Air China (753:HK) Fair Value: HK$7.50
Air China (753:HK) Rating: Outperform
China Eastern (670:HK) Fair Value: HK$5.00
China Eastern (670:HK) Rating: Outperform
China Southern (1055:HK) Fair Value: HK$6.30
China Southern (1055:HK) Rating: Outperform
31 August 2017, China – Based on the Big 3 Chinese carriers’ 1H 2017 results, Air China (753:HK) has once again delivered the strongest core operating profit margin, followed by China Eastern Airlines (670:HK) and China Southern Airlines (1055:HK). Air China also suffered the smallest decline in core operating margins y/y in 1H 2017. This could drive investors to revisit Air China as it has been the second worst performing stock among the Chinese airlines in the past 2 months.
Interestingly, from having the smallest exposure to US dollar debt among the Big 3 Chinese carriers two years ago, Air China is now the biggest beneficiary of the recent strengthening of the Renminbi as China Eastern and China Southern Airlines have pared down their US dollar debt exposure much more aggressively. Air China also has the largest revenue exposure to the air cargo market which is expected to have a robust peak season in 4Q 2017.
ASSESSING THE CORE EARNINGS POWER OF BIG 3 CHINESE CARRIERS
Chart: Operating profit margin less net finance costs and excluding forex gains/losses
Chart: China airlines share price performance since end June 2017
CHINA EASTERN AIRLINES HAS THE BEST HEADLINE FINANCIAL RESULTS
China Eastern Airlines reported the best headline results, with net profit up 34% y/y in 1H 2017, mainly boosted by Rmb1.7B gains from the disposal of Eastern Logistics. All three carriers also booked substantial forex gains in 1H 2017 due to the stronger Chinese yuan, and this helped Air China to report only a marginal 4% y/y decline in net profit as its forex gains were much larger than China Eastern and China Southern’s. However, these forex gains are non-cash in nature.
Chart: Headline net profits (1H 2017 vs 1H 2016)
AIR CHINA SUFFERED THE SHARPEST DECLINE IN CORE PROFITS
Stripping out the non-cash forex gains and China Eastern Airlines’ one-off gains from the disposal of Eastern Logistics, we gain a clearer picture of the core results of the Big 3 carriers.
As expected, Air China suffered the sharpest y/y decline (down 60%) in core profits among the Big 3 Chinese carriers, mainly due to the recognition of substantial losses from 29.99%-owned Cathay Pacific. Air China’s results were also dragged down by its aircraft maintenance subsidiary AMECO which turned loss-making in 1H 2017 and marked y/y decline in Shandong Airlines’ profits.
Air China’s earnings will continue to be dragged down by the recognition of its share of losses from 29.99%-owned Cathay Pacific in 2H 2017. This is the key reason behind Air China’s share price underperformance versus China Southern and China Eastern Airlines in the past 2 months. However, we expect Cathay Pacific to turn profitable from 2018 which could reverse Air China’s underperformance.
China Southern Airlines’ core profit decline was the smallest, down 52% y/y, followed by China Eastern Airlines’ 58% drop. This explains its relative share price outperformance versus Air China and China Eastern Airlines since end June 2017. Higher fuel costs and airport tariffs were the key drivers behind the weaker core profits for all the Chinese carriers.
Chart: Core profits (1H 2017 vs 1H 2016)
AIR CHINA STILL HAS THE HIGHEST CORE OPERATING MARGINS
Digging deeper into the results, if we were to strip out one more layer by removing the impact of the associates and joint ventures’ performance to focus on the core earnings power of each airline, Air China surprised by having the smallest y/y deterioration in core operating profit less net finance costs and excluding forex gains.
Air China’s core operating profit less net finance costs and excluding forex gains fell 34% y/y while China Southern and China Eastern Airline’ fell 44% and 45% y/y respectively. Air China’s profit margin (based on this calculation) was 7.3%, down 4.7ppts y/y, followed by China Eastern’s 6.6% (down 6ppts y/y) and China Southern’s 5.4% (down 5.4ppts y/y). See the first chart in the article above.
Chart: Operating profit less net finance costs and excluding forex gains/losses (1H 2017 vs 1H 2016)
AIR CHINA’S PASSENGER YIELDS HELD UP BEST WHILE CHINA SOUTHERN AIRLINES’ SUFFERED THE LARGEST DECLINE
This is mainly driven by Air China’s better yield management. All 3 Chinese carriers saw strong improvement in first & business class load factors which is positive and helped to support yields, with Air China experiencing the largest improvement in premium class load factors.
China Southern Airlines’ overall passenger yields weakened the most significantly while Air China and China Eastern’s passenger yields held up in 1H 2017.
On domestic routes, Air China’s passenger yields improved the most y/y while China Eastern Airline’ passenger yields suffered the smallest y/y decline on international routes. China Southern Airlines’ passenger yields improved on regional routes but its exposure to this market is too small to make a difference to its overall yield performance.
Chart: Passenger yield increase/decrease y/y in each route region (1H 2017)
INDUSTRY CARGO YIELDS SURGED, BENEFITTING AIR CHINA THE MOST
The strong cargo market also lifted Air China and China Southern Airlines’ cargo yield significantly y/y. Note that China Eastern Airlines disposed Eastern Logistics in February 2017.
Chart: Cargo yield increase y/y (1H 2017)
STRONGER RENMINBI IS BENEFICIAL
Air China has become the biggest beneficiary of the stronger Renminbi
From having the smallest exposure to US dollar debt among the Big 3 Chinese carriers in 2015, Air China is now the most leveraged to the recent strengthening in the Renminbi as China Eastern and China Southern Airlines have more than halved their proportion of US dollar debt since 2015.
Specifically, 44.4% of Air China’s total debt is US dollar denominated at the end of June 2017 (down from 49% at the end of 2016). In contrast, China Eastern Airlines and China Southern Airlines have further reduced their US dollar debt exposure to 34.1% (from 45% at the end of 2016) and 34.2% (from 39%) of total debt at the end of June 2017. Given that the Renminbi has strengthened another 3% since end June 2017, we expect the Chinese airlines to book further forex gains in 2H 2017 results if the Renminbi remains strong or strengthens further.
Chart: Forex gains/losses (1H 2017)
BIG 3 CHINESE CARRIERS 1H 2017 RESULTS AT A GLANCE
Chart: Air China 1H 2017 Results at a Glance
Chart: China Eastern Airlines 1H 2017 Results at a Glance
Chart: China Southern Airlines 1H 2017 Results at a Glance
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.
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