Eastern Revival

God moves in mysterious ways.

When Liu Shaoyong served as GM of China Eastern Airlines between 2000 and 2002, the Shanghai-based carrier led the country’s airlines in terms of profitability and in 2001 was among the world’s 10 most profitable carriers. Air China was struggling in its shadow. Today the situation is reversed. Shanghai-based China Eastern is generally recognized as the weakest of the big three state-owned carriers while CA is thriving and leading the domestic industry in profits. And Liu Shaoyong has returned to take on the challenge of bringing CEA back to its former glory.

“When I came back to CEA [at the end of 2008], it had become a carrier I couldn’t recognize,” Liu recalls to ATW.Among the changes: Plunging staff morale and a crisis in confidence over the carrier’s future. Passengers, meanwhile, feared that its deteriorating finances could affect safety.

CEA’s problems did not develop overnight and some of them are structural. It is forced to divide its operations at Shanghai, with around 200 daily domestic flights at Hongqiao and 158 domestic and international services from Pudong, which hurts economies of scale and undermines network connectivity.

Other problems are self-inflicted. A series of unsuccessful mergers with local airlines in the early 2000s and poor decisions, including an inconsistent strategy of capacity allocation from branch companies to Shanghai, pushed it into a period of heavy losses, culminating in a record deficit of CNY13.9 billion ($2 billion) in 2008, while total debt reached CNY84.3 billion and debt ratio was 115%. Also that year its much-hoped-for equity alliance with Singapore Airlines collapsed after Air China used its influence to mobilize minority shareholders to oppose the transaction. The Chinese government concluded that the only answer was to start fresh.

Liu, who helped nurse China Southern back to health earlier in the decade, has turned his surgical skills to healing CEA. One of his first steps was to persuade Beijing to provide a CNY9 billion cash injection and raise a further CNY5 billion in the capital markets. The company also adopted some 256 cost-saving measures intended to “stop the bleeding.” It reduced “unnecessary investment,” selling its 35% share in Joy Air, which is expected to go into operation in May, to AVIC and suspending the launch of six domestic branch companies. These measures have worked. CEA reported a small net profit in 2009 of CNY539.7 million, which Liu attributed mainly to “effective cost control” although outsiders also cite the government infusion.

“CEA has survived but we haven’t stood up and begun running again,” is how he puts it. So far, he says, management has supported his reforms, “but the most difficult part is how to regain staff confidence and unite the people again, so we need to fix our own strategy.”

Salvation Network

Compared to their counterparts abroad, Chinese carriers are still evolving from primarily point-to-point networks into fully integrated hub-and-spoke systems combining both international and domestic routes. Air China has the lead position in this regard with its strategy of having a hub in Beijing and a presence in Hong Kong through its equity and marketing alliance with Cathay Pacific Airways. It is trying to develop an international gateway in Shanghai with mixed results, while Chengdu serves as its regional gateway into Western China. Guangzhou-based China Southern is moving forward with its own dual-hub strategy at Guangzhou and Beijing.

So what is CEA’s plan? “Our strategic objective is to become a hub-and-spoke network carrier with Shanghai as the main hub, which mainly features increasing transfer passengers,” Liu tells this magazine firmly. The need to build its position in Shanghai was the driving force behind its acquisition of Shanghai Airlines in July 2009, which boosted CEA’s passenger share to roughly 50% from 35%. When the merger is completed, SAL will become a wholly owned subsidiary but is keeping its brand in order to “maintain a stable operation.” Following the merger, CEA will operate a fleet of 336 aircraft to 151 destinations at home and abroad with more than 1,200 daily departures, comprising 1,025 daily domestic and 198 daily international and regional departures (to Hong Kong, Macau and Taiwan).

Liu believes this merger is different from previous ones conducted by CEA because “the key is in depth instead of width . . . Through this merger we have increased share in the Shanghai market, optimized our route network and provided more than 2,000 transferring routes every week at Shanghai Pudong, which serves our Shanghai hub strategy well.” It plans to take delivery of 39 aircraft this year, 90% of which will operate from Shanghai.

CEA is considerably larger than SAL—it carried 44 million passengers in 2009 versus 10.1 million for SAL in 2008, the most recent year for which data are available. But the carriers are similar in that both are struggling, so this is not a situation of a stronger airline scooping up a much weaker one. Liu believes this will turn out to be one of the most successful mergers CEA has engineered. “Both carriers are based in Shanghai and in the same situation, as both have suffered continuous operating losses in recent years, which makes both carriers’ mentality quite similar,” he explains. SAL’s problems date back to its ill-fated decisions to invest in China United Airlines in 2004 and to develop Shanghai Airlines Cargo, as well as overaggressive international expansion.

Back Office Merger

While SAL will maintain its own market identity for an extended period, a number of areas are ripe for integration and consolidation, among them marketing, IT, ground handling, MRO, cargo and logistics. The merger is expected to create synergies valued at CNY1.5 billion-CNY2 billion annually. “I hope CEA’s relations with SAL will be like Cathay Pacific and Dragonair,” Liu says. He stresses that the double brand will be retained for quite a long time.

As an important part of the Shanghai hub strategy, CEA also enhanced its position in the Yangtze River Delta region by opening more routes and adding flight frequencies to increase transfer routes to Shanghai. It boosted its investment in its Jiangsu branch company to CNY700.7 million, giving it a 62.6% stake. Furthermore, in a move that reflects the growing importance of Zhejiang Province, it renamed its Ningbo branch company as the Zhejiang branch company and plans to raise its fleet number to 40-50 from the current 24 in the next three years. “In addition, we also increased flight frequencies to Fuzhou and Xiamen and this strategy works quite well, as many passengers transfer in Shanghai rather than Beijing as previously,” Liu notes.

To better focus on the Shanghai hub strategy, Liu eased the carrier out of less relevant markets. For example, CEA signed a strategic cooperation agreement with the Yunnan provincial government to launch a new venture based on the assets of its Yunnan branch company. It holds 65% of the new entity with the Yunnan government holding the balance. The new carrier will not fly with CEA’s logo or code but will use the green logo of Yunnan Airlines, the predecessor of CEA’s local branch company that merged with the larger airline in 2002.

Liu explains, “The Yunnan regional economy is quite unique with tourism as the main characteristic. Our route network there can only cover Southeast Asian and West Asian countries, which contribute little to our Shanghai hub. So it’s better for us to make it operate as an independent company through which we also can count on Yunnan local government support.”

International Expansion

Beijing has been seeking to implement its long-term plan to position Shanghai as an international aviation hub because Chinese carriers are collectively in a disadvantageous position when competing against their foreign counterparts owing to lack of  hubs in a real sense, especially on routes to Western countries. In the Sino-US market, for example, Chinese airlines not only are less competitive than US carriers but also lose market share to Korean and Japanese airlines that capitalize on their hubs at Seoul Incheon and Tokyo Narita to attract lots of Chinese passengers.

To have a successful intercontinental hub, the base airline needs to operate a diverse network of short- and long-haul destinations, both international and domestic. The reality, however, is that CEA’s services from Shanghai to Japan and Korea account for a whopping 45% of its total international routes while Hong Kong and Macau make up 22%. Routes to Western countries only account for 19%. Revenue from international routes totaled CNY7.32 billion last year while domestic routes contributed CNY24.57 billion. It currently serves 47 international and 105 domestic destinations. SAL’s international network, meanwhile, is limited to serving Japan and Korea. Too often, CEA ends up feeding the hubs of Japanese and Korean airlines that carry the passengers onward into the West.

Liu recognizes the problem and has mapped out a step-by-step strategy to address it: “From this year on, we will start to make a strategic shift gradually from domestic to international markets. Currently the ratio of international to domestic routes is roughly 3:7, which I plan to turn into 4:6 this year.”

To that end, CEA has resumed some  international long-haul routes that were suspended last year, such as London and Moscow, and would like to boost frequencies on services to New York, Vancouver and Paris. Liu also has plans to open more routes to Rome, Japan and Korea. “We have an ambitious international expansion plan that will be implemented in 2011 and 2012,” he discloses. To pave the way for the expansion, CEA signed a letter of intent with SkyTeam in April, setting its official entry into the airline grouping for mid-2011.

“All three global airline alliances are very good ones. Star Alliance boasts the perfect route network, but as another Chinese carrier is a Star member, and it is a strong carrier, we would be impacted if we joined Star. As to oneworld, it is a club for the rich, as most of its member carriers come from developed countries. China is still a developing country and CEA faces a lot of uncertainties, so our choice is SkyTeam,” Liu explains.

 “Also we can support China Southern and strengthen our network with it in the domestic market,” he adds. It is noteworthy that he guided CZ to formal SkyTeam membership in 2007 when he served as its chairman. The two already cooperate on ground handling services and codeshare on some domestic routes. In addition, CEA has started to explore deeper cooperation with Air France KLM. “We are negotiating with Air France to set up a JV on the Shanghai to Paris route right now,” he reveals.

Air cargo is another weakness the airline intends to address. Foreign carriers take a dominant position in the Chinese cargo market, with domestic carriers having less than a 20% share of cargo tonnes. As the country’s biggest cargo market, Shanghai is no exception; in 2008, foreign airlines had an 87% share of the Pudong market.

“We are consolidating our cargo business and plan to cooperate with another carrier involving stake sales in our cargo subsidiary, just like the cargo JV launched by Air China and Cathay,” Liu says. The new cargo JV is scheduled to be launched by year end, and it is widely speculated that the cooperative partner will be CZ, which Liu won’t confirm. CEA is negotiating with the stakeholders of its subsidiary China Cargo Airlines and Shanghai Airlines Cargo to merge the two companies into one.

Premium Goal

“Our ultimate goal is to attract high-end business customers,” Liu notes ambitiously. For this reason, he discloses that CEA will start to introduce a strategic investor this year. He has made it clear on more than one occasion that the investor will do more than supply much-needed funding—it will provide management and brand guidance. “I hope our strategic investor is a carrier famous for its brand,” he adds.

The carrier sealed a deal with Singapore Airlines in 2007 to sell a 25% stake but failed to get approval from its minority shareholders represented by Air China. CEA is in better shape now. In the 2010 first quarter it posted net income of CNY770 million, much improved over the CNY40.1 million reported in the year-ago quarter. But Liu is not satisfied. Although the airline has improved its bottom line, it is not where it should be and “we still face some difficulties including the high debt ratio that reaches 95%, labor redundancies and costly operating expense as we have to operate two airports in Shanghai,” he points out.

Given the various shocks in the airline industry, he is wary of making financial predictions, but he believes a breakeven result is possible in 2011 if things go well. “Regarding CEA’s future, five years is too short. I hope CEA will become a real network carrier and be remembered as the carrier with ‘the best service level’ in ten years.” It could happen. Sometimes history repeats itself.