Air China (753:HK) Fair value: HK$12.5
Air China (753:HK) Rating: Outperform
28 March 2018, China – We attended Air China’s post 2017 financial results management briefing. Here are our key takeaways. Note that Air China (753:HK) is one of our top picks and its share price has risen 49% since we initiated research coverage on the stock on 4th April last year. We rank 3rd in terms of absolute return among all analysts covering Air China for the past 1 year based on Bloomberg’s calculations, outperforming our peers by 31% in terms of absolute return. We remain bullish on Air China and maintain our Outperform rating and fair value of HK$12.50 on the stock.
Robust China outbound travel demand will exceed Air China’s moderate aircraft fleet expansion plans in the coming years
Air China Group’s gross aircraft fleet expansion plans will be moderate in the next three years. It is scheduled to add 54 aircraft to its fleet in 2018, 63 in 2019 and 53 in 2020, implying a gross capacity growth of only 8%, 9% and 7% in the respective years. This supports our view that China’s robust outbound travel demand will exceed the Chinese airlines’ capacity growth for the next 5 years. See our previous report below:
Although Air China’s planned capacity growth will pick up this year, China’s strong air travel demand growth will outpace this
Air China plans to grow its seat capacity (in available seat kilometres) by around 9% this year, ahead of its 6-7% capacity expansion last year. This is mainly skewed by the addition of long-haul flights which will raise its international capacity by 15% y/y while capacity growth on domestic and regional routes will be conservative at only 5-6% y/y and 3% respectively.
Greater upside in domestic passenger yields in 2018 which will help mitigate pressure on international passenger yields
We therefore see greater opportunity for Air China to boost its domestic passenger yields this year, particularly with the help of China’s progressive domestic airfares reform, while international passenger yields could remain under pressure due to industry overcapacity, particularly on North America, Europe and Australia routes. As Air China still derives a larger proportion (of 67.5%) of its passenger revenue from domestic routes, rising domestic passenger yields will help mitigate the negative impact of pressure on international passenger yields in the markets where it plans to expand more aggressively.
Chart: Air China passenger revenue contribution by route region (2017)
Marked improvement in front end passenger load factors and revenue which is favourable for passenger yields
Air China’s front end travel demand has increased; the improving traffic mix is favourable for passenger yields. Specifically, Air China’s front end passenger load factors improved 3.5ppts and 5.3ppts y/y respectively on domestic and international routes in 2017. First and business class revenue increased 16% and 10% y/y on domestic and international routes in 2017, contributing 17% of Air China’s passenger revenue based on our estimates.
Cargo business performing well, lifting cargo yields significantly
Air China Cargo’s profitability improved significantly, driven by the 9% growth in cargo traffic and 14% y/y increase in cargo yields. Air China Cargo contributed 15% of Air China’s net profit in 2017 based on our estimates.
Ancillary revenue increased but still small; significant earnings upside potential if Air China can learn from other best-in-class airlines
Air China’s ancillary revenue continued to grow, rising 32% y/y in 2017, mainly driven by seat selection fees (+56% y/y) and paid upgrade (+144% y/y). However, ancillary revenue of Rmb270 million still accounts for less than 1% of Air China’s overall revenue. There is significant earnings upside potential if Air China can learn from other best-in-class airlines.
High fuel price is the key earnings risk as Air China remains unhedged
Like other Asian airlines, fuel cost is Air China’s largest cost component and constitutes 25% of Air China’s total cost. Higher spot jet fuel prices (+20% y/y so far this year) will be the main negative earnings driver in 2018 as Air China remains unhedged and fuel surcharges are unlikely to completely pass on the higher fuel costs to customers in markets where competition is intense.
A mitigating factor is that Air China operates one of the youngest aircraft fleets globally, averaging only 6.5 years old, which is more fuel efficient. Every US$1/bbl increase in jet fuel price will raise Air China’s fuel cost by Rmb390m on a full year basis.
Air China will need to manage non-fuel costs to preserve profit margins in 2018
Air China’s unit cost ex-fuel rose 5% y/y in 2017 which is a concern. Management will need to implement greater cost management in order to reduce Air China’s profit margin decline in 2018.
Air China will no longer incur investment losses from Cathay Pacific as we expect Cathay Pacific to turn profitable from 2018
Air China booked Rmb986m for its share of losses from 29.99%-owned Cathay Pacific (293:HK), a 50% larger investment loss compared to 2016. However, we do not expect this to recur in Air China’s results in 2018 as 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.
Further forex gains in 2018 but lower exposure to US dollar volatility going forward
Air China’s US dollar debt exposure has fallen further to 40.84% in 2017 from 49.12% in 2016. We expect Air China to book further forex gains in 2018 as the US dollar has weakened further since Dec 2017. However, Air China’s overall earnings will be less leveraged to US dollar volatility going forward. Every 1% weakening (strengthening) in the US dollar boosts (cuts) Air China’s net profit by Rmb279m.
Air China’s 2017 financial results are in line with our forecasts
Air China’s net profit rose 6% y/y to Rmb7.2B in 2017, in line with our forecasts, mainly driven by stronger passenger traffic (+7% y/y) and improved cargo yields (+14%) which more than offset the higher fuel costs (+29%) and maintenance charges (+33%) in 2017. The results were boosted by Rmb2.9B forex gains but hurt by its Rmb986m share of losses from 29.99%-owned Cathay Pacific.
Free cash flow generation surged; balance sheet strengthened significantly following Air China’s strong financial results and A share private placement
Notwithstanding its substantial capex, Air China generated positive free cash flows of Rmb8 billion. This, plus its earlier A share private placement, has helped to reduce Air China’s net debt-equity from 1.5x at the end of 2016 to a much healthier level of 1.1x at the end of 2017. Every 50bps rise in interest rate will cut Air China’s net profit by Rmb163m.
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