Air China generates strong FCF and benefits from Cathay’s turnaround

Air China (753:HK) Fair value: HK$12.5
Air China (753:HK) Rating: Outperform

Cathay Pacific (293:HK) Fair value: HK$14
Cathay Pacific (293:HK) Rating: Outperform

30 April 2018, China – We attended Air China’s (753:HK) post 1Q18 financial results management briefing. Air China generated substantial positive free cash flows amounting to Rmb3.3 billion during 1Q18 and 29.99%-owned Cathay Pacific also contributed profits to Air China’s financial results, turning around from last year’s losses. Here are our 5 key takeaways:

#1 Generating significant positive free cash flows

Air China earned a net profit of Rmb2.6 billion in 1Q18, 81% higher y/y excluding non-recurring items under PRC accounting standards. The results were boosted by Rmb1.6 billion forex gains due to the stronger Renminbi. Notably, Air China generated positive free cash flow of Rmb3.3 billion during 1Q18, a marked improvement from its negative free cash flow of Rmb526 million in 1Q17.

Chart: Air China Cash Flow Summary (1Q18 versus 1Q17)

Chart: Air China Cash Flow Summary (1Q18 versus 1Q17)

#2 Cathay Pacific turns profitable in 1Q18

29.99%-owned Cathay Pacific (293:HK) contributed profits to Air China’s 1Q18 results versus losses a year ago. Air China booked investment income of Rmb133 million in 1Q18, a turnaround from its investment loss of Rmb142 million in 1Q17, largely driven by Cathay Pacific’s turnaround. This is in line with our expectations. We believe the worst is over for Cathay Pacific and we forecast Cathay to turn around with a small net profit this year. 2019 will be a much better year for Cathay Pacific as its expensive fuel hedges finally roll over. Apart from Cathay Pacific, associate Shandong Airlines’ profitability also improved meaningfully during 1Q18 which boosted Air China’s financial results.


#3 International expansion looks aggressive and could impede international passenger yield increase, potentially offsetting domestic yield improvement

Air China’s overall passenger yield held steady y/y, weaker than China Eastern Airlines’ 2% y/y improvement, as the stronger domestic passenger yields (+1% y/y) and regional yields (+4%) were offset by the weaker international passenger yields (+1%) in 1Q18.

We expect Air China’s passenger yields on domestic routes to increase y/y from 2H2018 given its moderate capacity growth and plans to raise fares on 30+ domestic routes progressively following China’s domestic airfare liberalization.

However, international passenger yields could remain under pressure and Air China’s international capacity expansion needs to be tempered given the rising fuel prices and less effective fuel price pass-through. In 1Q18, Air China increased capacity on European routes by 27% y/y which was not met by demand, resulting in a 6ppts decline in passenger load factor to 78%.

We expect Air China to accelerate its domestic capacity expansion and moderate its international capacity expansion in the coming months. Overall, Air China’s capacity growth is still expected to be moderate at around 10+% y/y in 2018.

Chart: Air China passenger traffic and capacity growth in major route regions (1Q18)

Chart: Air China passenger traffic and capacity growth in major route regions (1Q18)

Chart: Air China passenger load factors and y/y changes in major route regions (1Q18)

Chart: Air China passenger load factors and y/y changes in major route regions (1Q18)


#4 Cost efficiency is improving  

We had highlighted in our previous report that Air China will need to manage non-fuel costs to preserve profit margins in 2018 given the rising fuel prices and as Air China’s unit cost ex-fuel rose 5% y/y in 2017. This negative trend reversed in 1Q18 – unit cost ex-fuel per ASK fell 1% y/y and Air China could potentially reduce its unit cost ex-fuel further as its aircraft utilisation rises.

Key takeaways from Air China 2017 financial results briefing


#5 Bigger beneficiary of stronger Renminbi than China Eastern Airlines

Air China’s US dollar debt exposure has fallen further to 38.76% at the end of March 2018 from 40.84% in end 2017 but is higher than China Eastern Airlines’ (670:HK) 26.6% exposure. Based on our estimates, every 1% strengthening (weakening) in the Renminbi against the US dollar boosts (cuts) Air China’s net profit by 3% on a full year basis.


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