Consumer

David Fickling is a Bloomberg Gadfly columnist covering commodities, as well as industrial and consumer companies. He has been a reporter for Bloomberg News, Dow Jones, the Wall Street Journal, the Financial Times and the Guardian.

Airlines operate in such a brutally competitive market that it's sometimes tempting to view them as an undifferentiated group.

The most richly valued of the big three U.S. carriers, United Continental Holdings Inc., trades on a forward price-earnings ratio of 9.8; the cheapest, Delta Air Lines Inc., is on 8.7. The clustering is even tighter in China, where Beijing-based Air China Ltd. is on 10.4 and Shanghai-headquartered China Eastern Airlines Corp. on 10. China Southern Airlines Co., which operates out of Guangzhou, trails the field on 9.6.

Three of a Kind
Investors increasingly value China's major state-owned carriers as an undifferentiated group
Source: Bloomberg
Note: Based on blended forward 12-month price-earnings ratios.

That looks like a mistake. China Eastern is in a materially weaker position than the other two state-controlled carriers as they battle for supremacy in what's soon to be the world's biggest aviation market, and China Southern is being underestimated. If government intervention doesn't tilt the playing field in the former's favor, it risks getting squeezed.

Looked at through the frame of profit, China Eastern doesn't seem to be doing so badly. Net income fell just 0.9 percent to 4.5 billion yuan ($653 million) in the year through December, compared with a 3.5 percent drop to 6.8 billion yuan at Air China and a 35 percent jump to 5.04 billion yuan at China Southern. All three reported annual results overnight.

Under the surface, though, things aren't going so well. Booming markets can be dangerous places for airlines, which must balance the risk of losing market share with the possibility that they'll suffer weaker revenue if they add capacity faster than demand. The headlong pace of passenger yield declines at Chinese airlines suggests that, although the big three are continuing to fill up their planes, they're only doing it by undercutting each other on tickets.

Cheap Tickets
Chinese airlines' passenger yields -- a measure of airfare prices -- have slumped
Source: Company reports
Note: RPK = revenue passenger kilometer, a measure of the number of passengers multiplied by the distance flown by those passengers.

Who wins in a price war? Typically the player with the lowest expenses. That's the problem for China Eastern: Long the highest-cost of the big three, it's failed to trim expenses as radically as the other two in recent years.

In 2012, flying a metric ton of passengers or cargo for one kilometer cost China Eastern about 0.9 percent more than China Southern and about 6.1 percent more than Air China. Last year, China Eastern cost 8.1 percent more than China Southern, and 14 percent more than Air China.

Falling Behind
China Eastern's operating costs have dropped more slowly than its rivals
Source: Company reports, Gadfly calculations
Note: ATK = available metric ton kilometers, a capacity measure of total available passenger and cargo tonnage multiplied by distance flown.

Of course, there's more to an airline than cost structure -- in particular, geography. The big three U.S. carriers have expenses more than double those of budget airline Norwegian Air Shuttle ASA. They get better margins because they've managed to carve up the country's huge domestic aviation market between them, while Norwegian has to fight for a place on more competitive long-haul routes.

That's the trump card for China Eastern. Shanghai is China's second-busiest passenger airport after Beijing, and carries almost as much cargo traffic as the capital and Guangzhou put together. Being the main full-service carrier in any of China's tier-one cities is a prize, but having the dominant position in the high-income, trade-oriented population cluster at the mouth of the Yangtze river may be the richest of all.

Do I Move You?
Passenger traffic at China's big three airports is on a par with the world's biggest
Source: Civil Aviation Administration of China, Hartfield-Jackson Atlanta International Airport, Dubai Airports, U.K. Civil Aviation Authority

Unfortunately for China Eastern, it hasn't got that market to itself. The country's aggressive budget carriers, Spring Airlines Co. and Juneyao Airlines Co., are both based in Shanghai and pose the biggest competitive risk to their home-town rival. It's no coincidence that China Eastern has the smallest presence of the big three full-service carriers in the domestic market. Its significantly lower yields on international routes mean that profile will pose challenges.

Foreign carriers all want a piece of Chinese aviation. American Airlines' decision this week to buy a stake in China Southern may well be the death of its relationship with China Eastern, and is a potent demonstration of the lengths international airlines will go to get their feet in the door.

Those who expect the big three carriers to continue trading at about the same valuation as each other are underestimating the extent to which issues of cost and competition have created winners and losers in aviation since the dawn of the jet era. These three airlines won't fly in formation forever.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
David Fickling in Sydney at dfickling@bloomberg.net

To contact the editor responsible for this story:
Matthew Brooker at mbrooker1@bloomberg.net