In the Hutong, Beneath the Departure Path of Runway 18R at PEK

Whenever I sit at a table with Hong Kong Chinese I consider to be my friends, the discussion always turns into a caustic debate: they insist Hong Kong people understand China better than anyone other than mainland Chinese. I insist that seven years after reunification, Hong Kong people still understand Great Britain better than they understand China.

Case in point: Air China’s public offering yesterday in Hong Kong was 83 times oversubscribed.

Why?

WHY??

Maybe Hong Kong investors enjoy a good gamble. (See Macao.) I think punters in the Special Administrative Region have actually convinced themselves that because China is booming, Air China will boom as well. Which speaks to my point. Andrew Chan, an analyst at Pacific Sun Investment Management, told Bloomberg “The strong demand is more driven by the market sentiment (sic) than the company’s fundamentals.”

Understatement of the year.

Now, before I give a little insight into exactly why this is a bad investment (and on the eve of its London offering, no less), allow me to digress a moment:

When the wind is blowing in one direction, southbound departures out of Beijing International Airport curl in a graceful arc toward the Shahe navigational beacon in a way so that, from my third floor balcony, I can watch them from the time they are about 400 feet off the ground above the airport 4 kilometers away until they fly over northern Beijing.

When the wind blows the other way, those same departures lumber almost directly over the house at about 2500 feet. Some people would be bothered by that. As a semi-retired plane spotter, I love it.

So understand, I personally have a couple of very important reasons to be happy about the Air China IPO, not least of which is the better shape the company is in, the better shape the planes are in, and thus the safer I feel flying my hometown airline, and the safer I feel hearing them overhead. I have no airline clients, and I have no airline investments.

That said, Air China is another one of these state-owned enterprises that has gone to market before it was ready and at a bad time, hoping to catch investors who have China fever so bad they will miss the fundamentals. Except for a few very well run airlines that have turned their operations into high art, airline economics are awful, and being in China doesn’t change that.

• Fuel in China is preposterously expensive, and Chinese airlines pay more in their home airports than other airlines around the world because of a government-sanctioned monopoly. Now, China Aviation Oil Ltd. may or may not be affected by the misguided trading of its Singapore subsidiary, but as long as this monopoly stays in place, Air China’s fuel bills per seat-mile are going to be higher than other world airlines.

• Political pressure keeps ticket prices down even when aircraft are fully booked, meaning Air China can’t make money on high-demand routes.

• China was forced to eat two other airlines, Zhejiang Airlines and China Southwest – a year ago. It’s still digesting, and more important this underscores how the future strategy of the business is driven as much by politics as by commercial considerations.

• Air China’s fleet is ridiculously diversified in an era here most airlines are rationalizing theirs down to a single manufacturer and a handful of models. This increases the expense of training, operation, maintenence, etc. so much that the better run airlines only operate a handful of aircraft.
— Southwest only flies several models of only one aircraft type, the 737. Southwest is a well-run airline
— Singapore flies 3 types, the A340, the 777, and the 747. Singapore is a well-run airline.
— Virgin only flies the A340 and the 747. Virgin is a well-run airline.
— Air China operates nine distinct types of aircraft, including 4 models of 737, three models of the 747, the 757, two models of the 767, the 777, the Airbus A318, A320, A340, and the British Aerospace BAe-146.
Are their airlines that operate more types than Air China? Absolutely. But none of them are in good operational shape.

• China’s fleet problems are not likely to change soon, because aircraft purchases are as much driven by politics as they are by operational considerations. You can bet Air China will be operating the Boeing 7E7 and the Airbus A350 when those planes start flying, and will probably be forced to buy the A380 and the Boeing 747 Advanced as well.

• Even after consolidation, domestic competition remains cutthroat. Even though PRC airlines could raise prices, none are prepared to take the risk.

• International competition, on routes where Air China makes some good money in both passengers and cargo, is about to go way up.
— In passengers, China is opening up more slots to European, Asian, and American carriers. Even QANTAS is scheduled to begin direct Beijing-Sydney service. And Cathay Pacific, long denied entry into China because Hong Kong’s protectionist aparatchiks were backing Dragonair, is now being allowed into the market, turning it’s Hong Kong hub into the money-spinner it always should have been. Want to bet on an airline in China? Bet on Cathay Pacific or Dragonair.
— In cargo, Air China is moving too slowly with poor infrastructure on the ground. FedEx, UPS, DHL, and TNT, having built their businesses on high-value express shipments, will after the current round of international service agreements have enough belly space in aircraft coming into China that they can cream the better air-cargo shipments as well. And these companies offer something Air China cannot – not only tracking and delivery services and facilities on the ground around the world, but internal divisions that plan and manage global supply chains for clients. Air China, meantime, rents belly-space, leaving itself at the commoditized low-end of the business.

• Despite high-profile airport upgrades in Hong Kong, Guangzhou, Shanghai, and Beijing, most of the rest of China’s 119 commercial airports have facilities little different than what U.S. airports had in the early 1950s. This is the heart of Air China’s business, and it means that quick turnarounds are impossible (raising the capital cost per passenger flown), opportunities to grow to meet demand are less (airports can’t handle that many flights or large enough aircraft), and that because air travel in China is so uncomfortable at either end, the whole experience is miserable, keeping prices low and artificially restricting demand.

• The management are all bureaucrats, not businessmen. That needs to change. It should, but it won’t – not anytime soon.

• If you think Air China is such a hot stock, look at the past performance of China Southern and China Eastern. Zzzzzz. These airlines have been listed in New York for a decade and they’ve gone nowhere, because analysts recognize the fundamental issues in the market.

Whenever anyone talks about the Chinese commercial aviation market, they get drunk on the potential of the place. And there IS a lot of potential. Air China’s issues as a business, however, are fundamental. They must be changed – and the problems in the local industry environment must be changed – before this can be a good investment for an average punter.