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China cheapies loom as Qantas' new threat

18 Mar 2013

The Sydney Morning Herald

By Tony Webber

The Chinese carriers are in excellent geographic and unit cost positions to become a significant threat to Qantas on the Europe route, writes Associate Professor Tony Webber for Fairfacx Media.

Throughout the middle to latter part of the past decade, it was the Middle Eastern carriers that tormented the earnings of the likes of Qantas on the Australia-Europe route.

Their rapid expansion in capacity, superior products, lower prices and deep advertising and marketing pockets made them unstoppable.

Now it appears the Chinese carriers are the next big competitive threat.

Over the past two decades China's big three carriers, China Eastern, China Southern and Air China, have expanded their capacity in the Australian market by an astonishing compound annual rate of 21 per cent.

While they are not likely to pose a major competitive threat at the moment because they make up just 4.2 per cent of Australian capacity, we know from experience that this can change rapidly for motivated airlines.

In 2003, the Emirates and Etihad share of the Australian market was only 4.1 per cent. Over six years that grew to 11 per cent.

Given the 16 per cent growth in passengers on the Australia-China route over the past decade, and the expectation that this will continue for some time, it would not be surprising to see the Chinese carrier share of the market grow to around 10 per cent by 2019.

While the Chinese carriers are clearly interested in the Australia-China market, they also have their eyes on a much bigger prize, the Australia-Europe route, which makes up 18 per cent of Australian international travel.

The Chinese carriers are in excellent geographic and unit cost positions to become a significant threat to Qantas on the Europe route.

China Southern announced its "Canton Route" strategy last August with considerable fanfare.

The Canton route takes passengers from Australia to Europe via its hub point, Baiyun Airport (CAN), better known as Guangzhou.

Like Bangkok and Hong Kong, CAN is almost equidistant to Australia and Europe. The Sydney/Melbourne to CAN journey is around 8400 kilometres while CAN to London is around 10,500 kilometres. In comparison, Sydney to Dubai is almost 13,500 kilometres and Dubai to London 6200 kilometres.

An equidistant hub enables an optimal break point for the journey, which is especially well received by families with small children. Around 10 per cent of passengers are children travelling as part of a family.

While China Southern flies directly to multiple key points in Europe, including London, Paris and Amsterdam, it can't match the 30-plus European ports that the Qantas/Emirates partnership flies to - at least at the moment. In another five years that will change.

The other Chinese carriers appear to have poor connectivity for Australians travelling to Europe, suggesting they haven't co-ordinated their schedules yet to target that market, particularly the time-poor business or corporate segment.

While poor connectivity and total travel time is a significant issue for most travellers, it is of most importance to corporate and business travellers because they value their time more than leisure travellers.

For around 50 per cent of passengers who travel between Europe and Australia through Asia, there is a preference for at least one stopover night in Asia. For this very large subset of passengers, poor connectivity in China may not matter.

For a trip from Sydney to London Heathrow booked on February 13 for departure on September 16, China Southern was offering a one-way economy fare of $1165 as its best price. At the same booking and departure dates, the Qantas Red-e-Deal fare, which is its lowest internet fare class, was $1700.

The fare gap is even greater in the business section, with China Southern offering fares as low as $3743, while Qantas' lowest fare was $7500.

While comparing internet fares is fraught with danger because we don't know how many seats the airline sells at these lead-in fares, it is reasonable to conclude that China Southern set fares significantly lower than Qantas and most other international full service carriers.

These lower prices are to be expected. Chinese carriers operate at a significantly lower cost base, and unit cost is the number one driver of prices. In 2012 the average revenue per seat earned by the top 20 airline groups in the Asia Pacific shared a 90 per cent correlation with the cost per seat of those airlines.

I estimate that Chinese carrier unit costs, defined as cost per seat kilometre, are around 13 per cent lower than that of Qantas after adjusting for the fact that Qantas' average distance travelled is 35 per cent greater.

With this significant cost advantage, and perhaps an appetite to absorb weak earnings during the early phase of its rapid growth, it is of no surprise that China Southern can set fares well below those of Qantas.

It will be difficult for Qantas to maintain margins on European routes if the capacity pressure generated by Chinese airlines persists, which appears to be a safe bet.

Tony Webber was Qantas Group chief economist between 2007 and 2011. He is now managing director of Webber Quantitative Consulting and Associate Professor at the University of Sydney Business School.

First published in The Sydney Morning Herald




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