By China Daily (China Daily)
Updated: 2008-02-04 11:49

Citi Investment Research (CIR), a division of Citigroup Global Markets Inc, issued a report titled The China Traveler at the beginning of this year, to offer investors a perspective on how to gain exposure in the Chinese travel market.

The report says six key themes will affect China's travel sector in the near and mid-term, including robust demand, competition, deregulation and consolidation in the sector, infrastructure and operations upgrades, expansion into second-tier cities and fuel prices, as well as the impact of a possible slowdown in the US and global economies:

Demand outlook: robust

One of the primary drivers of travel demand is underlining economic growth. Accordingly, CIR believes that the expected continued strong Chinese economic growth and rising consumer spending will drive rapid growth in a string of travel-related sectors, such as airlines, airports, hotels, travel consolidators and intermediaries.

In addition, over the next two to three years, China will host several world class events, notably the Beijing Olympics in 2008 and both the Shanghai World Expo and Asian Games in Guangzhou in 2010, which will give a further boost to the travel market in the short and mid-term.

Regarding the Olympics specifically, CIR expects it to attract two million visitors and help to elevate China in the longer run as an inbound tourist destination for international visitors. In 2008, airlines in particular will enjoy a "super up-cycle", while the hotel market continues to expand with growing investment attracted by the rising tourism.

Competition, deregulation and consolidation

As part of its entry into the WTO in 2001, China committed to opening up segments of its travel industry, such as airlines and travel agencies, to foreign participation. However, it still remains somewhat protective of national interests, in CIR's view, which includes many segments of the travel sector.

For example, TravelSky, China's global distribution system (GDS), still dominates domestic air ticketing, and CIR does not expect the sector will be opened in the near term. Foreign investment in the high-end hotel segment was also tightened in 2007.

Deregulation is clearly a mixed bag, in CIR's view. Even though deregulating the sector would benefit China's travel economy in terms of importing best practices and new technologies, allowing more participants would also naturally intensify competition, which has positive and negative implications for different segments.

Infrastructure and operations upgrades to continue

CIR expects to see the effects of past infrastructure projects in 2008, as well as the start of new infrastructure projects. Specifically, both major expansion projects at the Beijing and Shanghai airports will enter operation in the first quarter of this year. Going forward, the Chinese government has budgeted 16 billion yuan (US$2.23 billion) for construction of airports in western and northern China in its 11th Five-Year Plan (2006 to 2010).

The primary goals, of course, are to accommodate the anticipated rise in civil aviation demand and to improve air traffic management. While this is no doubt a positive for the entire travel sector, certain segments are likely to be negatively impacted by this expansion or construction in the near to mid-term.

Specifically, CIR sees impetus for airlines to improve their operational capability and competitiveness, which may include market consolidation, and major costly and disruptive expansion plans for the country's airports.

Expansion into second-tier cities across the country

CIR expects to see continued expansion by the travel industry into second-tier cities, which promotes more balanced economic development across the country, especially in western and northeastern parts of China.

While expanding early to establish one's footprint and market position in a new and growing geographic market is an overall positive, investors should be mindful that expansion into these low-income cities may translated into lower average prices and yields for companies.

In addition, expansion into new markets where brand preference is not set may mean that companies must invest more marketing dollars for brand advertising, which coupled with lower average revenue result in a negative margin impact.

Impact of fuel prices

Jet fuel prices surged by 48 percent in 2007. Jet fuel is a major cost component for airlines and thus rising prices materially impact airlines' profitability. Rising prices may also impact travel demand, depending on pass-through rates and elasticity of demand.

CIR has raised its 2008 and 2009 crude oil price estimates to US$80 per barrel and US$90 per barrel respectively, and the long-term sustainable crude oil price estimate to US$75 per barrel.

With respect to the ultimate impact on the travel sector, CIR believes that airlines are the most directly exposed to volatility in fuel prices, as jet fuel is the major cost component for airlines, Travel consolidators, hotels and GDS are indirectly exposed, depending on the magnitude to which airlines pass on fuel cost increases to consumers and consumers' elasticity of demand.

Impact of a possible slowdown in the US and global economies

If there is slowdown in the US and global economies, and if it is serious enough, it could potentially have a knock-on effect on China's economic growth, which has been, and is expected to continue to be, largely driven by export and investment growth.

A moderate slowdown would probably not have a discernable impact on the China travel market, especially given the offsetting positive effects of the Beijing Olympics in August.

However, a more severe slowdown would probably first show up in international travel before it hits the domestic hotel industry, especially the budget segment.

Ultimately, if China's growth slows, CIR would expect leisure travel to be hit first, and thus prefer segments that are more resilient, such as higher exposure to domestic business passenger travel.

Finally, companies that have a clear ability to grow market share in an otherwise slowing market are likely to be best positioned.