The following discussion should be read in conjunction with the audited consolidated financial statements of the Company and the notes thereto included elsewhere in this Annual Report. Such financial statements have been prepared in accordance with IAS. For a discussion of certain differences between IAS and PRC Accounting Regulations as well as IAS and US GAAP, see supplementary financial information in this annual report.
OVERVIEW
The Company's primary business is the provision of domestic, Hong Kong and international passenger and cargo airline services. As part of its expansion strategy, the Company has, in recent years, added larger aircraft to its fleet as well as expanded the geographic scope of its airline services.
The Company's passenger traffic (as measured in passenger-kilometers ("PKs")) increased from 8,609.5 million PKs in 1996 to 10,051.3 million PKs in 1997, or 17%. This increase was due primarily to a 19% increase in the Company's capacity on an available seat kilometer ("ASK") basis over the same period. The Company's passenger revenues increased from RMB 5,894.5 million in 1996 to RMB 6,891.7 million in 1997, or 17%, and its cargo and mail revenues increased from RMB 1,109.3 million in 1996 to RMB 1,332.0 million in 1997, or 20%.
The airlines industry is characterized by a high degree of operating leverage. Due to high fixed costs, including payments made in connection with the Company's aircraft leases, the expenses relating to the operations of any given flight do not vary proportionately with the number of passengers carried, while revenues generated from a particular flight are directly related to the number of passengers carried and the fare structure of the flight. Accordingly, a decrease in revenues will result in a proportionately higher decrease in profits.
CERTAIN FINANCIAL INFORMATION BY GEOGRAPHIC REGION
The following table sets forth passenger revenues, passenger traffic and passenger yield by geographic region for the years ended 31 December 1996 and 1997.
RESULTS OF OPERATIONS
1997 Compared to 1996
The Company's profit attributable to shareholders increased from RMB 590.6 million in 1996 to RMB 635.1 million in 1997, or 8%, reflecting a 18% increase in revenues, offset in part by a 22% increase in operating expenses. The increase in the Company's revenues was attributable to higher passenger revenues resulting from increased passenger traffic on the Company's domestic, Hong Kong and international routes and increased passenger yield on the Company's domestic and Hong Kong routes, as well as higher cargo and mail revenues and other operating revenues. The Company's operating expenses increased in 1997 over 1996, primarily as a result of costs relating to the continued expansion of the Company's fleet, an increase in fuel prices, higher depreciation expenses resulting from the revaluation of the Company's net asset as at 30 June 1996 and certain provision made relating to post-retirement benefits. The Company's operating profit increased from RMB 1,438.8 million in 1996 to RMB 1,443.4 million in 1997, or 0.3%. The Company's net interest expenses declined in 1997 from 1996, which also contributed to the improvement in profit attributable to shareholders.
Revenues
The Company's revenues increased from RMB 7,286.1 million in 1996 to RMB 8,574.0 million in 1997, or 18%. This increase was attributable to increases in passenger revenues, cargo and mail revenues and other operating revenues.
Passenger revenues, which accounted for 80% of the Company's revenues in 1997, increased from RMB 5,894.5 million in 1996 to RMB 6,891.7 million in 1997, or 17%, reflecting increases in domestic revenues as well as Hong Kong and international revenues. Passenger capacity (as measured in ASK) increased by 19%, reflecting primarily the addition of two A340 wide-body jet aircraft and three Boeing MD-90 aircraft in 1997 as well as the full year effect, in 1997, of aircraft acquired in 1996. Despite the high rate of increase in passenger capacity, passenger load factor (passenger-kilometers expressed as a percentage of ASK) declined only slightly, from 65.5% in 1996 to 64.2% in 1997, which reflected a high rate of increase in overall passenger demand. Average daily aircraft utilization increased by 0.5 hours to 7.2 hours per day.
Domestic passenger revenues, which accounted for 41% of the Company's passenger revenues, increased from RMB 2,534.0 million in 1996 to RMB 2,858.1 million in 1997, or 13%, as a result of both higher domestic passenger traffic and yield. Passenger traffic increased by 9% in 1997 over 1996, primarily as a result of a 17% increase in domestic passenger capacity, which was in part attributable to the additional of three new Boeing MD-90 aircraft in 1997, as well as improved passenger demand, reflecting the Company's efforts in market development, route expansion, and exploration of new passenger sources. The Company has been adding capacity to its domestic routes since 1995, in anticipation of increased demand. In 1997, the Company also increased capacity on certain high traffic and high yielding domestic routes by increasing flight frequencies and by utilizing higher capacity aircraft. However, the capacity expansion of China's airline industry has generally outpaced demand in recent years which, coupled with increasing competition, has caused declines in load factors. In 1997, the Company's domestic load factor declined by 4.5 percentage points from 1996. In 1997, domestic passenger yield increased by 5% over the previous year, reflecting the full year effect of increases in domestic airfares effected in the second half of 1996.
Hong Kong passenger revenues, which accounted for 27% of the Company's passenger revenues, increased from RMB 1,658.5 million in 1996 to RMB 1,859.6 million in 1997, or 12%, reflecting increased passenger traffic and yield. Hong Kong passenger traffic increased by 8% in 1997 over that of 1996, which was attributable to a 6% increase in passenger capacity as well as higher passenger demand. The rate of increase in passenger demand surpassed the rate of increase in passenger capacity, causing Hong Kong passenger load factor in 1997 to increase by 1.3 percentage points over 1996, primarily as a result of a high level of passenger demand in the first half of 1997 resulting from increased activity leading up to Hong Kong's return to China. However, the Asian financial crisis in the second half of 1997 had adversely affected the Company's Hong Kong passenger traffic in the second half of 1997. The Company's Hong Kong passenger yield increased by 3% in 1997 over that of 1996, reflecting the full year effect of fare increases effected during the second half of 1996 combined with a lower discount rate. As a result, Hong Kong passenger revenue increased by a greater rate compared to the rate of passenger traffic increase.
International passenger revenues, which accounted for 32% of the Company's passenger revenues, increased significantly from RMB 1,702.0 million in 1996 to RMB 2,174.0 million in 1997, or 28%. The increase was primarily the result of a 29% increase in passenger traffic which, in turn, was attributable to higher passenger demand (including as a result of the full year effect, in 1997, of new routes to Sydney, Munich and Pusan opened in 1996) and a 27% increase in passenger capacity resulting from the addition of two A340 aircraft in 1997 and three A340 aircraft in 1996, which are primarily used for the Company's international routes. The Company also opened a Shanghai-Beijing-San Francisco route in 1997, which also contributed to the growth in international passenger traffic. International passenger load factor increased by 0.9 percentage points in 1997 over 1996. Passenger yield was essentially unchanged. Expansion and optimization of the international route network are important elements in the Company's overall route strategy as international expansion provides additional feeder traffic to the Company's domestic route network. In addition, the expansion of the Company's international operations will also increase the Company's foreign currency income, reducing foreign exchange risks.
The Company generates cargo revenues from the transport of cargo and mail on the Company's Boeing MD-11F aircraft, as well as from the carriage of cargo on passenger aircraft. Revenues from cargo and mail operations, which accounted for 16% of the Company's revenues, increased from RMB 1,109.3 million in 1996 to RMB 1,332.0 million in 1997, or 20%. The increase in cargo revenues was primarily the result of increased cargo traffic which, in turn, was primarily attributable to growth in cargo capacity resulting from the expansion of the Company's passenger fleet and re-opening of cargo routes to the U.S. In 1997, cargo traffic (as measured in cargo tonne - kilometers) increased by 22% from 1996, while cargo capacity (measured by available cargo tonne - kilometers) increased by 24% from 1996. The rate of increase in revenue from cargo and mail operations was less than the rate of cargo traffic increase, as the cargo yield on re-opened long haul routes are generally lower, causing a decrease in overall cargo yield (as measured in cargo revenues per cargo tonne - kilometers).
Other operating revenues, primarily generated from airport ground services, including loading, aircraft cleaning, refueling, unloading and ground transportation of cargo and passenger luggage for airlines operating to or from Shanghai Hong Qiao International Airport ("Hong Qiao Airport"), and ticket handling services, increased from RMB 282.3 million in 1996 to RMB 350.3 million in 1997, or 24%. The Company is currently the principal provider of airport ground services at Hong Qiao Airport. The increase in other operating revenues was primarily due to the increase in revenues generated from airport ground services resulting from an increase in volume of traffic at Hong Qiao Airport.
Operating Expenses
Total operating expenses increased from RMB 5,847.3 million in 1996 to RMB 7,130.6 million in 1997, or 22%. This reflects increases in nearly all categories of operating expenses, resulting principally from higher depreciation and major overhaul costs resulting from the expansion of the Company's fleet in 1996 and 1997, increased fuel prices as a result of an adjustment in domestic fuel prices effected on March 1, 1997, and increase in depreciation expenses resulting from the full year effect, in 1997, of the revaluation of the Company's net assets as at 30 June 1996. In addition, operating expenses in 1997 included a provisional loss amount of RMB 50.0 million made in respect of the Company's contract to dispose of ten Fokker aircraft commencing in 1998, as well as a RMB 120.0 million provision for post-retirement benefits resulting from new IAS requirements. Details of the disposition charge and the disposal of Fokker aircraft are disclosed in Notes 11(b) and 32(a) to the consolidated financial statements, and details of post-retirement benefits are disclosed in Notes 2(d) and 26(b) of the notes to the consolidated financial statements. Operating expenses as a percentage of revenues increased from 80% in 1996 to 83% in 1997.
Interest Expense, Net, and Other Income, Net
Net interest expenses decreased from RMB 884.2 million in 1996 to RMB 784.4 million in 1997, or 11%, primarily due to repayment of debt from the proceeds of the Company's public offerings. Net other income, which includes net foreign exchange gains, decreased from RMB 182.0 million in 1996 to RMB 168.2 million in 1997.
Provision for Taxation
The Company had an effective tax rate of 30.7% in 1997 and 28.4% in 1996. The Company recorded an income tax provision of RMB 292.8 million in 1997, compared with an income tax provision of RMB 239.2 million for 1996. The income tax provision for 1997 consisted of a deferred tax provision of RMB 102.0 million and a current provision of RMB 190.8 million.
LIQUIDITY AND CAPITAL RESOURCES
The Company finances its working capital requirements through a combination of funds generated from operations and short-term bank loans. The Company had cash and cash equivalents at 31 December, 1996 and 1997 of RMB 1,090.0 million and RMB 1,559.6 million, respectively.
Net cash provided by operating activities in 1996 and 1997 were RMB 1,747.2 million and RMB 1,962.6 million, respectively. During the last two years, the Company's primary cash requirements have been for additions of, and advances on, aircraft and flight equipment and payments on related indebtedness. Cash generated from operations has been the principal source for these cash requirements.
Net cash used in investing activities in 1996 and 1997 were RMB 841.8 million and RMB 2,196.2 million, respectively. In 1996 and 1997, advances on aircraft and flight equipment were RMB 725.2 million and RMB 1,443.2 million, respectively, while additions of aircraft and flight equipment were RMB 361.3 million and RMB 1,121.6 million, respectively. The Company funds its additions to aircraft and flight equipment primarily through lease arrangements, bank loans and funds generated from operations.
Net cash provided by financing activities were RMB 738.3 million in 1997. The source of cash from financing activities were primarily proceeds of approximately RMB 2.8 billion (net of issuance expenses) from the Company's public offerings in 1997. See "H share offering and A share offering". Excluding such proceeds, net cash used in financing activities were RMB 1,028.9 million and RMB 2,135.1 million in 1996 and 1997, respectively, and was primarily used for repayments of long-term loans, principal repayments on capital lease obligations, repayments of short term and bank loans.
The Company has generally been able to arrange short-term bank loans with domestic and foreign banks in China as necessary to meet its working capital requirements. The Company believes it can obtain these short-term bank loans when required because of its continuing relationships with various lenders. Short-term loans outstanding totaled RMB 548.3 million at 31 December 1996 and RMB 312.4 million at 31 December 1997, a decrease of 43%. Long-term loans decreased from RMB 5,208.7 million at 31 December 1996 to RMB 3,890.9 million at 31 December 1997, or 25%. The Company expects that cash from operations and short-term bank borrowings will be sufficient to meet its operating cashflow requirements although events that materially affect the Company's operating results could also have a negative impact on liquidity.
The Company's aircraft orders as of 31 December 1997 included commitments to acquire six Boeing MD-90 aircraft to be delivered between 1998 and 1999. The Company's previous commitment to purchase three Airbus A340 aircraft has been cancelled. The Company plans to purchase ten Airbus A320 aircraft, and is currently negotiating such purchase and applying for relevant government approvals. A320 aircraft will be used primarily for the Company's domestic routes, and the revised fleet expansion strategy reflects the Company's plan to continue to expand its domestic operations. In addition, in order to further develop the Company's domestic transportation market and to upgrade the Company's fleet, the Company signed an agreement with Boeing in March 1998 to acquire three Boeing 737-300 aircraft, which are expected to be delivered in July, October and November 1998. Expenditures for these aircraft and related equipment, including deposits, through the year 2000 are expected to total approximately RMB 8,061.2 million, including RMB 2,629.0 million in 1998, RMB 3,196.1 million in 1999 and RMB 2,236.1 million in 2000, in each case subject to contractually stipulated increases related to inflation and any discounts available upon delivery of the aircraft. In addition, the Company expects to expend approximately RMB 609.9 million in 1998 and approximately RMB 810.0 million in 1999 on construction of the Company's airport base at the new Pudong airport, the purchase of maintenance equipment and other property and equipment. The Company plans to finance its aircraft acquisitions and other capital commitments through a combination of funds generated from operations, bank loans, leasing arrangements, the remaining proceeds of its public offerings and other external financing arrangements.
H SHARE OFFERING AND A SHARE OFFERING
In February 1997, the Company completed its initial public offering of 1,566,950,000 H shares and listing of its H shares on the Hong Kong Stock Exchange and American Depositary Shares (ADSs) representing its H shares on the New York Stock Exchange. In addition, in October 1997, the Company completed a public offering of 300,000,000 domestic A shares to public shareholders in China and the listing of its A shares on the Shanghai Stock Exchange. The H shares and A shares held by public shareholders together represented approximately 38.36% of the total issued and outstanding shares of the Company as of 31 December, 1997. Proceeds of approximately RMB 2.8 billion (net of issuance expenses) were received by the Company from such public offerings. A shares are generally identical to H shares in all respects except that the A shares may only be held by PRC domestic investors, and dividends on A shares are payable in Renminbi.
TAXATION
A uniform income tax rate of 33% is generally applicable to all Chinese domestic enterprises, including the Company. See Note 8 of the Notes to the Company's audited consolidated financial statements prepared in accordance with IAS.
SUPPLEMENTARY FINANCIAL INFORMATION
The Company's audited consolidated financial statements are prepared in accordance with IAS, which differs in certain material respects from PRC Accounting Regulations and US GAAP. Supplementary financial information on pages 112 to 115 provide a description of the principal differences between IAS and PRC Accounting Regulations and differences between IAS and US GAAP as they relate to the Company and reconciliation, to respective accounting standards/regulations, of consolidated profit attributable to shareholders for the year ended, and consolidated net assets at, 31 December, 1997.
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