The air travel market in China appears to be back on a growth trajectory, as evidenced by a significant increase in passenger numbers compared to 2019, with domestic airlines reporting figures that surpass pre-pandemic levelsHowever, despite the upsurge in the volume of travelers, many airlines are grappling with profitability issuesThe primary challenge facing these airlines is the stubbornly low gross margins, which have yet to rebound to their former gloryThe heightened competition from both airlines and the high-speed rail network, alongside the lack of stringent industry regulations, makes it difficult for these carriers to translate increased passenger volumes into substantial profits without a significant decrease in operational costs, such as fuel prices.

From January to October 2024, China's civil aviation industry reported a total transport turnover of 123.83 billion ton-kilometers, marking a 26.5% increase year-on-year

The number of passengers transported reached 620 million, up 18.6%, and the cargo and mail transportation volume hit 7.298 million tons, boasting a 23.9% spikeSuch robust growth across these key metrics signifies that the recovery story for airlines has largely been toldNotably, international routes have shown remarkable resilience, with cargo and mail transport volumes surging by 48.5%. Even more encouraging is the fact that by October 2024, the passenger transport volume on international flights was nearly back to 96% of 2019 levels.

Despite the impressive numbers, the market sentiments are shifting as investors begin to eye the competitive landscape with concern, particularly the implications of a potential price war on ticketsA case in point is the third quarter of 2024, which is traditionally a peak travel season for airlinesDuring this period, many companies reported disappointing earnings, with stock prices trending downward, despite an overall favorable climate for air travel

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The combination of lower ticket prices and increased capacity led to a fierce competitive environment, and many airlines ended up with higher volumes but lower profits.

In the third quarter of 2024, the financial performance of seven major A-share listed airlines showed a worrying trend: all experienced declines in gross margins due to a drop of over 10% in the average ticket price during the peak summer travel seasonEven as the number of travelers surged—up 12% compared to the previous year—the overall profitability was adversely affected, underscoring the unsustainable nature of relying solely on capacity expansion and fare reductions to generate profits.

A closer examination reveals that overall airline performance in the first three quarters of 2024 was indeed better than in the same period of the previous year, with both revenue and net income experiencing growth

However, Spring Airlines, one of the key players in the market, reported a decline in net profit, attributed largely to a decrease in gross margins of nearly 2 percentage pointsThis was compounded by an increase in the effective tax rate, marking a shift from the prior year when losses had resulted in lower tax obligations.

Spring Airlines excelled among A-share counterparts, with a remarkable return on equity (ROE) of 15% in 2023, which climbed to 15.45% in the first three quarters of 2024. This performance can be traced back to Spring Airlines' low-cost business model and operational efficiencies, which keep ticket prices competitive while maintaining high load factorsIn contrast, the other six listed airlines showed much variability in ROE, with numbers ranging from -0.68% for China Eastern Airlines to as high as 62% for Hainan Airlines, although the latter's elevated figure is somewhat misleading due to its highly leveraged situation and minimal net assets.

The discrepancy in profitability metrics across these airlines can be largely attributed to variations in gross margins and operating expenses

Key factors that influence gross margins include load factors, average ticket prices, and aircraft utilization ratesConversely, the expense side encompasses sales costs, management expenses, and financial costs that stem from debt obligations.

In this competitive landscape, Spring Airlines stands out with a commendable performance marked by superior gross margins and effectively managed costsConversely, the three state-owned carriers—Air China, China Southern Airlines, and China Eastern Airlines—struggle with high expense ratios exceeding 9-10%, combined with gross margins that hover between 6-10%. This scenario hampers their ability to achieve substantial profitability in a saturated market.

Looking ahead, the landscape for domestic airlines holds potential for further stories to unfold, including the recovery of international flights, the possibility of decreasing fuel prices, and fluctuations in the value of the Chinese yuan

However, the critical theme emerging from the current environment is the necessity for these airlines to navigate the pressures of competition and potential market consolidation to remain viableThe third quarter of 2024 offered a telling glimpse into the realities of the passenger air travel market, revealing that many domestic airlines can no longer rely exclusively on increased passenger loads or enhanced capacity to achieve economies of scale and generate robust profit growthThis trend often forces airlines into aggressive pricing strategies, leading to lower ticket prices, insufficient gross margins, and increased pressure from sales, management, and financial expenses.

One pressing issue contributing to the industry’s struggles is the financial burden stemming from pre-pandemic losses, which have inflated liability ratiosAdded to this are the high interest rates on foreign currency-denominated debts, particularly noticeable in HNA Group, Juneyao Airlines, and China United Airlines

In terms of leverage, figures from the end of 2019 show that the asset-liability ratios of major airlines—Air China at 66%, China Southern Airlines at 75%, China Eastern Airlines also at 75%, and HNA at 71%—have climbed to alarming new heights by the third quarter of 2024, with rates of 89%, 82%, 85%, and 97% respectively, despite recent efforts to raise capital.

Furthermore, the domestic air transport market is increasingly characterized by intense competition, not only among airlines but also with the rapidly expanding high-speed rail network, particularly impacting medium-haul routesThis growth is evident through the surge in aircraft numbers across the country, which rose from 3,818 in late 2019 to 4,270 by the end of 2023—a remarkable increase of over 11%.

At present, Spring Airlines appears to be the standout player

However, its current trailing twelve months price to earnings (TTM PE) ratio approaches 25, which some analysts consider high given the fierce competition in the market and projections for annual growth of just 3-5%. A more realistic PE ratio might fall between 15 and 18. If fuel prices, exchange rates, and market conditions remain stable, one can expect Spring Airlines to achieve approximately 10% revenue growth, with steady gross margins and expenses, resulting in an expected net profit growth rate of around 10-12%—thus yielding an earnings per share (EPS) projection of about 2.63 yuan.

For HNA, the current TTM PE is about 46, with a projected EPS for 2025 around 0.05 yuan, resulting in a dynamic PE of 34. Juneyao Airlines shows a TTM PE of 35, with a forecasted EPS of 0.57 yuan and a dynamic PE of 25. Meanwhile, the performance of major state-owned carriers like Air China, China Southern, and China Eastern continue to be lackluster, with TTM PEs reflecting losses exceeding 45, dependent largely on external variables like fuel prices and the return of international traffic.

Ultimately, it would be wise for airlines to adopt a focus on cost control measures to improve their bottom lines, reducing their combined sales and management expense ratios to below 4-5%. With the rise of mobile booking applications, substantial advertising budgets may no longer be necessary, offering airlines the opportunity to save on promotional expenses.

In conclusion, the investment logic surrounding airline stocks has experienced a significant shift from the anticipated high elasticity of post-pandemic earnings to a more sustained focus on operational management and competitiveness