A perfect storm of mounting debt, lack of government support and declining demand, often accompanied by shareholder disputes and shaky management, is pushing China’s private airlines to the edge of bankruptcy.
Consider the plight of Okay Airways, the first private airline company in China, which started operating in March 2005. In mid-December last year, Okay grounded its passenger planes for more than a month, becoming the first Chinese airline ever to suspend services. (As of February 16, it has resumed all of its flights.) Other private carriers are also struggling: United Eagle Airlines and East Star Air have been publicly penalized by airports for failing to pay their overdue bills, which total tens of millions in yuan. To collect the payments, the airports threatened to deny services and file legal proceedings against the delinquent airlines.
Even Spring Airlines, the Shanghai-based private airline considered one of the most robust private carriers in China, has hit turbulence. It managed to post a net profit of 21 million yuan (US$ 3.1 million) in 2008, but that was down sharply from the 70 million yuan (US$ 10.3 million) it earned in 2007.
When private airlines were first launched in China four years ago, an air of optimism accompanied their arrival. They were supposed to bring lower fares, more customer choice and healthy competition to the formerly state-run sector. But now the question is: How many of them can ride out the current storm?
Suspended Flights
Just before Okay Airways suspended its services in December, the Juneyao Group, a Chinese private company which operates Juneyao Airlines and is the controlling shareholder of Okay Airways, filed an application to the Civil Aviation Administration of China (CAAC), claiming that Okay could not guarantee the safety of its passengers. Wang Junjin, the chairman of both the Juneyao Group and Okay Airways, said at the time that Okay’s corporate governance did not comply with the aviation safety regulations of China.
That position put him sharply at odds with Okay Airways president Liu Jieyin, who had launched the airline and managed it initially. Liu said that the real reason for the suspension was a fierce internal dispute between the old and new owners of the airline. “The operation of Okay is safe, and it was unreasonable for the airline to stop flying,” he said.
Okay Airways, based in the northeastern city of Tianjin, has about 800 employees and nine planes: eight Boeing 737s and one Chinese-built Xinzhou-60 turboprop. Three of the 737s are cargo planes, which Okay operates as a partner to FedEx, and six are passenger planes. In 2007, Okay carried 1.2 million passengers, accounting for a quarter of the total passenger volume at Tianjin Binhai International Airport.
But Okay has been losing money since its first flight in 2005. Korean Air, the world’s largest international airfreight carrier, signed a preliminary agreement to buy a majority stake in Okay Airways in September 2006, but Okay instead chose a Chinese investor to avoid foreign control of company shares. That investor was Juneyao, which took control of Okay in 2006 by buying 71.4% of the shares of Beijing Transport Energy Shareholding Co., which owns 63% of Okay Airways. Minor stakeholders are Dadiqiao Investment Co. (Beijing), with 26%, and three individual investors.
At the time of the investment, Okay and Juneyao also agreed to share personnel, routes, marketing and managerial expertise. “When Juneyao came in, we had a good relationship,” Liu Jieyin said. But the relationship soon turned sour. Wang Junjin took over Liu Jieyin’s position as chairman, and disagreements between Juneyao and the original shareholders multiplied.
The two sides first argued about Juneyao’s investment, as Okay’s three individual shareholders filed a court complaint alleging that Juneyao’s promised capital contribution of nearly 100 million yuan (US$14 million) was never fulfilled. Juneyao officials denied the charges, and said the capital was provided by May 2006. The Juneyao group also acknowledged that it never conducted an audit of Okay’s equity and debt before signing the investment agreement.
The two sides also had management disputes. The main disagreement involved “how to run the company,” Juneyao chairman Wang said. During the previous two years, Okay had been placing equal emphasis on core and non-core businesses, and on passenger and cargo operations, without a clear business focus. “This resulted in growing debt arising from day-to-day operations, and increasing conflict between the board of directors and corporate executives over business development direction,” he said.
A major dispute erupted over the decision to purchase 10 China-made Xinzhou-60 aircraft, a regional turboprop plane with 50 to 60 seats. In July 2007, Okay Airways signed a contract to purchase or lease 10 Xinzhou-60s, making it the first user of the aircraft in China. But Wang did not approve of the purchase, saying that the addition of a new aircraft type would raise training and maintenance fees. The Xinzhou-60s were bought anyway, a move that so angered Wang that he asked the board to remove Liu Jieyin from his position as chairman, although Okay’s other shareholders rejected this request.
Such shareholder disputes are very common among China’s private carriers. Many private Chinese airlines endure management chaos because they lack formal management structures, and they also lack adequate capital at inception, according to Zhang Qihuai, an expert on aviation law. Financial pressures then force them to introduce new investors, which can damage management and morale, and render board decisions ineffective.
United Eagle’s Troubles
Similar problems plague United Eagle Airlines, another private airline that launched just after Okay Airways. United Eagle was established in Chengdu by an investor named Li Jining and two partners, with 80 million yuan (US$ 12 million) in registered capital. After its launch, the airline’s ownership changed many times, and by June 2007, Chengdu-based Huaying Investment Consultancy Co. was the largest of five shareholders, with a 29% stake in United Eagle. Later, Sichuan Airlines and Juneyao Group both became shareholders in United Eagle.
“Having so many shareholders made the company’s decision-making very slow, because the different shareholders usually cannot get together to hold a meeting, and they also cannot come to an agreement in a meeting,” said Sun Zhijun, the airline’s financial director.
United Eagle also became the first Chinese airline to be penalized by a Chinese airport, after receiving a letter in late November from Sichuan Airports Corp., which oversees all airports in Sichuan Province, demanding immediate payment of overdue charges and threatening sanctions. The airline was ordered to pay 30.45 million yuan (US$ 4.5 million) in overdue takeoff and landing fees, plus surcharges accumulated between March 2007 and October 2008. The threatened penalties would start with service phase-outs (such as denying use of the VIP lounge at Sichuan airports) and end in legal proceedings.
At the time, United Eagle’s debt, including money owed to the airport and banks, had grown to 90% of its assets. If the carrier cannot find new investors and additional investments from existing shareholders, it may soon go bankrupt. Just like Okay Airways, United Eagle — launched with great fanfare only four years ago — is beset by slumping demand, shareholder squabbles, cash-flow problems, overdue bills and managerial struggles. The first private carriers to launch in China may also become the first ones to go out of business.
Great Expectations
Such hardship was not anticipated in 2005, when China first opened its aviation market to private airline competition. Until 2005, China’s skies were the exclusive monopoly of a group of state-owned airlines, most of which sprang out of the old CAAC. But in early 2005, the CAAC opened the door to private airlines, a move that promised greater consumer choice and more efficiency across the board.
Twelve new airlines have taken to the skies since 2005, although China’s airline industry is still dominated by the three big state-run carriers: Air China, China Eastern Airlines and China Southern Airlines. The longevity of those three carriers is virtually guaranteed by government support and preferential policies, which put private carriers at an even greater disadvantage.
For example, the “big three” carriers normally snatch up the best routes. The CAAC allows private airlines to participate in the competition for routes; however, the reviews for route applications by private airlines has always been more rigorous, so that the most lucrative routes, especially those serving the coastal cities, end up in the hands of the state-owned airlines. The private airlines, meanwhile, are stuck with the less-desirable “feeder” routes.
The state-owned carriers have also received generous government handouts. China Eastern and China Southern have received 7 billion yuan (US$1.03 billion) and 3 billion yuan (US$ 441 million) respectively from the government, to balance falling passenger numbers and huge hedging losses from the plummeting price of oil. At the same time, even local government-controlled Hainan Airlines has received 500 million yuan (US$ 73.5 million), and industry insiders also expect Air China to get its own government handout soon.
Despite the favors lavished upon them by the government, even the “big three” carriers are struggling. China Eastern is expected to post a loss of 9.2 billion yuan (US$ 1.35 billion) for 2008, while China Southern is expected to lose 4.2 billion yuan (US$ 618 million). Even Air China, the strongest of the three state-owned carriers, is expected to lose 4.6 billion yuan (US$ 676 million) in 2008, according to figures provided by Macquarie Research in Hong Kong.
Faltering Demand
Faltering demand due to the economic slowdown has stricken all of China’s airlines, but only the state-run carriers have enjoyed huge bailouts to help them weather the crisis. China’s private carriers cannot count on such government support – the government is unlikely to invest in carriers in which it is not a major shareholder, a senior CAAC official told China Knowledge at Wharton.
It is not easy being a small fish in a big pond, especially in an economic downturn. “While all state-owned airlines are now losing money due to falling traffic demand, private airlines are even more vulnerable,” said Li Lei, an analyst with CITIC China Securities.
To make the situation even worse, the “budget airline” model used so successfully in the U.S. and Europe – incorporating a single aircraft type, point-to-point flights, high frequencies and low costs – is difficult to duplicate in China. According to Okay Airways president Liu Jieyin, a true low-cost carrier cannot exist under current policies in China, because nearly 80% of private airline operating costs, such as aircraft import tariffs, landing fees, fuel and the like, are under government control. With state-set fuel prices, Chinese airlines often pay far more for fuel than overseas competitors, especially when oil prices are low.
But the biggest problem for most private airlines in China is that they are short of cash. In China, it costs just 80 million yuan to register a private airline company, but it will cost more than 200 million yuan to buy a narrow-body jet airplane. And unless an airline reaches a certain fleet size, it is difficult for it to achieve low-cost operations or an economy of scale.
But in the current recessionary environment, raising capital is very difficult. According to Okay president Liu Jieyin, the private airlines cannot borrow money as easily as state-owned carriers. “Banks are not lending to private airlines,” he said. “Instead, they are practicing a rather stringent policy.”
Meanwhile, any plans that the private airlines had for raising cash through initial public offerings (IPOs) are on hold for now, due to the global financial crisis. Spring Airlines and Juneyao Airlines still hope to list in 2010. It is equally hard to raise private capital. In 2007, Juneyao Airlines signed an agreement with an unidentified foreign investor to sell a 25% stake for US$100 million, but the investment is still awaiting government approval.
The tough conditions forced the temporary suspension of Okay Airways flights, and just this week the company resumed all 13 of its original flight routes. But the airline has lost nearly 200 million yuan (US$29 million) over the past three years, and it continues to hemorrhage. “The suspension of Okay Airways is a reflection of the tough conditions for private airlines during the bad economic times,” noted Zhang, the aviation law expert.
Last month, China’s aviation regulator stopped accepting applications to set up new airlines until 2010, due to the recent decline of aviation demand. “If the CAAC opens the application again, things that should be examined and approved should include not only safety, but also the shareholders’ financial strength,” said Zhang.
Yet it is highly unlikely, given the hurricane-force headwinds, that any entrepreneur would wish to launch a new private airline in China. A more likely scenario is continuing hardship for the private airlines that are now flying the unfriendly skies. If they do manage to weather the storm, they will emerge stronger on the other end, and if not, they will be forced to suspend flights again, perhaps permanently.
