast, China Eastern was able to grow much faster in other months, and Guangzhou-based China Southern and Beijing-based Air China grew 8.1%, with 4.0% group growth. In these circumstances it is unclear how the airspace will be able to accommodate the traffic expansion that will come with Shanghai Pudong's much-needed fourth runway. Beijing Capital Airport, also in need of expansion, with very few slots currently available for new services, will have to wait for its new airport later this decade.

On the revenue side, airlines are not confident of attaining yield premiums in what is a very price sensitive market. Short-haul premium load factors are about 50% and much of the capacity is occupied by free upgrades.

The conservative atmosphere in the domestic Chinese market contrasts to Northeast Asia's other big story, North American growth. Some airlines such as American and China Eastern are growing to take what they consider rightfully theirs but which has been carried by intermediate competitors. Other airlines are seeking to expand their hub roles - quite at odds with living within their means, as the sheep is urged. EVA Air has quietly emerged as a strong player on trans-Pacific routes; 15% growth is planned for 2015 and 2016. Transit passengers, mostly to Southeast Asia, account for 50% of its flights.

Cathay Pacific is having to turn to more transit passengers as local Hong Kong full service demand reaches saturation. The pressure has boiled over: Cathay's North American load factor dropped nearly 10ppt in Nov-2014, albeit to a still high 78%. However, with the level of competition and low fares in the market, high load factors may be the only way to remain standing.

Cathay is withdrawing the three weekly Chicago flights it added in 2014 (it will be left with a daily service). Delta is down-gauging its Pacific network, with more reductions expected as A350s replace larger aircraft, but otherwise airlines are still pumping in growth. United, in 2015, will add a second daily San Francisco-Shanghai service - the first double daily from a US carrier into China - and boost recently-launched Chengdu, but these are only seasonal adjustments.

2014 was a year of partnerships in Northeast Asia, with notable tie-ups or major strengthening including Cathay-Qatar Airways, EVA-Singapore Airlines, China Eastern-Qantas and Air China planning three JVs: with Air Canada, Air New Zealand and the Lufthansa Group. As these partnerships work through the details, astrology offers advice: sheep are sensitive to seemingly inconsequential matters and will be bold and insistent in what they need. Trust takes a long time to build. The press announcements may be upbeat, but those working through the details are wary of the many pitfalls.

Sheep are also known to spend much time planning, and Japan is expected to announce visa changes this year that will make it easier for Chinese nationals to visit. Japan is optimistically seeking to boost visitor figures from about 10 million in 2013 to 20 million by 2020. Liberalising access for regional visitors will be the only way this can be achieved. Japan expects to replicate the boost it saw when it made it easier for Thais to visit, and hopes to shadow Korea's recent influx of Chinese visitors.

Chinese airlines, with their much lower cost base, can be expected to be the primary beneficiaries. Spring Airlines Japan, a unit of the Shanghai-based LCC, also stands to gain. Spring Japan had been flying domestically with an under-utilised fleet accumulating exceptionally weak yields, but domestic operations were never its primary interest.

Fellow Japanese LCCs Peach and Vanilla Air have also been more interested in the international market, while Jetstar Japan is finally being permitted to fly internationally; its first route will be Osaka Kansai-Hong Kong, perhaps picking up an opportunity the much-delayed Jetstar Hong Kong planned to seize.

The Korean LCCs are only gradually moving away from the domestic market, despite that market being much smaller than Japan's. Jeju Air had taken the lead and plans to build its 17-strong 737 fleet to 40 by 2018. Jin Air, affiliated with Korean Air, became the first Northeast Asian LCC with widebodies as it placed a 777-200 on the Seoul-Guam route. Later route development could include Hawaii, and perhaps Europe or Australia. Korea's LCCs continue to be medium-cost and not low-cost; Jin Air retrofitted the 777 but kept nine-abreast seating rather than opting for 10.

Jin Air had mooted using the 777 to Hong Kong but appears to favour growth through frequency. Korean LCCs, and HK Express, have seen LCCs account for 21% of the Seoul-Hong Kong market. More remarkably, Tokyo-Hong Kong has experienced a 20% LCC penetration rate, up from zero a mere 18 months prior. HK Express' sister, Hong Kong Airlines, did not end up going public in 2014. Spring and Juneyao in mainland China also experienced more delays to their IPO.

Every major Northeast Asian market now has an LCC for the first time, with the conversion of HK Express to an LCC and the launch of two LCCs in Taiwan. Tigerair Taiwan and V Air are initially focusing on Southeast Asia but North Asia remains an objective. V Air is the LCC of TransAsia, which in Dec-2014 ordered four A330neos. TransAsia's existing two A330s are flying regional routes, with limited success.

Long-haul is likely to be the end game, but TransAsia is not well-known and nor does it have the size to support transfer traffic, as EVA has shown is necessary. Long-haul from Taiwan will become more competitive as flag carrier China Airlines replaces ageing 747s, thereby becoming more efficient.

All Nippon Airways will grow in Southeast Asia to support its expanding North American network, which will include the addition of Houston. EVA will add Houston and Chicago while Cathay will add Boston. Hainan Airlines, struggling to secure route approvals from local competitor and heavyweight Air China, has proposed nine long-haul routes, only some of which could be approved or likely be profitable.

ANA may resume Australian services, along with a new one to Istanbul that would be accompanied by a partnership with Turkish Airlines, giving it access to markets sometimes-partner Lufthansa cannot. Singapore Airlines is also partnering with Turkish, and Cathay with Qatar. Hong Kong Airlines has partnered with Etihad Airways and may fly to Abu Dhabi, complementing Etihad's forthcoming Abu Dhabi-Hong Kong service.

All together, there have been many changes: there is tremendous growth, new partnerships and new airlines taking to the air. The worry for 2015 is that sheep are not adept at sudden adjustments, and the spark of changing fuel prices could set off a new fire of change.

Astrology aside, Northeast Asian airlines have seldom been agile in the past and 2015 poses many what ifs: airlines can be caught on their fuel hedges or be exposed to competitors dropping fares in response to declining costs; Chinese airlines do not hedge and have been lowering their domestic fuel surcharges, which in Jan-2015 are at their lowest since 2009.

One solution to ease the process of change is through aggressive cost reduction and efficiency improvements. ANA has an ongoing savings plan while Cathay in 2014 formed one focused on gains mostly through efficiency. In Northeast Asia, there is yet to be the cost-reduction or capital return zeal that has captivated Europe, North America and its neighbours to the south.

Sheep aspire to an idyllic life of relaxation and daydreams surrounded by loyal partners in a slow-changing environment. With the year of the monkey - quick witted and opportunistic - looming in 2016, the ones who can adapt and evolve quickly this year will have a flying start.