Air China: 1.0x P/B valuation unjustified given best 1H18 results among Big 3 Chinese carriers

Air China company logo

Air China Ltd (753:HK)

Price Target: HK$12.50 | Rating: Buy

31 August 2018, China – Air China’s 1H18 results beat our expectations significantly. 1H18 operating profit and net profit grew 14% and 4% y/y to Rmb6.6B and Rmb3.5B respectively notwithstanding the 29% rise in fuel costs and Rmb518m forex translation losses from the weaker yuan. This was mainly driven by improving domestic passenger yields, higher cargo yields and decline in non-fuel unit costs. Air China continues to be our top pick in the Chinese airline sector - with valuations down to 1.0x Price/Book, the stabilizing yuan provides a good buying opportunity. Here are our key takeaways:

#1 Air China maintained its lead with the highest operating profit margin among the Big 3 Chinese carriers. Air China’s operating profit margin of 10.3% beat China Eastern Airlines’ 10.0% and China Southern Airlines’ 6.9% in 1H18. Based on our estimates, Air China also had the highest recurring pre-tax profit margin of 6.0% versus China Southern Airlines’ 2.5% and China Eastern Airlines’ 1.7% excluding forex loss and government grants.

#2 Profitability improved y/y notwithstanding the higher fuel costs and forex loss in 1H18. Air China’s operating profit and net profit grew 14% and 4% y/y respectively, implying operating and net profit margins of 10.3% (steady y/y) and 5.4% (steady) respectively notwithstanding the 29% y/y rise in fuel costs (which accounted for 30% of its total costs) and Rmb518m forex translation losses from the weaker yuan. Excluding Rmb1.7B government grants, Rmb183m net reversal of impairment losses and Rmb518m forex loss, Air China’s recurring pre-tax profit was Rmb3.8B, up 47% y/y, and its recurring pre-tax profit margin was 6.0% (up 1ppt y/y) in 1H18, based on our estimates.

#3 Domestic passenger yields improved 1.4% y/y, helped by the domestic airfare reform. Air China managed to adjust prices on 99 domestic routes for the premium class segment and on 22 domestic routes for the economy class segment, helping to lift its revenue by Rmb356m y/y in 1H18.

#4 However, passenger yields on international routes and HK/Macau/Taiwan routes fell 1.8% and 3.2% y/y respectively which was disappointing.

Chart: Air China Revenue Contribution by Route Region (1H18)

Air China Revenue Contribution by Route Region (1H18)

#5 Premium class revenue increased 8% and 15% y/y on domestic and international routes respectively.

#6 Ancillary revenue surged 43% y/y to Rmb92m in 1H18, still a tiny contribution to Air China’s passenger revenue but nevertheless encouraging.Interlining revenue also grew 14% y/y. The total number of “Phoenix Miles” members rose to 54.2m and the revenue contribution grew 12% y/y.

#7 Non-fuel unit cost fell 4% y/y, which helped to mitigate the 29% rise in fuel costs which amounted to 30% of Air China’s operating costs.

#8 Reduced losses from 29.99%-owned Cathay Pacific enabled Air China to book a Rmb77m profit from associates versus Rmb514m loss in 1H17.

#9 Air China plans to sell its 51% stake in Air China Cargo to China National Aviation Capital Holding (a wholly owned subsidiary of CNAHC) for a consideration of Rmb2.44 billion and will focus on growing its passenger business.

#10 Air China has pared down its US dollar debt exposure further to 37.5% at the end of June 2018, down 4.2ppts y/y which will further reduce its forex risk going forward. Its Chinese yuan debt has increased 10.1ppts y/y to 61.0%. Other currencies debt amount to 1.5% of Air China’s total debt.

#11 Key headwinds and Air China’s earnings sensitivities to these negative drivers: 1) Jet fuel prices remain high – every US$1/bbl rise in jet fuel price will increase Air China’s 2H18 fuel cost by Rmb200m , 2) Further weakening of the Renminbi – every 1% weakening in the CNY will cut Air China’s net profit by Rmb235m and 3) Rising interest rates – every 10bps increase will cut Air China’s net profit by Rmb32m.

 

Note: Stocks with upside of more than 10% based on our fair value are assigned an Outperform rating. Stocks with downside of more than 10% based on our fair value are assigned an Underperform rating. Stocks with upside or downside of less than 10% based on our fair value are assigned an In-line rating. These are Crucial Perspective’s proprietary rating classifications and by no means serve as investment recommendations.

Independent Research Declaration: Crucial Perspective does not own any position in the equities featured in this report nor have we received any compensation for writing this report.

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