Business Overview 

 

General

 

The Group provides commercial airline services throughout China, Hong Kong and Macau regions, Southeast Asia and other parts of the world. The Group is one of the three largest Chinese airlines and, as of year end 2006, ranked first in terms of passengers carried, number of scheduled flights per week, number of hours flown and size of route network and aircraft fleet. During the three years ended December 31, 2006, the Group’s RPKs increased at a compound annual rate of 36.8%, from 37,196 million in 2004 to 61,923 million in 2005, and to 69,582 million in 2006, while its capacity, measured in terms of ASKs, increased at a compound annual rate of 34.4%, from 53,769 million in 2004 to 88,361 million in 2005, and to 97,059 million in 2006. In 2006, the Group carried 49.21 million passengers and had passenger revenue of RMB 41,549 million (US$5,321 million).

 

The Group conducts a portion of its airline operations through its airline subsidiaries namely Xiamen Airlines, Southern Airlines (Group) Shantou Airlines Company Limited (“Shantou Airlines”), Guangxi Airlines Company Limited (“Guangxi Airlines”), Zhuhai Airlines Company Limited (“Zhuhai Airlines”) and Guizhou Airlines Company Limited (“Guizhou Airlines”) (collectively, the “Airline Subsidiaries”). In 2006, the Airline Subsidiaries carried 12.90 million passengers, had traffic revenue of RMB 8,726 million (US$ 1,118 million) and accounted for 26.2% and 19.4 % of the Group’s passengers carried and traffic revenue, respectively. Guangxi Airlines become a wholly-owned subsidiary of the Group in 2006. All the assets and liabilities of Guangxi Airlines were transferred to the Company on December 31, 2006.

 

The Group also provides air cargo and mail services. The cargo and mail revenue of the Group increased by 14.5% to RMB3,538 million (US$ 453 million) in 2006 as compared with 2005. The Group’s airline operations are fully integrated with its airline-related businesses, including aircraft and engine maintenance, flight simulation and air catering operations.

 

As of the year end 2006, the Group operated 616 routes, of which 501 were domestic, 90 were international and 25 were to/from Hong Kong and Macau. The Group operates the most extensive domestic route network among all Chinese airlines. In 2006, the Group operated an average of 9,308 landings and take-offs per week, serving 152 destinations. Its route network covers commercial centres and rapidly developing economic regions in Mainland China.

 

The Group’s corporate headquarters and principal base of operations are located in Guangzhou, the capital of Guangdong Province and the largest city in southern China. Located in the rapidly developing Pearl River Delta region, Guangzhou is also the transportation hub of southern China and one of China’s major gateway cities. Guangzhou’s significance has increased as the transportation infrastructure of Guangdong Province has developed through the construction and development of expressways, an extensive rail network and the port cities of Yantian, Shekou, Chiwan, Mawan, Huangpu and Zhuhai.

In December 2005, the Company established a branch company in Beijing and has added wide-body airplanes to its operation base in Beijing, with the view to expanding its Beijing aviation business and building another main hub there in addition to its Guangzhou base. The establishment of Guangzhou and Beijing hubs will facilitate strategic refinement and enhancement of its route network operations putting the Company in a better position to explore and seize the opportunities in the regional aviation market expected to be brought about by the 2008 Beijing Olympic Games.

In 2006, the Comapny expedited the pace of its expansion into the international market by entering into an operation agreement to join the SkyTeam Alliance, a strategic partnership with foreign airlines. The Company broadened its global market coverage and successfully added 18 new international routes, including Lagos and Tehran, and nine international destinations.

 

The Group’s operations primarily focus on the domestic market. In addition, the Group also operates Hong Kong and Macau and international flights. As of year end of 2006, the Group had 25 Hong Kong and Macau routes and 90 international routes. The Group’s Hong Kong and Macau operations include flights between destinations in China and Hong Kong and Macau.

 

As of December 31, 2006, the Group operated a fleet of 309 aircraft, consisting primarily of Boeing 737 series, 747, 757, 777, Airbus 300, 319, 320, 330, McDonnell Douglas 82, 90. The average age of the Group’s fleet was 6.37 years as of the year end of 2006.

 

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Restructuring and Initial Public Offering

 

As part of China’s economic reforms in the 1980’s, the PRC State Council directed the CAAC to separate its governmental, administrative and regulatory role from the commercial airline operations that were being conducted by the CAAC and its regional administrators. As a result, CSAHC was established on January 26, 1991 for the purpose of assuming the airline and airline-related commercial operations of the Guangzhou Civil Aviation Administration, one of the six regional bureaus of the CAAC. CSAHC was one of the 55 large-scale enterprises designated by the Chinese Government to play a leading role in their respective industries.

 

CSAHC was restructured in 1994 and 1995 in anticipation of the initial public offering of the Company. The restructuring was effected through the establishment of the Company and the execution of the Demerger Agreement, dated as of March 25, 1995, as amended (the “Demerger Agreement”), between CSAHC and the Company. Upon the restructuring, the Company assumed substantially all of the airline and airline-related businesses, assets and liabilities of CSAHC, and CSAHC retained its non-airline-related businesses, assets and liabilities. Upon this separation, all interests, rights, duties and obligations of CSAHC, whenever created or accrued, were divided between the Company and CSAHC based on the businesses, assets and liabilities assumed by each of them under the Demerger Agreement. Under the Demerger Agreement, CSAHC agreed not to conduct or participate or hold any interest in, either directly or indirectly, any business, activity or entity in or outside China that competes or is likely to compete with the commercial interests of the Group, although CSAHC may continue to hold and control the affiliates of CSAHC existing on the date of the Demerger Agreement and may continue to operate the businesses of such affiliates.

 

In July 1997, the Company completed a private placement of 32,200,000 H Shares to certain limited partnership investment funds affiliated with Goldman Sachs & Co. and an initial public offering of 1,141,978,000 H Shares, par value RMB 1.00 per share, and listing of the H Shares on The Stock Exchange of Hong Kong Limited (the “Hong Kong Stock Exchange”) and American Depositary Shares (“ADSs”, each ADS representing 50 H Shares) on the New York Stock Exchange. Prior to the private placement and the initial public offering, all of the issued and outstanding shares of capital stock of the Company, consisting of 2,200,000,000 Domestic Shares, par value RMB 1.00 per share, were owned by CSAHC, which owns and exercises, on behalf of the Chinese Government and under the supervision of the CAAC, the rights of ownership of the Domestic Shares held by CSAHC. After giving effect to the private placement and the initial public offering, CSAHC’s continued ownership of the 2,200,000,000 Domestic Shares, represented approximately 65.2% of the total share capital of the Company, and will be entitled to elect all the directors of the Company and to control the management and policies of the Group. Domestic Shares and H Shares are both ordinary shares of the Company.

 

Pursuant to an extraordinary general meeting of shareholders held on May 21, 2002, a resolution was passed authorizing the Company to issue not more than 1,000,000,000 A Shares of par value of RMB1.00 each. The Company issued 1,000,000,000 A Shares with a par value of RMB1.00 each in July 2003 and listed these shares on the Shanghai Stock Exchange. Subsequent to the A Share issue, the shareholding of CSAHC on the Company was reduced from 65.2% to 50.3%.

 

Share Reform Plan

 

Pursuant to the regulations including the "Guidelines of the State Council for Promoting the Reform and Opening-up and Sustained Development of the Capital Market" promulgated by the State Council of the PRC and the "Guiding Opinions on the State Share Reform of the Listed Companies" jointly promulgated by the China Securities Regulatory Commission (“CSRC”), the State-owned Assets Supervision and Administration Commission of the State Council, the Ministry of Finance, People's Bank of China and the Ministry of Commerce, and pursuant to the operating procedures of share reform proposals, the Company announced the Share Reform Plan (“Plan”) on April 13, 2007 which was subsequently amended on April 23, 2007. Under the Plan, all the 2,200,000,000 non-tradable domestic shares held by CSAHC will be converted into tradable A shares 36 months after the commencement date of the Plan. In return, CSAHC will grant 1,400,000,000 put options to those holders of tradable A shares who are listed in the Shareholders’ register on the record date which is May 8, 2007, which will be equivalent to 1.5970 shares for every 10 A shares held by the holders of tradable A shares. The rights under the put options as referred above will be automatically exercised in a European way on the expiring date in that the exercise ratio will be 2 to 1 (i.e., the value of the exercise ratio is 0.5), the effective period will be 12 months period, the initial exercise price will be RMB7.43, and the put options will be paid in cash. The share reform plan was approved in the relevant shareholder’s meeting held on May 17, 2007.

 

Traffic

 

The following table sets forth certain statistical information with respect to the Group’s passenger, cargo and mail traffic for the years indicated.

 

		Passenger carried						Cargo and Mail Carried (tons)						Total traffic (tons kilometers)
					Increase						Increase						Increase
					(decrease)						(decrease)						(decrease)
					over						over						over
		Total			previous year			Total			previous year			Total			previous year
Year		(in million)			(%)			(in thousand)			(%)			(in million)			(%)
2002			21.49			12.4			470.0			18.1			3,614.0			19.1
2003			20.47			(4.7	)		464.0			(1.3	)		3,561.0			(1.5	)
2004			28.21			37.8			545.0			17.5			4,663.0			30.9
2005			44.12			56.4			775.0			42.2			7,284.0			56.2
2006			49.21			11.6			819.0			5.4			8,071.0			10.8

 

 

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Route Network

 

Overview

 

The Group operates the most extensive route network among the Chinese airlines. As of December 31, 2006, the Group operated 616 routes consisting of 501 domestic routes, 25 Hong Kong and Macau routes and 90 international routes. In 2006, the Group conducted an average of 9,308 landings and take-offs per week, serving 152 destinations.

 

The Group continually evaluates its network of domestic, Hong Kong and Macau and international routes in light of its operating profitability and efficiency. The Group seeks to coordinate flight schedules with the Airline Subsidiaries on shared routes to maximize load factors and utilization rates. The acquisition of domestic, Hong Kong and Macau and international routes is subject to approval of the CAAC, and the acquisition of Hong Kong and Macau and international routes is also subject to the existence and the terms of agreements between the Chinese Government and the government of the Hong Kong SAR, the government of Macau Special Administrative Region of the People’s Republic of China (“Macau SAR”) and the government of the proposed foreign destination.

 

In order to expand the Group’s international route network, the Group has entered into code-sharing agreements with several international airlines, including Delta Airlines, Asiana Airlines, Japan Air System, Vietnam Airlines, Royal Dutch Airlines and Garuda Indonesian. Under the code sharing agreements, the participating airlines are permitted to sell tickets on certain international routes operated by the Group to passengers using the Group’s codes. Similarly, the Group is permitted to sell tickets for the other participating airlines using its “CZ” code. The code sharing agreements help increase the number of the Group’s international sales outlets.

 

Route Bases

 

In addition to its main route bases in Guangzhou and Beijing, the Group maintains certain regional route bases in Zhengzhou, Wuhan, Changsha, Shenzhen, Shenyang, Changchun, Dalian, Harbin, Urumqi, Haikou, Zhuhai, Xiamen, Fuzhou, Nanning, Guilin, Shantou, Guiyang, Sanya and Beihai. Most of its regional route bases are located in provincial capitals or major commercial centres in the PRC.

 

The Group believes that its extensive network of route bases enable it to coordinate flights and deploy its aircraft more effectively and to provide more convenient connecting flight schedules and access service and maintenance facilities for its aircraft. The Group believes that the number and location of these route bases may enhance the Group’s ability to obtain the CAAC’s approval of requests by the Group to open new routes and provide additional flights between these bases and other destinations in China. Current regulations of the CAAC generally limit airlines to operations principally conducted from their respective route bases.

 

Domestic Routes

 

The Group’s domestic routes network serves substantially all provinces and autonomous regions in China, including Guangdong, Fujian, Hubei, Hunan, Hainan, Guangxi, Guizhou, Henan, Heilongjiang, Jilin, Liaoning and Xinjiang, and serves all four centrally-administered municipalities in China, namely, Beijing, Shanghai, Tianjin, and Chongqing. In 2006, the Group’s most profitable domestic routes were between: Guangzhou and Beijing, Guangzhou and Shanghai, Shanghai and Guangzhou, Beijing and Guangzhou, Shenzhen and Beijing, Shenzhen and Shanghai, Urumqi and Beijing, Beijing and Shenzhen, Beijing and Urumqi, and Beijing and Dalian.

 

Hong Kong and Macau Routes

The Group offers scheduled service between Hong Kong and Guangzhou, Kunming, Xiamen, Shantou, Beijing, Guilin, Meixian, Haikou, Wuhan, Zhengzhou, Nanning, Changsha, Quanzhou and Sanya; and between Macau and Fuzhou, Hangzhou and Xiamen. The Group’s Hong Kong and Macau regional routes also include routes between Hong Kong and Zhanjiang and Macau and other destinations in China, including Zhang Jia Jie and Wu Yi Shan, which the Group operates on a “charter” flight basis, as explained below. The Group believes that the routes on which it operates these “charter” flights are among its highest yielding routes, primarily because the Group faces limited competition on such routes and is consequently less subject to downward pricing pressures. In 2006, the most profitable Hong Kong and Macau routes (other than these “charter” flights) were between: Hong Kong and Wuhan, Hong Kong and Guangzhou, Guangzhou and Hong Kong, Hong Kong and Beijing, Wuhan and Hong Kong and Hong Kong and Shantou.

 

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The Group’s “charter” flights are regularly scheduled flights, but permission to operate these flights is subject to monthly review by the CAAC and the Civil Aviation Department of the Hong Kong SAR. The CAAC has informally indicated that it primarily considers market demand and airline capability in granting permission for such flights. The Group has been able to maintain all of the Hong Kong regional routes which it operates on a “charter” flight basis and believes that demand on such routes will continue. In 2006, the Group conducted a total of 16,949 flights on its Hong Kong and Macau routes, accounting for approximately 28.8% of all passengers carried by Chinese airlines on routes between Hong Kong or Macau and destinations in China.

 

International Routes

 

The Group is the principal Chinese airline connecting the rapidly developing Pearl River Delta region of China to Southeast Asia, with 23 routes serving 11 Southeast Asian destinations, including Singapore and major cities in Indonesia, Thailand, Malaysia, the Philippines, Vietnam and Cambodia. In 2006, the Group’s most profitable international routes were: Shenyang-Seoul, Guangzhou-Tokyo, Seoul-Dalian, Guangzhou-Los Angeles. The Group believes that, among Chinese airlines, it is well-positioned to benefit from the business opportunities arising out of increased air traffic and the growing economic relationships between China and Southeast Asian countries.

 

In addition to the 23 routes serving 11 Southeast Asian destinations, the Group operates 67 other international routes providing scheduled services to Almaty, Amsterdam, Baku, Bishkek, Cheju, Cheong Ju City, Dubai, Dushanbe, Fukuoka, Hiroshima, Islamabad, Irkutsk, Khabarovsk, Kita Kyushu, Kwangju, Lagos, Los Angeles, Melbourne, Moscow, Nagoya, Nigata, Novosibirsk, Osaka, Paris, Pusan, Pyongyang, Sapporo, Sendai, Seoul, Sharjah, Sydney, Taegu, Tashkent, Teheran, Tokyo and Toyama.

 

Aircraft Fleet

 

The Group’s fleet plan in recent years has emphasized expansion and modernization through the acquisition of new aircraft, the acquisition of existing aircraft in conjunction with our acquisition of CNA and XJA, and the retirement of less efficient, older aircraft. As of December 31, 2006, the Group operated a fleet of 309 aircraft with an average age of 6.37 years. Most aircraft of the Group are Boeing and Airbus aircraft. The Group has the largest fleet among Chinese airline companies. Most of the aircraft operated by the Group are leased pursuant to various types of leasing arrangements.

 

The following table sets forth certain information regarding the Group’s fleet of 309 aircraft as of December 31, 2006.

 

Model		Number of Aircraft			Average age (years)			Average Passenger Capacity
Boeing 777-200			4			10.53			380
Boeing 777-21B			6			8.20			292
Boeing 757-200			34			11.58			200
Boeing 747F			2			4.42			n/a
Boeing 737-800			38			2.86			167
Boeing 737-700			38			3.01			138
Boeing 737-500			8			12.57			130
Boeing 737-300			29			12.72			145
Airbus 300-600			6			11.96			272
Airbus 319-100			27			1.66			128
Airbus 320-200			49			4.09			158
Airbus 321-200			17			2.24			182
Airbus 330-200			4			1.72			264
McDonnell Douglas 82			23			21.54			144
McDonnell Douglas 90			13			8.85			157
Embraer 145 Jet			6			2.23			50
ATR-72			5			8.95			72
			309

 

During 2006, the Group continued to expand and modernize its aircraft fleet. The Group’s major aircraft transactions included:

In 2006, the Company exercised purchase options of ten Boeing 737-300, three McDonnell Douglas 90, seven McDonnell Douglas 82 and three Airbus 300-600 upon expiry of the respective lease terms.

 

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Six Airbus 319-100, ten Airbus 320-200, seven Airbus 321-200, five Boeing 737-700, ninteen 737-800 aircraft were acquired under operating lease, and two Boeing 737-300, nine Boeing 737-500, one Boeing 757-200 aircraft under operating lease were returned during 2006. In addition, nine Airbus 320-200, four Boeing 737-700 and four Boeing 737-800 aircraft acquired in 2006 were financed by a combination of internal funds, long-term bank loans and finance lease agreements.

 

On April 30, 2006, the Company acquired one McDonnell Douglas 82 aircraft through the acquisition of the assets from CSAHC Hainan, originally operated by the Company under a wet lease agreement. The wet lease agreement was discontinued on April 30, 2006.

In August 2006, the Group exercised its option to change an order from three Boeing 787 aircraft to six Boeing 737-700 aircraft in respect of an agreement signed on August 8, 2005.

 

In July 2006, the Company entered into a purchase agreement with Airbus SNC to acquire ten Airbus 319-100, fifteen Airbus 320-200 and twenty-five Airbus 321-200 aircraft, scheduled for deliveries in 2009 to 2010.

 

In October 2006, the Company executed the Boeing Aircraft Acquisition Agreement for the purchase of six Boeing 777F freighters. The freighters will be delivered in stages to the Company in 2008 to 2010.

 

In October 2006, the Group executed the Boeing Aircraft Acquisition Agreement for the purchase of six Boeing 737-800 aircraft, scheduled for deliveries in 2010.

In 2006, the Company disposed of three Boeing 757-200 and three Cessna 208B aircraft.

 

Aircraft Financing Arrangements

 

Overview 

 

A significant portion of the Group’s aircraft is acquired under long-term capital or operating leases or long-term mortgage loans with remaining terms to maturity ranging from one to twelve years. As of December 31, 2006, 81 of the Group’s 309 aircraft were operated under capital leases, 123 were operated under operating leases, 19 were financed by long-term mortgage loans, while the remaining were acquired either with cash proceeds or acquired by exercising the purchase options upon expiry of the respective capital leases. The Group’s planned acquisition of aircraft in the foreseeable future will generally be made pursuant to operating leases or capital leases. The Group’s determination as to its acquisition strategy depends on the Group’s evaluation at the time of its capacity requirements, anticipated deliveries of aircraft, the Group’s capital structure and cash flow, prevailing interest rates and other general market conditions.

 

The following table sets forth, as of December 31, 2006, the number of aircraft operated by the Group pursuant to capital and operating leases and the remaining terms, expressed in years, of such leases.

 

Model		Capital Lease			Operating Lease			Average Remaining Lease Term
Boeing 777-200 and 777-21B			6			4			3.48
Boeing 757-200			2			14			2.29
Boeing 737-700			11			15			6.37
Boeing 737-800			—			22			7.45
Boeing 737-500			—			8			1.81
Boeing 737-300			5			8			1.31
Airbus 300-600			—			3			0.77
Airbus 319-100			6			21			8.42
Airbus 320-200			33			16			6.16
Airbus 321-100			6			7			9.47
Airbus 330-200			4			—			10.28
McDonnell Douglas 82			—			5			—
McDonnell Douglas 90			8			—			1.09
			81			123

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Capital Leases 

 

As of December 31, 2006, the Group’s aggregate future minimum lease payments (including future finance charges) required under its capital leases were RMB 18,403 million (US$ 2,357 million). As of year end 2006, a majority of the Group’s capital leases had original terms ranging from ten to fifteen years from the date of delivery of the relevant aircraft, and the remaining terms of these leases ranged from one to ten years. The Group’s capital leases typically cover a significant portion of the relevant aircraft’s useful life and transfer the benefits and risks of ownership to the Group. Under its capital leases, the Group generally has an option to purchase the aircraft at or near the end of the lease term. As is customary in the case of capital leases, the Group’s obligations are secured by the related aircraft, as well as other collateral.

 

Operating Leases 

 

As of December 31, 2006, the Group’s aggregate future minimum lease payments required under its operating leases were RMB 21,969 million (US$ 2,813 million). As of year end 2006, the Group’s operating leases had original terms generally ranging from five to fifteen years from the date of delivery of the relevant aircraft, and the remaining terms of these leases generally ranged from one to twelve years. Pursuant to the terms of the operating leases, the Group is obligated to make rental payments based on the lease term, with no termination payment obligations or purchase option, and the lessor bears the economic benefits and risks of ownership. Under its operating leases, the Group has no option to purchase the aircraft and is required to return the aircraft in the agreed condition at the end of the lease term. Although title to the aircraft remains with the lessor, the Group is responsible during the lease term for the maintenance, servicing, insurance, repair and overhaul of the aircraft.

 

Pursuant to capital or operating leases, the Group is obligated to indemnify the lessors against any withholding or similar taxes that may be imposed on the lessors by taxing authorities in China with regard to payments made pursuant to such leases. In accordance with relevant PRC tax regulations, a PRC lessee is liable to pay PRC withholding tax in respect of any lease payments regularly made to an overseas lessor. Depending on the circumstances, this tax is generally imposed at a fixed rate ranging from 10% to 20% of the lease payments, or in certain cases, the interest components of such payments. Pursuant to an approval document from the State Taxation Bureau, lease arrangements executed prior to September 1, 1999 are exempt from PRC withholding tax. The PRC withholding tax payable in respect of the operating leases executed after September 1, 1999 of RMB23 million, RMB55 million and RMB60 million during 2004, 2005 and 2006 respectively, have been included as part of the operating lease charges.

 

Aircraft Flight Equipment

 

The jet engines used in the Group’s aircraft fleet are manufactured by General Electric Corporation, Rolls-Royce plc, United Technologies International, Inc., CFM International, Inc. and International Aviation Engines Corporation. As of year end 2006, the Group had 69 spare jet engines for its fleet. The Group determines its requirements for jet engines based on all relevant considerations, including manufacturers’ recommendations, the performance history of the jet engines and the planned utilization of its aircraft. Acquisition of rotables and certain of the expendables for the Group’s aircraft are generally handled by Southern Airlines (Group) Import & Export Trading Corporation (“SAIETC”), a subsidiary of CSAHC acting as agent for the Group, in consideration of an agency fee. The Group arranges the ordering of aircraft, jet engines and other flight equipment for the Airline Subsidiaries and keeps an inventory of rotables and expendables for the Airline Subsidiaries.

 

Aircraft Maintenance

 

A major part of the maintenance for the Group’s fleet other than overhauls of jet engines is performed by GAMECO, a jointly controlled entity established by the Company, Hutchison Whampoa (“Hutchison”) and South China International Aircraft Engineering Company Limited, consistent with the Group’s strategy to achieve fully integrated airline operations and to assure continued access to a stable source of high quality maintenance services. The remaining part of the maintenance for the Group’s fleet other than overhauls of jet engines is performed by service providers in China and overseas. GAMECO performs all types of maintenance services, ranging from maintenance inspections performed on aircraft before, after and between flights (“line maintenance services”) to major overhaul performed at specified intervals. GAMECO was the first of three aircraft maintenance facilities in China having been certified as a repair station by both the CAAC and the FAA. In March 1998, GAMECO received an approval certificate from the United Kingdom Civil Aviation Authority for the repair and maintenance of aircraft and aircraft engines.

 

The Group believes that GAMECO performs major maintenance checks on the Group’s aircraft within time periods generally consistent with those of large international airline maintenance centers. GAMECO’s repair and maintenance capabilities include overhaul of more than 90% of the Group’s aircraft. Although rotables for the Group’s aircraft are generally imported through SAIETC, a portion of expendables and other maintenance materials are directly imported by GAMECO. GAMECO also provides line maintenance services to eight other Chinese airlines and 17 international airlines. GAMECO provides heavy maintenance services to four other Chinese airlines and nine international airlines.

 

The Company and GAMECO had entered into an Aircraft Maintenance and Engineering Agreement for the provision of aircraft repair and maintenance services. On May 17, 1996, the Company and GAMECO entered into an agreement regarding the fee arrangement for the provision of such repair and maintenance services (the “Fee Agreement”). Pursuant to the Fee Agreement and subsequent agreements, GAMECO charged the Company for expendables at cost plus 16%, and labour costs at US$30 per hour during 2006. For the year ended December 31, 2006, the amount incurred by the Group for such repair and maintenance services was RMB 686 million.

 

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Overhauls of jet engines are performed by MTU Maintenance Zhuhai Co., Ltd., (“MTU Zhuhai”), a jointly controlled entity of the Company and MTU Aero Engines Gmbh, and also by overseas qualified service providers in Germany, Malaysia, Canada and England. For the year ended December 31, 2006, repair fees amounting to RMB497 million were paid to MTU Zhuhai.

 

Safety

 

The Group endeavors to maintain strict compliance with all laws and regulations applicable to flight safety. In addition, the Group has adopted measures to eliminate or minimize factors that may impair flight safety, including specialized training programs and safety manuals. The Air Safety Management Department of the Company implements safety-related training programs on an ongoing basis in all of the Group’s operations to raise the safety awareness of all employees. As a result, overall flight safety has gradually improved. There were no serious incidents involving casualty or flight damage throughout the three years ended December 31, 2006. For minor “incidents” which include various events and conditions prescribed by the CAAC which do not involve serious personal injury or material damage to flight equipment, the Group has kept the number consistently below the standard prescribed by the CAAC. For example, the Company’s “flight incident” ratio was 0.13, 0.13 and 0.065 in 2004, 2005 and 2006, respectively. In comparison, CAAC’s published maximum acceptable flight incident ratio was 0.9 in 2004 and 0.29 in 2005 and 0.7 in 2006. This ratio is defined as the occurrence of one incident for every 10,000 hours of flight time.

 

Jet Fuel

 

Jet fuel costs typically represent a major component of an airline’s operating expenses. The Group’s jet fuel costs for 2006 accounted for 35.2% of the Group’s operating expenses. Like all Chinese airlines, the Group is generally required by the Chinese Government to purchase its jet fuel requirements from regional branches of CAOSC and Bluesky Oil Supplies Company, except at the Shenzhen, Zhuhai and Sanya airports which are supplied by Sino-foreign joint ventures in which CAOSC is a joint venture partner. CAOSC is a State-owned organization controlled and supervised by the CAAC that controls the importation and distribution of jet fuel throughout China.

 

Jet fuel obtained from CAOSC’s regional branches is purchased at uniform prices throughout China that are determined and adjusted by CAOSC from time to time with the approval of the CAAC and the pricing department of the National Development and Reform Commission (“NDRC”) based on market conditions and other factors. As a result, the costs of transportation and storage of jet fuel in all regions of China are spread among all domestic airlines. Jet fuel costs in China are influenced by costs at State-owned oil refineries and limitations in the transportation infrastructure, as well as by insufficient storage facilities for jet fuel in certain regions of China.

 

Prior to 1994, domestic jet fuel prices were generally below international jet fuel prices. The Chinese Government had gradually increased domestic jet fuel prices in order to reflect more accurately the costs of supplying jet fuel in China. As a result, domestic jet fuel prices have become higher than those in the international market since the beginning of 1994.

 

CAOSC’s maximum fuel price in 2006 was RMB6,850 per ton. The average price paid by the Group in 2006 was RMB 5,838 per ton, which represents a 20.5% increase from that of 2005.

 

According to the Notice of the National Development and Reform Commission (“NDRC”) and the Civil Aviation Administration of China (“CAAC”) on Issues Relating to Introduction of the Fuel Surcharge for Domestic Routes, domestic airlines imposed fuel surcharges for all the domestic routes (excluding those from the mainland PRC to Hong Kong and Macau) with effect from August 1, 2005 (based on flight time). On February 16, 2006, the NDRC and CAAC released a supplementary document on Issues Relating to the Introduction of Fuel Surcharge for Domestic Routes, stating that due to the rising jet fuel price, the period of imposition of fuel surcharge by airlines was extended. The NDRC and CAAC released separate supplementary documents on Issues Relating to the Introduction of Fuel Surcharge for Domestic Routes on March 28 and September 1, respectively, thereby adjusting the amount of fuel surcharges in a range of RMB20 to RMB60 per passenger for distance, flown less than 800 kilometers, and in a range of RMB40 to RMB100 for distance, exceeding 800 kilometers, during the period temporarily from April 10, 2006 to October 10, 2006. On January 21, 2007, the NDRC and CAAC released additional supplementary documents on Issues Relating to the Introduction of Fuel Surcharge for Domestic Routes, thereby adjusting the amount of fuel surcharges from RMB60 to RMB50 per passenger for distance, flown less than 800 kilometers, and from RMB100 to RMB80 for distance exceeding 800 kilometers.The introduction of fuel surcharge, and the extension of the duration of the same will help relieve, to a certain extent, the burden of high jet fuel cost, on the Group.

 

In addition to purchases of jet fuel from CAOSC, the Group is also permitted by the Chinese Government to purchase a portion of its jet fuel requirements for its international flights from foreign fuel suppliers located outside China at prevailing international market prices. Jet fuel purchased from such sources outside China accounted for approximately 20% of the Group’s total jet fuel consumption in 2006.

 

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Flight Operations

 

Flight operations for the Group’s flights originating in Guangzhou are managed by the Company’s flight operations and marketing divisions, which are responsible for formulating flight plans and schedules consistent with route and flight approvals received from the CAAC. The Company’s flight operations center in Guangzhou is responsible for the on-site administration of flights, including the dispatch and coordination of flights, deployment of aircraft, ground services and crew staffing. In addition, each of the Airline Subsidiaries maintains flight operations centers at all servicing airports for on-site administration of their flights. The Company’s general dispatch offices are responsible for monitoring conditions on the Group’s route network, administering the Group’s flight plans, collecting and monitoring navigation data and analyzing and monitoring airport conditions.

 

To enhance its management of flight operations, the Group’s computerized flight operations control system (SOC) began operation in May 1999. The system utilizes advanced computer and telecommunications technology to manage the Group’s flights on a centralized, real-time basis. The Group believes that the system will assist it to (i) compile flight schedules more efficiently; (ii) increase the utilization of aircraft; (iii) allow real-time tracking of all of the Group’s flights; and (iv) improve coordination of the Group’s aircraft maintenance and ground servicing functions.

 

Training of Pilots and Flight Attendants

 

The Group believes that its pilot training program which was established in cooperation with the CAAC affiliated Beijing Aeronautics and Aviation University (the “BAAU”) has significantly improved the quality of the training received by the Group’s pilots and has helped maintain the quality of the Group’s staff of pilots at a level consistent with the expansion of operations called for by the Group’s business strategy.

 

In the Group’s pilot training program, trainees have two years of theoretical training at the BAAU. After successful completion of academic and physical examinations, the trainees receive flight training for a period of approximately 20 months at China Southern West Australian Flying College Pty Ltd. (the “Australian Pilot College”), a company that is 65% owned by the Company and 35% owned by CSAHC. Each trainee at the Australian Pilot College is required to fly at least 230 hours before being awarded a flight certificate. Graduates of the BAAU and the Australian Pilot College are hired by the Group as trainee pilots after passing a CAAC-administered examination to obtain a pilot license. The total training period for the Group’s trainee pilots is approximately five years. About 110 trainee pilots graduated from the Australian Pilot College each year.

As part of the pilot training program, trainee pilots receive their initial training in the operation of a specific aircraft with Zhuhai Xiang Yi Aviation Technology Company Limited (“Zhuhai Xiang Yi), a jointly controlled entity between the Company and CAE International Holdings Limited, which also provides training to pilots from other Chinese airlines. Zhuhai Xiang Yi is equipped with simulators for all models of aircraft currently operated by the Group and provides flight simulation training services to the Group.

 

The Group’s pilots are required to be licensed by the CAAC, which requires an annual recertification examination. The Group’s pilots attend courses in simulator training twice annually and in simulator emergency procedures annually. The Group also conducts regular advanced training courses for captains and captain candidates. Pilots advance in rank based on number of hours flown, types of aircraft flown and their performance history.

 

The Group conducts theoretical and practical training programs for its flight attendants at its Flight Attendants Training Center in Guangzhou (the “Guangzhou Training Center”). The Guangzhou Training Center is equipped with computerized training equipment, as well as simulator cabins for all models of aircraft currently operated by the Group. At the Guangzhou Training Center, flight attendants of the Group receive comprehensive training in areas such as in-flight service, emergency evacuation and water rescue.

 

Ground Services

 

The Group makes arrangements with airport authorities, other airlines or ground services companies for substantially all ground facilities, including jet-ways, waiting areas, ticket counters and support services buildings, at each airport that it serves. The Group pays landing, parking and other fees to such airports, including Guangzhou Baiyun Airport. At domestic airports, such fees are generally determined by the CAAC.

 

At Guangzhou Baiyun Airport, the Group operates its own passenger check-in, cargo, mail and baggage handling, aircraft maintenance and cleaning services. The Group also provides such services to other airlines that operate in Guangzhou Baiyun Airport.

 

Ground services at the airports in Shenzhen, Changsha, Wuhan, Zhengzhou, Haikou, Zhuhai, Xiamen, Fuzhou, Guilin, Shantou, Guiyang and Beihai are primarily operated directly by the Group. Ground services at the airport in Beijing are primarily provided by Beijing Southern Airlines Ground Services Company Limited, a jointly controlled entity between the Company and Beijing Aviation Ground Services Co. Ltd., since April 2004. Ground services at other airports in China are provided to the Group by local airport authorities or local airlines pursuant to various service agreements. Ground services and other services at airports outside China are provided to the Group by foreign services providers pursuant to various service agreements with such parties. All such agreements of the Group are short-term and otherwise on terms that are customary in the industry.

 

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Air Catering

 

The Company owns a 75% equity interest in Guangzhou Nanland Air Catering Company Limited (“Nanland”). Nanland provides in-flight meals, snacks, drinks and related services for all of the Group’s flights originating in Guangzhou and substantially all other flights departing from Guangzhou Baiyun Airport. The Group contracts with various air catering suppliers with respect to in-flight catering services for flights originating from other airports, generally on an annual basis and otherwise on terms that are customary in the industry.

 

Cargo and Mail

The Group also provides air cargo and mail services. A significant portion of these services are combined with passenger flights services. Currently, the Group has two Boeing 747-400 freighters mainly servicing four international cargo routes, Shenzhen to Shanghai to Anchorage to Chicago, Shenzhen to Anchorage to Chicago, Shanghai to Anchorage to Chicago and Shenzhen to Shanghai to Amsterdam.

 

Currently, the Group conducts its cargo business primarily through its cargo division in Shenzhen.

 

Sales, Reservations and Marketing

 

 Passenger Ticket Sales and Reservations 

 

The Group’s ticket sales and reservations are conducted by or through independent sales agents and the Group’s own network of exclusive sales offices as well as the CAAC’s sales offices and CSAHC’s affiliates. The Group has sales offices in Guangzhou and its other route bases. In addition, the Group maintains regional sales offices in other cities in China, including Beijing and Shanghai. The Group maintains international sales offices in Almaty, Amsterdam, Baku, Bangkok, Bishkek, Cheju, Cheong Ju City, Daejeon, Dubai, Dushanbe, Fukuoka, Hanoi, Hiroshima, Ho Chi Minh City, Islamabad, Irkutsk, Jakarta, Khabarovsk, Kita Kyushu, Kuala Lumpur, Kwangju, Lagos, Los Angeles, Manila, Melbourne, Moscow, Nagoya, Nigata, Novosibirsk, Osaka, Paris, Penang, Phnom Penh, Pusan, Pyongyang, Sapporo, Sendai, Seoul, Sharjah, Singapore, Sydney, Taegu, Tashkent, Teheran, Tokyo, Toyama and Vladivostok.

 

In Hong Kong, ticket sales and reservations services are provided to the Group by China National Aviation Corporation and Nanlung Travel Agency Limited (a subsidiary of CSAHC) for a commission of 6% of the ticket price. The Group also has agency agreements with airlines in the Asia-Pacific region, Europe, the United States and Africa for the processing of ticket sales and reservations on a reciprocal basis. In 2006, approximately 30% of all ticket sales for the Group’s scheduled flights were made by the Group’s and CAAC’s network of sales offices and CSAHC’s affiliates. The Group also sells tickets and accepts reservations through an extensive network of non-exclusive independent sales agents, substantially all of whom operate in cities throughout China, with the remainder operating principally in Hong Kong and other Southeast Asian destinations served by the Group. Under the agency agreements with these sales agents, the Group pays commissions based on the value of tickets sold. The Group pays independent sales agents in China a commission of 1.5%-9.0% of the ticket price, and pays independent sales agents outside China a commission ranging from 3% - 9% of the ticket price. Sales agents are typically permitted to withhold their commission from the proceeds of ticket sales that are remitted to the Group. In 2006, independent sales agents accounted for approximately 70% of the Group’s ticket sales for its scheduled flights.

 

Substantially all of the Group’s sales offices and agents in China are linked electronically to the CAAC’s computerized ticketing and reservations system, which is in turn linked to all domestic airlines for flights throughout China. The Group has also entered into membership agreements with several international reservation systems, including ABACUS in Southeast Asia, SABRE and GALILEO in the United States, AMADEUS in Europe and INFINI in Japan. These systems facilitate reservations and sales of tickets for the Group’s international flights.

 

 Cargo 

 

The Group’s cargo and mail services are promoted through its own cargo divisions and independent cargo agents both within and outside China that track available space among all airlines. In particular, the Group employs a number of cargo agents in the Pearl River delta region. The Group generally pays such agents a commission of 4% - 5% of the relevant cargo freight rate for domestic and international services.

 

 Promotional and Marketing Activities 

 

The Group engages in regular promotional and marketing activities in an effort to increase its market share. The Group’s promotional and marketing activities for domestic routes emphasize safety, passenger comfort and the frequency of the Group’s flights. The Group’s promotional and marketing activities for international and Hong Kong and Macau regional passengers emphasize the Group’s quality of service, extensive route network in China and greater frequency of flights relative to other Chinese airlines. In addition, the Group also promotes and markets its Hong Kong and Macau regional and international routes on the basis of price.

 

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The Group has been seeking to increase its name recognition by offering new services to passengers. For example, the Group was the first Chinese airline to provide off-airport check-in services. The Group also offers transfer and baggage “through-handling” services to passengers connecting to other airlines, including passengers connecting in Hong Kong for flights to Taiwan.

 

To enhance relationships with its passengers, the Group has launched two frequent flyer programs, namely the “China Southern Airlines Sky Pearl Club”, and the “Egret Mileage Plus”. By the end of 2006, the Group had approximately 4,608,000 members under these programs.

 

Regulation

 

The Chinese commercial aviation industry is subject to a high degree of regulation and oversight by the CAAC. Regulations and policies issued or implemented by the CAAC encompass substantially all aspects of airline operations, including the approval of domestic, Hong Kong and Macau and international route allocation, published air fares, aircraft acquisition, jet fuel prices and standards for aircraft maintenance, airport operations and air traffic control. The Civil Aviation Law, which became effective in March 1996, provides a framework for regulation of many of these aspects of commercial aviation activities. Although China’s airlines operate under the supervision and regulation of the CAAC, they are accorded an increasingly significant degree of operational autonomy, including with respect to the application for domestic, Hong Kong and Macau and international routes, the allocation of aircraft among routes, the purchase of flight equipment, the pricing of air fares within a certain range, the training and supervision of personnel and their day-to-day operations.

 

As an airline providing services on international routes, the Group is also subject to a variety of bilateral civil air transport agreements that provide for the exchange of air traffic rights between China and various other countries. In addition, China is a contracting state, as well as a permanent member, of the International Civil Aviation Organization (the “ICAO”), an agency of the United Nations established in 1947 to assist in the planning and development of international air transport, and is a party to many other international aviation conventions. The ICAO establishes technical standards for the international aviation industry. The Group believes that it, in all material respects, complies with all such technical standards.

 

 Route Rights 

 

 Domestic Routes. The right of any Chinese airline to carry passengers or cargo on any domestic route must be obtained from the CAAC. Non-Chinese airlines are not permitted to provide domestic air service between destinations in China. The CAAC’s policy is to assign a domestic route to the Chinese airline that is best suited to serve the route based, in part, on the location of the airline’s main or regional base at the point of origin. Under current regulations, airlines are generally expected to operate mainly from their route bases, and flights within a particular region are expected to be served by airlines based in that region. The Group believes that these regulatory parameters benefit airlines, such as the Group, that have a large number of regional route bases. The CAAC also considers other factors that may make a particular airline suitable to operate a domestic route, including the applicant’s general operating authority, compliance with pricing regulations and regulations applicable to safety and service quality, market demand, the ability of the applicant in terms of its existing routes, and airport facilities and related support services.

 

The CAAC considers market conditions for a domestic route in determining whether the route should be allocated to one or more airlines. The CAAC requires the passenger load factor on a particular route to reach 75% before additional flights may be put on that route. Airlines serving the route are given priority for such additional flights, and only if such airlines cannot operate more flights will the CAAC permit another airline to commence service.

 

 Hong Kong and Macau Routes. Hong Kong and Macau routes and landing rights are derived from agreements between the Chinese Government and the government of the Hong Kong SAR, and between the Chinese Government and the government of Macau SAR. Such rights are allocated by the CAAC among the four Chinese airlines permitted to fly to Hong Kong or Macau. The Group understands that the criteria for determining whether a Hong Kong and Macau route will be allocated to a particular airline include market demand, the ability of the airline to service the route and the appropriateness of the airline’s aircraft for such route.

 

A number of Hong Kong routes are operated by Chinese airlines on a “charter” flight basis. Permission to operate these flights is in theory subject to monthly review by the CAAC and the Hong Kong Civil Aviation Department. The CAAC has informally indicated that it primarily considers market demand and airline capability in granting permission for such flights.

 

 International Routes. International route rights, as well as the corresponding landing rights, are derived from air services agreements negotiated between the Chinese Government, through the CAAC, and the government of the relevant foreign country. Each government grants to the other the right to designate one or more domestic airlines to operate scheduled service between certain destinations within each of such countries. Upon entering into an air services agreement, the CAAC determines the airline to be awarded such routes based on various criteria, including the availability of appropriate aircraft, flight and management personnel, safety record, the overall size of the airline, financial condition and sufficiency of assets to bear civil liabilities in international air services. These route rights may be terminated by the CAAC under special circumstances.

 

The criteria for determining whether an international route will be allocated to a second airline generally include (i) the terms of the relevant bilateral civil aviation agreement; (ii) consistency with overall national plans and the national interest and the enhancement of reasonable competition; and (iii) whether the international airports to be used are sufficient for the aircraft flown and employ security measures consistent with international standards.

 

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In addition, if the relevant bilateral civil aviation agreement permits more than one Chinese airline to operate a particular international route, the CAAC will only permit a second airline to operate on such route if the number of passengers carried annually exceeds 100,000 and if there is a minimum average load factor of 68% for routes with at least five weekly flights by Chinese airlines, or 80% for routes with four or fewer weekly flights by Chinese airlines.

 

 Air Fare Pricing Policy 

 

Pursuant to “Pricing Reform of Domestic Civil Aviation” as approved by the State Council of the PRC effective on April 20, 2004, prices on domestic routes now fluctuate freely within a predetermined range. Instead of direct supervision by setting prices of air tickets through a local price bureau, the government now provides guidance on domestic flights and domestic civil aviation is controlled by the government indirectly. Market-oriented pricing policy was introduced and pricing system has been adjusted as a result of the above pricing reform.

 

Published air fares of Chinese airlines for the Hong Kong and Macau routes are determined by the CAAC and the relevant civil aviation authorities in Hong Kong or Macau, subject to consultation between the relevant Chinese airlines and Hong Kong or Macau airlines. Airlines may offer discounts on flights on their Hong Kong regional routes.

 

Published air fares of Chinese airlines for international routes are determined through consultation between the relevant Chinese airlines and foreign airlines in accordance with the civil aviation agreements between the Chinese Government and the relevant foreign government, taking into account the international air fare standards established through the International Air Transport Association. All air fares for international routes must be approved by the CAAC. Discounting of published international air fares is permitted.

 

 Acquisition of Aircraft and Flight Equipment 

 

The CAAC requires all Chinese airlines to acquire their aircraft through China Aviation Supplies Import and Export Corporation (“CASC”), an entity controlled by the CAAC. If a Chinese airline plans to acquire an aircraft, the airline must first seek approval from the CAAC and NDRC. The airline must, as a condition of approval, provide specific acquisition plans, which are subject to modification by the CAAC and NDRC. If the CAAC and NDRC approve an aircraft acquisition, the airline negotiates the terms of the acquisition with the manufacturer together with CASC because CASC possesses the license required to import or export aircraft, and CASC receives a commission in respect thereof. Most Chinese airlines are also required to acquire their aircraft engines, spare parts and other flight equipment through CASC. The Company and a few other Chinese airlines are permitted to import jet engines and other flight equipment for their own use without the participation of CASC. In the case of the Company, SAIETC acts as its import agent and is paid an agency fee for its services.

 

 Jet Fuel Supply and Pricing 

 

CAOSC and Bluesky Oil Supplies Company, companies controlled and supervised by the CAAC, are the only jet fuel supply companies in China, with the exception of the joint venture jet fuel supply companies that supply the Shenzhen, Zhuhai and Sanya airports, in each of which CAOSC is a partner. Airlines are generally not permitted to buy jet fuel from other suppliers in their domestic operations, since the direct import of jet fuel for domestic purposes is prohibited. As a result, all Chinese airlines purchase their domestic jet fuel supply requirements (other than in respect of their Shenzhen, Zhuhai or Sanya operations) from the seven regional branches of CAOSC. Jet fuel obtained from such regional branches is purchased at uniform prices throughout China that are determined and adjusted by CAOSC from time to time with the approval of the CAAC and the pricing department of the NDRC based on market conditions and other factors.

 

 Safety 

 

The CAAC has made the improvement of air traffic safety in China a high priority and is responsible for the establishment of operational safety, maintenance and training standards for all Chinese airlines. The Chinese airlines are required to provide monthly flight safety reports to the CAAC, including reports of flight or other incidents or accidents and other safety related problems involving such airline’s aircraft occurring during the relevant reporting period. The CAAC periodically conducts safety inspections on individual airlines.

 

The CAAC oversees the standards of all Chinese airline pilots through its operation of the CAAC Aviation College. The CAAC Aviation College is a monitoring unit located in Tianjin which implements a uniform pilot certification process applicable to all Chinese airline pilots and is responsible for the issuance, renewal, suspension and cancellation of pilot licenses. Every pilot is required to pass CAAC-administered examinations before obtaining a pilot license and is subject to an annual recertification examination.

 

All aircraft operated by Chinese airlines, other than a limited number of leased aircraft registered in foreign countries, are required to be registered with the CAAC. All aircraft operated by Chinese airlines must have a valid certificate of airworthiness, which is issued annually by the CAAC. In addition, maintenance permits are issued to a Chinese airline only after its maintenance capabilities have been examined and assessed by the CAAC. Such maintenance permits are renewed annually. All aircraft operated by Chinese airlines may be maintained and repaired only by CAAC-certified maintenance facilities, whether located within or outside China. Aircraft maintenance personnel must be certified by the CAAC before assuming aircraft maintenance posts.

 

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 Security 

 

The CAAC establishes and supervises the implementation of security standards and regulations for the Chinese commercial aviation industry. Such standards and regulations are based on Chinese laws, as well as standards developed by international commercial aviation organizations. Each airline and airport in China is required to submit to the CAAC an aviation security handbook describing specific security procedures established by such airline or airport for the day-to-day operations of commercial aviation and procedures for staff training on security. Such security procedures must be based on relevant CAAC regulations and international commercial aviation treaties. Chinese airports and airlines that operate international routes must also adopt security measures in accordance with the requirements of the relevant international agreements.

 

 Noise and Environmental Regulation 

 

All airlines in China must comply with the noise and environmental regulations of the PRC State Environmental Protection Agency. Applicable regulations of the CAAC permit Chinese airports to refuse take-off and landing rights to any aircraft that does not comply with noise regulations.

 

 Chinese Airport Policy 

 

The CAAC supervises and regulates all civilian airports in China. The local government of the PRC manages the administration of most civilian airports in China, including the Guangzhou Baiyun Airport as of 2006, with limited exceptions. Airports in China are also subject to regulation and ongoing review by the CAAC, which determines take-off and landing charges, as well as charges for the use of airports and airport services.

 

 Competition 

 

The CAAC’s extensive regulation of the Chinese commercial aviation industry has had the effect of managing competition among Chinese airlines. Nevertheless, competition has become increasingly intense in recent years due to a number of factors, including relaxation of certain regulations by the CAAC, an increase in the number of Chinese airlines and an increase in the capacity, routes and flights of Chinese airlines.

 

In the Chinese aviation industry, the three dominant airlines are the Group, Air China and China Eastern Airlines (“China Eastern”). In 2006, these three airlines together controlled approximately 72.48% of the commercial aviation market in China as measured by passengers carried.

 

Most major Chinese airlines have in recent years significantly expanded their fleets, while at the same time passenger traffic has not increased proportionately. This has resulted in a reduction in the passenger load factors for most Chinese airlines. As a result, Chinese airlines are required to be more competitive with respect to, for example, quality of service, including ticketing and reservations, in-flight services, flight scheduling and timeliness.

 

The Group expects that competition in China’s commercial aviation industry will continue to be intense. The Group will also face increasing competition from alternative means of transport, such as highway and rail, as China’s transportation infrastructure improves.

 

Relative to other Chinese airlines, however, the Group believes that it possesses certain competitive advantages. The Group has the most extensive route network and the largest number of regional route bases among Chinese airlines, which the Group believes places it in a favorable position in the route allocation process. The Group also has the largest aircraft fleet of any Chinese airline, which, together with the Group’s planned aircraft acquisitions, will permit the Group to expand its operations and to improve the deployment of the aircraft in its fleet. The Group also believes that its dominant presence in the populous and economically developed southern and central regions of China provides it with a competitive advantage in attracting new customers and that its fully integrated flight training, aircraft and engine maintenance, and air catering operations enable it to achieve and maintain high quality service to its customers.

 

The following table sets forth the Group’s market share of passengers carried, cargo and mail carried and total traffic of Chinese airlines for the years indicated.

		Passenger carried						Cargo and Mail Carried (tons)						Total traffic (ton kilometers)
		Industry			Group’s			Industry			Group’s			Industry			Group’s
		Total			Share			Total			Share			Total			Share
Year		(in million)			(% of total)			(in thousand)			(% of total)			(in billion)			(% of total)
2000			67.2			24.9			1,967			22.5			12.3			20.0
2001			75.2			25.4			1,709			23.3			14.1			21.5
2002			85.9			25.0			2,021			23.3			16.5			21.9
2003			87.6			23.4			2,190			21.2			17.1			20.8
2004			121.2			23.3			2,770			19.7			23.1			20.2
2005			138.3			31.8			3,067			25.3			26.1			27.9
2006			159.7			30.8			3,494			23.4			30.6			26.4

 

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 Domestic Routes 

 

The Group competes against its domestic competitors primarily on the basis of flight schedule, route network, quality of service, safety, type and age of aircraft and, to a lesser extent and until recently, price. The Group competes against 10 other Chinese airlines in its various domestic route markets. Of these competitors, the largest are two airlines owned or controlled by the Chinese Government, and the remaining eight airlines are operated by or under the control of various Chinese provincial or municipal governments.

 

The following table sets forth the Group’s market share of the passengers carried, cargo and mail carried on departing flights and total departing flights at the ten busiest airports in China, based on passenger volume, in 2006.

					Cargo and Mail
		Passenger carried			Carried			Departing flight
Airport		(% of total)			(% of total)			(% of total)
Beijing			18.6%			13.2%			17.6%
Shanghai Pudong			9.2%			4.4%			9.6%
Guangzhou			53.1%			42.1%			53.6%
Shanghai Hongqiao			18.7%			19.9%			17.7%
Shenzhen			30.8%			26.3%			29.9%
Chengdu			13.7%			15.8%			11.7%
Kunming			18.4%			18.9%			17.3%
Hangzhou			37.5%			32.9%			35.6%
Xian			15.3%			18.0%			13.8%
Chongqing			21.3%			24.9%			19.0%

 

The following table sets forth the Group’s market share of the passengers carried, cargo and mail carried on departing flights and total departing flights at eight busiest airports in southern and central China (excluding Guangzhou and Shenzhen, which are included in the table above), based on passenger volume, in 2006.

					Cargo and Mail
		Passenger carried			Carried			Departing flight
Airport		(% of total )			(% of total)			(% of total)
Changsha			29.1%			33.6%			25.2%
Wuhan Tianhe			51.4%			68.9%			50.7%
Guilin			38.3%			41.1%			35.2%
Sanya			41.1%			41.1%			40.7%
Zhengzhou			41.2%			31.1%			41.9%
Nanning			65.2%			67.1%			56.1%
Zhang Jia Jie			38.4%			40.4%			33.2%
Shantou			30.7%			35.5%			33.5%

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 Hong Kong and Macau Routes 

 

The Group dominates the routes operated by Chinese airlines between Hong Kong and Macau and China. In 2006, the Group operated an average of more than 16,949 “charter” and other scheduled flights per week between China and Hong Kong or Macau, accounting for approximately 28.8% of the total number of passengers carried by all Chinese airlines on the Hong Kong and Macau routes. The Group believes that the routes on which it operates “charter” flights are among its highest yielding routes, primarily because the Group faces limited competition on such routes and is consequently less subject to downward pricing pressures. Dragon Air, which is a Hong Kong-based airline, competes with the Group on many of the Group’s Hong Kong and Macau routes.

 

Air Macau Group Ltd. (“Air Macau”), a Macau-based airline, started to operate routes in 1996 between Macau and China, to destinations such as Beijing, Shanghai, Xiamen and Wuhan. Air Macau also operates routes between Macau and Taiwan, including flights which allow passengers to travel between Taiwan and China through Macau. The air fares on some of Air Macau’s routes are significantly less than air fares on comparable routes of the Group. Air Macau’s routes provide an alternative to, and compete with, the Group’s Hong Kong and Macau routes for passengers travelling between Taiwan and China.

 

 International Routes 

 

The Group competes with Air China, China Eastern and many well-established foreign airlines on its international routes. Most of these international competitors have significantly longer operating histories, substantially greater financial and technological resources and greater name recognition than the Group. In addition, the public’s perception of the safety and service records of Chinese airlines may adversely affect the Group’s ability to compete against its Hong Kong and Macau and international competitors. Many of the Group’s international competitors have larger sales networks and participate in reservation systems that are more comprehensive and convenient than those of the Group, or engage in promotional activities that may enhance their ability to attract international passengers.

 

Air China has the most extensive international route network among Chinese airlines. Beijing, the hub of Air China’s operations, has been the destination for most international flights to China. The Group competes against, among other airlines, Thai Airways International, Singapore Airlines, Malaysian Airlines System, Air China and China Eastern on flights to Southeast Asian destinations. In the case of its European routes, the Group’s competitors include Air France — KLM. The Group faces competition on its international routes from Air China and China Eastern, each of which operates several routes between destinations in China and the United States, as well as international airlines that fly to Los Angeles from Hong Kong. The Group competes in the international market primarily on the basis of safety, price, timeliness and convenience of scheduling.

 

 Airline Subsidiaries 

 

The Airline Subsidiaries are joint ventures established by the Company and local companies in the provinces or special economic zones where the Airline Subsidiaries are based and are engaged in providing airline and related services. Except for Guangxi Airlines, of which the Company owns a 100% equity interest, the Company owns a 60% equity interest in each of the remaining Airline Subsidiaries.

 

As of December 31, 2006, Xiamen Airlines operated under its own “MF” code a fleet of 41 aircraft on 85 domestic routes, 11 international route and six Hong Kong and Macau routes. In 2006, Xiamen Airlines carried a total of about 7.78 million passengers, or approximately 15.8% of the passengers carried by the Group in that year, and had RMB5,982 million in traffic revenue.

 

As of December 31, 2006, Shantou Airlines operated under the Group’s “CZ” code eight aircraft on 12 domestic routes, one international route and one Hong Kong and Macau route. In 2006, Shantou Airlines carried a total of about 1.39 million passengers, or 2.8% of the passengers carried by the Group in that year. Total traffic revenue of Shantou Airlines for the year ended December 31, 2006 was RMB1,042 million.

 

As of December 31, 2006, routes previously operated by Guangxi Airlines under the “CZ” code nine aircraft on 33 domestic routes, one international routes and two Hong Kong and Macau routes were transferred to the Company. In 2006, Guangxi Airlines carried a total of about 1.55 million passengers, or 3.1% of the total number of passengers carried by the Group in that year. Total traffic revenue of Guangxi Airlines for the year ended December 31, 2006 was RMB706 million.

 

As of December 31, 2006, Zhuhai Airlines operated under the “CZ” code five aircraft on nine domestic routes. In 2006, Zhuhai Airlines carried a total of about 868,700 passengers, or approximately 1.8% of the total number of passengers carried by the Group in that year. Total traffic revenue of Zhuhai Airlines for the year ended December 31, 2006 was RMB780 million.

 

As of December 31, 2006, Guizhou Airlines operated under the “CZ” code seven aircraft on 20 domestic routes. In 2006, Guizhou Airlines carried a total of about 1.35 million passengers, or approximately 2.7% of the total number of passengers carried by the Group in 2006. Total traffic revenue of Guizhou Airlines was approximately RMB982 million for the year ended December 31, 2006.

 

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Insurance

 

The CAAC maintains fleet and legal liability insurance on behalf of the Group and all other Chinese airlines with the People’s Insurance Company of China (“PICC”) under the PICC master policy. The Group maintains aviation hull all risks, spares and airline liability insurance, aircraft hull all risks and spare engines deductible insurance, aviation hull war and allied perils policy of the type and in the amount customary in the Chinese aviation industry.

 

Under Chinese law, civil liability of Chinese airlines for injuries suffered by passengers on domestic flights is limited to RMB400,000 (approximately US$51,225) per passenger. Under the Convention for the Unification of Certain Rules Relating to International Transportation by Air of 1929 (as amended by the protocol of 1955, the “Warsaw Convention”), unless a separate agreement has been entered into between China and a specific country, civil liability for injuries suffered by passengers on international flights is limited to US$122,000 per passenger. The Group believes that it maintains adequate insurance coverage for the maximum civil liability that can be imposed in respect of injuries to passengers under Chinese law, the Warsaw Convention or any separate agreement applicable to the Group.

 

The CAAC allocates insurance premiums payable in respect of the PICC master policy to each participating airline based on the value of the airline’s insured aircraft or, in the case of leased aircraft, based on the amount required by the terms of the lease. Insurance claims made by any participating airline may cause the premiums paid by the Group under the PICC master policy to increase. PICC’s practice has been to reinsure a substantial portion of its aircraft insurance business through reinsurance brokers on the London reinsurance market.

 

Intellectual Property

 

The Group’s businesses and operations, other than the businesses and operations of Xiamen Airlines, are conducted under the names “China Southern” and “China Southern Airlines” in both English and Chinese. The Group uses as its logo a stylized rendition of a kapok plant. Xiamen Airlines conducts its businesses and operations under the name of “Xiamen Airlines” in English and Chinese and uses its own logo depicting a stylized rendition of an egret.

 

The names “China Southern” and “China Southern Airlines” contain Chinese words of common usage and are therefore not eligible for registration as tradenames under current Chinese law. The kapok logo is a trademark registered in China and recorded with the International Air Transport Association (“IATA”), the rights to which are owned by CSAHC. The Company and CSAHC have entered into a trademark license agreement (the “Trademark License Agreement”), pursuant to which CSAHC has licensed to the Group the right to use the names “China Southern” and “China Southern Airlines” in both English and Chinese and granted the Company a 10-year renewable license from 1997 to use the kapok logo on a world-wide basis. CSAHC has retained the right to use the kapok logo in connection with its non-airline related businesses conducted as of the date of the Trademark License Agreement and to permit its affiliates that do not compete, directly or indirectly, with the Group to use the kapok logo. Xiamen Airlines owns all rights to its egret logo, which is a trademark registered in China, and recorded with the IATA.

 

The Company owns all rights to three trademarks, being SKY PEARL CLUB, the logo relating to Easy Cargo 5000 and “SKY PEARL CARD” which are registered in China, and recorded with Trademark Office of the State Administration for Industry and Commerce. Zhuhai Airlines Company Limited owns all rights to the airline logo which is registered with the Trademark Office of the State Administration for Industry and Commerce.

 

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The Group recorded a net exchange gain of RMB1,220 million in 2005, compared to a net exchange loss of RMB124 million in 2004, mainly resulting from Renminbi appreciation in July 2005. Such amount represents mainly unrealised translation exchange gain, resulting from exchange gains on translated year end foreign currency denominated liabilities, rather than foreign exchange transactions incurred during the year.

 

Taxation 

Income tax benefit for the year amounted to RMB35 million and the actual effective tax rate was 3% in 2005 while the Group’s enacted tax rate was 15%. The difference is mainly due to a portion of tax loss with a deferred tax effect of RMB135 million not recognized, as well as the effect of change in the enacted income tax rate applicable to airline operations of CNA and XJA of RMB79 million. In 2004, income tax expense of RMB261 million was recorded and actual effective tax rate was 38% while the Group’s enacted tax rate in 2004 was 15%. The difference is mainly due to the effect of the change in enacted income tax rate applicable to airline operations of CNA and XJA of RMB99 million, rate differential on airline operations of CNA and XJA of RMB43 million and non-deductible expenses of RMB37 million.

 

Liquidity and Capital Resources 

 

Prior to the initial public offering of the Company, the Group met its working capital and capital expenditure requirements through cash from its operations, the proceeds of certain long-term and short-term bank loans, capital lease financing and rebates available under certain of the Group’s aircraft leases.

 

In July 1997, the Company received net proceeds of RMB5,459 million from its initial public offering. A majority part of these net proceeds was utilized to finance the Group’s working capital and capital expenditure requirements. In July 2003, the Company issued 1,000,000,000 A Shares with a par value of RMB1.00 each at issue price of RMB2.70 by way of a public offering to natural persons and institutional investors in the PRC. The proceeds received by the Company of RMB2,641 million, net of the issuance costs of RMB59,233, have been used for the purchase of Boeing 737-800 aircraft in accordance with the disclosure in the Prospectus for Offering of the A Shares.

 

As of December 31, 2006, the Group had banking facilities with several PRC commercial banks for providing loan finance up to an approximate amount of RMB49,041 million to the Group. As of December 31, 2006, an approximate amount of RMB28,295 million was utilized. As of December 31, 2005 and 2006, the Group’s cash and cash equivalents totaled RMB2,901 million and RMB2,264 million, respectively.

 

Net cash inflows from operating activities in 2004, 2005 and 2006 were RMB3,574 million, RMB4,417 million and RMB2,217 million, respectively. Cash from operations was RMB4,533 million, RMB6,001 million and RMB4,641 million in 2004, 2005 and 2006 respectively. The increase in cash from operations in 2005 was due to the delay in payment of liabilitieis. Interest expense increasd from RMB754 million in 2004, to RMB1,616 million in 2005 and further to RMB2,419 million in 2006 as a result of the increased borrowings during the years.

 

Net cash used in investing activities in 2004, 2005 and 2006 was RMB8,824 million, RMB8,547 million and RMB5,404 million, respectively. Cash capital expenditures in 2004, 2005 and 2006 were RMB6,631 million, RMB5,473 million and RMB2,566 million, respectively, reflecting predominantly additional investments in aircraft and flight equipment under the Group’s fleet expansion plans and Guangzhou new airport, and, to a small extent, additional investments in other facilities and buildings for operations.

 

Financing activities resulted in net cash inflows of RMB6,231 million, RMB3,992 million and RMB2,550 million in 2004, 2005 and 2006, respectively. Net cash from new notes payable and repayments amounted to RMB7,447 million, RMB6,045 million and RMB5,870 in 2004, 2005 and 2006, respectively. The additional cash is for capital expenditures and general working capital. Repayment of capital leases in 2004, 2005 and 2006 was RMB1,272 million, RMB2,050 million and RMB3,313 milion, respectively, resulting from the aircraft acquisitions under capital leases.

 

As of December 31, 2006, the Group’s aggregate long-term debt and obligations under capital leases totaled RMB29,330 million. In 2007, 2008, 2009, 2010, 2011 and thereafter, amounts payable under such debt and obligations will be RMB7,005 million, RMB5,786 million, RMB3,853 million, RMB1,831 million, RMB6,474 million and RMB4,381 million respectively. Such borrowings were denominated, to a larger extent, in United States dollars and, to a smaller extent, in Japanese yen and Hong Kong dollars, with a significant portion being fixed interest rate borrowings. In the normal course of business, the Group is exposed to fluctuations in foreign currencies. The Group’s exposure to foreign currencies primarily results from its foreign currency debts. Depreciation or appreciation of the Renminbi against foreign currencies affects the Group’s results significantly because the Group’s foreign currency payments generally exceed its foreign currency receipts. The Group is not able to hedge its foreign currency exposure effectively other than by retaining its foreign currency denominated earnings and receipts to the extent permitted by the State Administration of Foreign Exchange, or subject to certain restrictive conditions, entering into forward foreign exchange contracts with authorised PRC banks.

 

As of December 31, 2006, the Group’s short term bank debt was RMB19,908 million. The Group’s weighted average interest rate on short-term bank notes payable was 5.77% per annum as of December 31, 2006. The primary use of the proceeds of the Group’s short-term debt is to finance working capital needs. The Group has generally been able to arrange short-term bank loans with domestic banks in China as necessary and believes it can continue to obtain them based on its well-established relationships with various lenders.

 

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Through May 31, 2007, the Group refinanced certain short-term bank debts of RMB4,170 million. The refinanced bank debts are unsecured, bear interest at floating rates ranging from 3-month LIBOR/6-month LIBOR +0.50% to 0.55% per annum and are repayable one year from their respective refinanced dates. In addition, the Group entered into new short term bank debts agreement totalling RMB6,435 million subsequent to December 31, 2006. These new short-term bank debts are unsecured and bear interest at floating rates ranging from 3-month/6-month/12-month LIBOR + 0.45% to 0.55% per annum with are repayable from five months to one year from their respective origination dates.

 

As of December 31, 2006, the Group had obligations under operating leases totaling RMB21,969 million, predominately for aircraft. Of such amount, RMB3,077 million, RMB2,965 million, RMB2,775 million, RMB2,613 million, RMB2,493 million and RMB8,046 million, respectively, is due in 2007, 2008, 2009, 2010, 2011 and thereafter.

As of December 31, 2006, the Group had a working capital deficit of RMB32,180 million, as compared to a working capital deficit of RMB25,907 million as of December 31, 2005. Historically, the Group operated in a negative working capital position, relying on cash inflow from operating activities and short-term bank debt refinancings to meet its short-term liquidity and working capital needs. The increase in the Group’s working capital deficit from 2005 to 2006 was mainly because the Group sought increased short-term debts to finance its aircraft acquisitions. Upon deliveries of the aircraft, the Group continued to seek renewal of its short-term debts instead of replacing such debts with long-term debts, as the interest rates for short-term debts are lower. In 2007 and thereafter, the liquidity of the Group is primarily dependent on its ability to maintain adequate cash inflows from operations and to obtain adequate external financing to meet both its debt obligations as they fall due and committed future capital expenditures. At December 31, 2006, the Group entered into loan financing agreements with several PRC banks to provide financing up to RMB49,041 million during 2007, of which approximately RMB28,295 million was utilized. Subsequent to December 31, 2006 and up to May 31, 2007, the Group entered into additional loan financing agreements to obtain financing up to RMB5,045 million during 2007. The directors of the Company believe that sufficient financing will be available to the Group.

 

As the Group is subject to a high degree of operating leverage, a minor decrease in the Group’s yield and/or load factor could result in a significant decrease in its operating revenue and hence its operating cashflows. This could arise in such circumstances as where competition between Chinese airlines increases or where PRC aviation demand decreases. Similarly, a minor increase in the jet fuel prices, particularly in the domestic market, could result in a significant increase in the Group’s operating expenses and hence a significant decrease in its operating cashflows. This could be caused by fluctuations in supply and demand in international oil market. Currently, the Group’s existing debt and lease facilities do not contain any financial covenants. Nevertheless, as the Group is subject to a high degree of financial leverage, an adverse change in the Group’s operating cashflows could adversely affect its financial health and hence weaken its ability to obtain additional debt and lease facilities and to renew its short-term debt facilities as they fall due.

As of December 31, 2006, the Group had capital commitments as follows:

		2007			2008			2009			2010			2011			Total
		(RMB million)
Acquision of aircraft and related equipment			12,299			22,572			17,483			14,232			295			66,881
Others			945			328			261			145			145			1,824
			13,244			22,900			17,744			14,377			440			68,705

Others mainly represent airport and office facilities and equipment, overhaul and maintenance bases and training facilities.

As of December 31, 2006, the Group undertook to make a capital contribution of approximately RMB83 million to a jointly controlled entity.

 

As of December 31, 2006, the cash and cash equivalents of the Group totaled RMB2,264 million. Of such balance, 15.0% was denominated in foreign currencies.

 

The Group expects that the cash from operations and short-term and long-term bank borrowings will be sufficient to meet its cash requirements in the foreseeable future.

 

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ITEM 6. DIRECTORS, SENIOR MANAGEMENT AND EMPLOYEES.