Commercial Aviation

China Market Outlook

2014-2033

China Market Outlook 2014-2033

Global Market Overview

China Regional Aviation Market - Overview and Outlook

Large Regional Jets to Boost the Development of Regional Aviation

Low-Cost Carrier Model in Regional Aviation

China Regional Aircraft Market Forecast

Definitions

Join us as we build a bright future for the Chinese regional aviation market.

Guan Dongyuan Senior Vice President, Embraer President, Embraer China

China Market Outlook 2014-2033

Global Market Overview

Global Air Transportation Market Overview Over the past 40 years, the global air transport industry has been characterized by strong growth rates. Although the global air transport system has faced frequent downturns, it has withstood external shocks and has always maintained normal growth. Embraer foresees a 4.8% year-over-year increase in revenue passenger kilometers (RPKs) over the next two decades. The Middle East will be the fastest-growing region with 7.1%

Global Market Overview

average annual PRK growth, followed by China with 6.8%, Latin America with 6.0%, the AsiaPacific region with 5.4%, Africa with 5.3% and the Commonwealth of Independent States (CIS) with 5.2%. Developed economies will grow less due to their market maturity - Europe at 3.9% and North America at 2.7%. By 2033, global air transport demand is expected to increase 2.6 times, reaching 13.6 trillion RPKs. The Asia-Pacific region and China will be the largest markets in the world, accounting for 40% of global RPKs. Europe and North America will follow at 36% of global RPKs. The main drivers of future growth are:

· full recovery of the economy of the United States and Europe · rapid economic growth in emerging markets · surge of an urban middle class and its purchasing power · more liberal industry regulation · increased competition and search for business efficiency · vigorous promotion of energy-saving technology Global Economic Trends - Overview The average annual global GDP growth rate is expected to be 3.2% over the next 20 years. The average annual growth rate in emerging economies is expected to reach 5.0% while that of developed economies will be 2.0%. China remains the economy with the fastest growth rate (5.5%) while Africa ranks second with 4.6%, followed by the Middle East with 3.9% and Latin America with 3.8%. The average annual growth rates in North America and Europe are expected to be 2.5% and 1.9%, respectively. However, downside economic risks still loom large in the future. Ukraine's domestic political conflict led to serious friction among the United States, the European Union and Russia, especially economic sanctions between the EU and Russia, which have seriously hampered economic development. Volatility in the Euro zone financial markets increased. China’s overheated economy led to austerity measures and credit restrictions. Infrastructure bottlenecks and regional conflicts in emerging markets led to disruption of oil exports and transportation. These, together with other factors, will undoubtedly produce unfavorable effects on the global economy.

Urban Middle Class to Surge in Emerging Economies More than half of the world’s population lives in urban areas. Around half of the population in the Asia-Pacific region and China is expected to live in urban areas by 2020. Half of all Africans will live in cities by 2035. The surge in purchasing power of the world’s urban middle class is correlates to the effects 6

Main Trends

USA

Europe

Emerging Markets

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Strong economic recovery (2013: 1.9%; 2014: 2.5%)

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Developed consumption, commerce, housing and trade

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Economic recovery in Euro-zone (2013: -0.4%; 2014: 1.1%)

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Favorable turn of economic conditions in Spain, Portugal and Ireland

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Gradually increased market competitiveness in Eastern European countries

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Increase of imports from USA, the Euro-zone and Japan to boost foreign demand

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Increase of disposable income to encourage consumption

Embraer foresees these growth rates impacting the need for civil aircraft over the next 20 years (Chart 1):

Forecast for 70 to 130-Seat Jet Deliveries Embraer foresees world demand for 6,250 new jets in the 70 to 130-seat jet segment by 2033, representing a total market value of US$ 300 billion (Chart 2). Forty-four percent of new aircraft will be added to fleets to support demand growth and the other 56% to replace aging aircraft. Embraer forecasts world demand for 2,300 new jets in the 70 to 90-seat capacity segment

Chart 1

Global RPK and GDP Forecast

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Forecast for Turboprop Deliveries Short-haul point-to-point operations will boost demand for turboprops of 70 seats or more. By 2033, 2,050 new turboprops within this capacity segment will be delivered, 30% to support market growth and another 70% to replace aging aircraft. The average range of turboprops is expected to increase. For medium and long-haul missions, jets will still be preferred due to their higher overall operating efficiency. Almost all turboprops will be deployed on short-haul routes (Chart 5).

Chart 4

Forecast of 90 to 130-Seat Jet Deliveries

Chart 5

Forecast of Turboprop Deliveries

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Current Conditions China’s civil aviation industry has maintained steady, rapid growth as the global economy recovers and rapid growth in parallel with the domestic economy. Civil aviation RPKS grew more than 11% annually from 2004 to 2013. The total number of passengers carried in 2013 was 354 million and accounted for one ninth of the world volume. In 2013, civil aviation posted a profit of RMB 24.81 billion, of which RMB 16.24 billion was attributed to

China Regional Aviation Market - Overview and Outlook

airlines. By the end of 2013, there were 31 airlines. Six of those airlines operated regional aircraft with 100 or fewer seats.

Definition of China’s Regional Aviation Market A regional airport is defined by traffic volume, its role in route a network, the airport city’s political and economic status, and its geographical location. Therefore, airports excluding Beijing, provincial or autonomous capital cities and Special Economic Zones (SEZs) are defined as regional airports. This definition of the regional market is the same as that in the Interim Measures for Administration of Subsidies on Regional Aviation issued by the Civil Aviation Administration of China (CAAC) and the Notice of the Ministry of Finance on Civil Airport Construction Fee Management, which defines a regional market as a market with at least one end of its routes connected to a regional airport.

Rapid Growth of Business to Generate Strong Demand in HighPotential Domestic Regional Markets Regional aviation, supported by the civil aviation policies over the past decade, is experiencing rapid development and playing an irreplaceable role in the air transport system and China’s “Essential Air Service” program. According to statistics from the CAAC, there were 111 regional airports nationwide in 2005 and 160 in 2013. The number of regional

Chart7

2013 Regional Network (Covered by Regional Aircraft)

Source: INNOVATA

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On the other hand, for some airlines, regional aircraft still means older 50 to 70-seat aircraft. With greater demand for flights on long routes and rising fuel prices, large capacity jets have been flying in regional markets since 2000. 70 to 130-seat regional jets, new-generation, large regional aircraft, are significantly superior to narrow-body aircraft. These new airplanes are spacious, quiet, comfortable, and economical to operate. They have the same advanced technology and proven reliability as the latest and most advanced narrow-body and widebody aircraft. They are more suitable for serving markets that average 45-135 travelers per flight and are ideal for opening new routes with comfortable and convenient air service for passengers.

Aircraft to Be Right-Sized According to Route Demand According to official CAAC statistics, airlines operated 2,499 scheduled domestic routes in 2013. The majority of those were categorized as medium and low-density (measured by passengers per day each way (PDEW)). By industry standards, medium and low-density routes are best served by regional airlines when there are 300 or fewer PDEWs. In China, 74% of all routes in 2013 had an average of fewer than 300 travelers. This suggests huge, untapped potential for regional aviation (Chart 10).

“Irrational Competition” in Regional Aviation Due to a lack of aircraft of suitable capacity to match variations in demand across their network, it is difficult for airlines to optimize their fleets at their hubs and on their routes. Competitiveness of their domestic trunk and international routes are also weakened. Large airports find their status as major international hubs also diminished. Moreover, regional and low-cost airlines are virtually unable to access large hubs and provide capacity for network airlines. They must acquire narrow-body aircraft with more seats to compete directly with large network airlines on trunk routes or deal with over-capacity caused by bigger aircraft

Chart9

2013 Passenger Per Day Each Way (PDEW) of Domestic scheduled flights

Source: Civil Aviation Administration Of China

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not nonstop because airlines try to compensate for their over-capacity aircraft on low and medium-density routes. Carriers reduce daily flight frequency or have multi-stop flights. Low frequency service does not satisfy the needs of business travelers and reduces customer loyalty and satisfaction. Moreover, stops, especially at cities that are not major airline bases, reduce profitability due to their higher route costs, diminished consumer appeal, reduced operating efficiency and risk of schedule delays. Multi-stop flights are rarely used in the world - nonstop flights are the clear trend. A mismatch between aircraft capacity and market demand limits network connectivity and flight frequency (width and depth) on domestic routes. That imbalance simply encourages more multi-stop flights. (Chart 12). Chart11

Aircraft Matching Status on Domestic Regional Routes in 2013

Source: Civil Aviation Administration Of China

Chart12

2013 Network Connectivity in China

Source: Civil Aviation Administration Of China

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better meet these needs with their right-sized capacity and ability to offer frequent flights. Urbanization will lead to the development of a large number of small and medium-sized cities and increased demand for air travel. China's economic growth will also increase national income and with it, the disposable income of residents of small and medium-sized cities. Higher discretionary expenditures for travel to visit friends and relatives will open unprecedented opportunities for regional aviation.

Local Government Support to Promote Accelerated Development of Regional Aviation Local governments attach great importance to promoting regional air service in order to stimulate local economic development. For example, in the six provinces in which regional air service is relatively well developed (Yunnan, Heilongjiang, Inner Mongolia, Sichuan, Xinjiang and Guizhou,) there are 65 regional airports which account for about 50% of the total number in China. The local economies in these areas, especially tourism, have developed rapidly as regional air service has grown. The Strategic position and value of regional airports is not limited to economic benefits. In natural disaster-stricken areas, regional airports can play an important role in rescue and relief efforts (Yushu Airport, for example, in 2009.) Consequently, many local governments are promoting regional air services by providing a variety of subsidies to airlines choosing to fly to regional cities and to local start-up carriers. At present, 25 of the 34 provincial-level administrative regions in the country have established or proposed to set up local airlines to serve provincial and neighboring regional markets. This will help advance regional aviation in the future.

Chart14

Proportion of Travel Expense per Capita Disposable Income in Urban Areas

Source: National Bureau of Statistics of China

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Market Needs Call for the “Large Regional Jet” Concept Satisfy the Need for Aircraft Range, Economy and Comfort Further expansion of hub-and-spoke networks and more demand for long-haul, nonstop, pointto-point services in low and medium-density markets will promote a transition from turboprops to regional jets. Airlines need to further reduce an aircraft’s operating cost per seat in order to address rising oil prices. These requirements will, in turn, drive aircraft manufacturers to provide

Large Regional Jets to Boost the Development of Regional Aviation

new generations of 70 to 130-seat regional jets that are more market-oriented. Small regional aircraft can no longer adapt to market needs. With their lower seat capacity, shorter range, narrower cabins, poor high-temperature and high-altitude performance, and lower reliability than mainline aircraft, they will cede to 70 to 130-seat jets that have the same economics, technology and reliability as larger narrow and wide-body aircraft. These new jets feature relatively longer range (up to 4,000 km or more), with spacious, quiet cabins for a more comfortable flight, that can generate significant profits. Embraer’s E-Jets and E-Jets E2 (that will enter service in 2018) are both excellent examples of large regional jets. Since entering service in 2004, more than 1,000 E-Jets have been delivered to customers in China and around the world. Some 65 airlines from 45 countries fly E-Jets. The E2s, the next generation of E-Jets, were launched in June 2013 and have already accumulated an impressive number of orders.

Satisfy the Need for High Network Connectivity By deploying new-generation regional jets that are better aligned with low and mediumdemand routes, airlines can break even with 70% loads. Compared to narrow-body aircraft, these large regional jets are lower-risk assets with which to open new markets yet have similar per seat operating costs. This allows them to access low and medium-sized routes in remote areas more profitably and significantly improve the scope of network connectivity.

Satisfy the Need for High Frequency Flights Because they have the right capacity, new-generation, 70 to 130-seat regional jets can offer more frequent service between small and medium cities and large hubs. This makes those hubs more internationally competitive. Increasing frequency and the connectivity of a network stimulates demand and improves local control. The range capability of the aircraft allows more nonstop flights which leads to greater operational efficiency.

Satisfy the Need for “Orderly Competition” New-generation large regional jets can play different roles in building hubs and opening new markets. Large fleets of those aircraft can provide new capacity for network airlines, better allocate aircraft type to variations in market sizes, and can turn “disorganized competition” into win-win “orderly competition.”

Significance of Large Regional Jets in Different Airline Business Models These larger regional jets are versatile and can operate in different business applications.

Network Airlines: Helping with Hub Network Development Network airlines should focus more on international and trunk routes. They can introduce large new-generation regional jets through their partner companies and subsidiaries or purchase of capacity from regional airlines. This can help them improve the scope their 26

The Future of China’s Domestic Low-Cost Airlines Lies in the Development of Low-Cost Regional Aviation Regional Market to Enjoy Greater Pricing Freedom than Mainline Market According to the Air Travel Price Index, excessive competition has brought domestic mainline flight ticket prices to rock-bottom levels and left almost no room for further price reductions. In contrast, ticket prices and yields for regional flights are higher. Moreover,

Low-Cost Carrier

new regional jets, with fewer seats and similar per seat operating costs as larger narrow-

Model in Regional

bodies, have plenty of room to reduce ticket prices because of their low trip cost advantage

Aviation

(Chart 16).

Regional Airports with Abundant Slots to Meet Low-Cost Airline Requirements for Higher Utilization and Lower Operating Costs Today, China's domestic slots at mainline airports are generally in short supply. In 2013, 24 airports had annual passenger volume of over 10 million and accounted for 77% of all traffic in the country. Fifteen of those 24 airports were deemed to be overloaded. Fight schedules in major cities such as Beijing, Shanghai and Guangzhou are extremely tight. Low-cost airlines cannot be guaranteed slot access in mainline markets. This affects daily aircraft utilization and the ability of an airline to reduce operating costs. Traffic at China’s regional airports grew 17% in 2013 compared to the previous year yet most are still underutilized and have sufficient capacity to accommodate new flights. However, airlines do not have the right aircraft types to profitably serve those local routes. These are the “Blue Ocean Markets” in which low-cost regional airlines can show their capabilities (Chart 17).

Chart16

Air Ticket Price Index

Source: Civil Aviation Administration Of China

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airports (Chart 18). There are few rail lines in the vast central and western regions. That indicates that there are no significant market conflicts between future high-speed rail service and the majority of civil airports in the central and western regions. Therefore, regional markets are less affected by high-speed rail than mainline markets and are more conducive to the development of low-cost airlines.

Low-Cost Air Service to Be More Essential for Passengers in Regional Areas China’s essential air service program aims at enabling people in 89% of administrative areas (at or above the prefectural level) to enjoy convenient air services within a 100 km or 1.5 hour drive by 2020 (Chart 19). To achieve this, more regional airports must be constructed. These regions need low-cost regional air service because of the scattered population and resources, a weak economic foundation and relatively small economies. Low-cost regional air service can effectively connect the central and western regions, promote links with economically developed areas, and aggressively support the rapid development of local economies.

Strategic Positioning of Low-Cost Regional Airlines Having a differentiated strategy for low-cost regional airlines is key to accessing “Blue Ocean” markets. Low-cost regional airlines with small and medium-sized fleets can choose second-tier cities with relatively huge potential, establish bases, offer frequent flights, charge low ticket prices and develop surrounding markets and even create secondary hubs. With the long range performance of new 70 to 130-seat jets, airlines can eliminate less-attractive multi-stop and connecting flights that are currently the only option by carriers with narrow-

Chart19

China Essential Air Service Development Plan

Source: Civil Aviation Administration Of China

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Aircraft Segmentation

· ATR-72

70+Seat Turboprop

· Q400 · Ilyushin ll-114 · BAe ATP

Definitions

· EMBRAER 170, 175 · GRJ700, 900 · Antonov An-148 · TU-134 · BAe 146-100, -200,

70-to 90-Seat Jet

· AVRO-RJ70, -RJ85 · Fokker F28, F70 · DC9-10, -20 · EMBRAER 175-E2 · ARJ-21 · Mitsubishi MRJ90 · EMBRAER 190, 195 · CRJ1000 · Superjet100 · A318 · B737-600 · F100

90-to 130-Seat Jet

· BAe 146-300 AVRO-RJ100 · DC9-30, -40 · B71, 727-100, 737-100, -200, -500 · MD87 · YAK-42 BAC-111 · EMBRAER 190-E2, 195-E2 · CS100 · A319, A320, A321 · B737-700, -800, -900 · B707, 757, 727-200, 737-300, -400 · DC9-50

130-to 210-Seat Jet

· MD-80, -81, -82, -83, -88, -90 · Tupolev TU-154, -204 · Ilyushin IL-62 · A320neo Family · B737 MAX Family · CS300

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