Air China (753:HK) Fair Value: HK$7.50 (reduced from HK$7.70)
Air China (753:HK) Rating: Outperform
China Eastern Airlines (670:HK) Fair Value: HK$5.00 (reduced from HK$5.30)
China Eastern Airlines (670:HK) Rating: Outperform
China Southern Airlines (1055:HK) Fair Value: HK$6.30 (no change)
China Southern Airlines (1055:HK) Rating: Outperform
24 August 2017, China – We expect the Chinese airlines to report weak 1H 2017 financial results at the end of August. Our full year 2017 EPS forecasts are 30% below consensus. The market is likely to revise down the earnings forecasts following the results announcements. As the Chinese airline stocks have already underperformed since the end of June 2017 and valuations are not expensive, the weak 1H 2017 financial results may not necessarily drive the Chinese airline stocks significantly lower. Improving yields and lower fuel prices will be strong positive catalysts for the stocks.
CURRENT VALUATIONS OF BIG 3 CHINESE CARRIERS ARE UNDEMANDING
Chart: China Airline Sector Price-to-Book Valuation Range (2012 to 2017)
CHINESE AIRLINE STOCKS HAVE UNDERPERFORMED THE MARKET SINCE END JUNE 2017
The Chinese airline stocks have corrected 8% on average and underperformed their respective market indices, the Hang Seng Stock Exchange China Enterprises Index (HSCEI) and Shanghai Stock Exchange Composite Index (SHCOMP), by 12% since the end of June 2017. We believe this was mainly driven by investors’ concerns about the 7% rise in spot jet fuel prices given the Chinese airlines’ unhedged position, continued pressure on passenger yields due to their more aggressive capacity growth in 3Q17 (see our previous report below) and expectations of weak financial results in 1H17.
The Big 3 carriers Air China (753:HK), China Eastern Airlines (670:HK) and China Southern Airlines (1055:HK) share prices have corrected more than most of their domestically-listed counterparts Hainan Airlines (600221:CH), Spring Airlines (601021:CH) and Juneyao Airlines (603885:CH).
Chart: China Airline Sector – Share Price Performance Since End June 2017
WEAKER 1H 2017 HEADLINE PROFITS COULD DRIVE EARNINGS ESTIMATES DOWNGRADES BY THE MARKET
Overall, we expect 1H 2017 headline net profit to decline substantially y/y for the Chinese airline sector, mainly driven by higher fuel prices, airport tariff hikes, lower international passenger yields, sharp drop in the highly lucrative China-Korea travel demand, declining regional traffic on Hong Kong/Macau/Taiwan routes y/y.
These headwinds will more than offset the positive impact of stronger passenger traffic growth, favourable domestic passenger yields, rebounding cargo revenue and potential foreign exchange translation gains following the rebound in the Renminbi h/h. Note that last year was a Leap year, implying 1 extra day of profits.
We expect the market to revise down their full year earnings forecasts for the Big 3 Chinese carriers following their 1H 2017 results announcements at the end of August. Our full year 2017 EPS forecasts are 40%, 20% and 30% below consensus average estimates for Air China, China Eastern Airlines and China Southern Airlines respectively.
- China Eastern Airlines’ headline results will be relatively stronger than sector peers due to disposal gains
We expect China Eastern Airlines to report the strongest 1H 2017 financial results among the Big 3 Chinese carriers, mainly boosted by gains from the disposal of its entire equity interest in Eastern Logistics as at 8th February 2017 which will more than offset the decline in margins from yield pressure and higher fuel costs. We forecast a net profit growth of 2% y/y to Rmb3.3B in 1H 2017 for China Eastern Airlines. Our full year 2017 EPS forecast is 20% below consensus average estimate.
- China Southern Airlines’ aggressive international expansion will be a drag on its otherwise strong profits from domestic operations
We expect China Southern Airlines to report a net profit of Rmb2.0B in 1H 2017, down 37% y/y, mainly dragged down by the higher fuel costs and yield pressure on international routes. We expect the results to be slightly above consensus expectations. Our full year 2017 EPS forecast is 30% below consensus average estimate.
- Air China’s share of Cathay Pacific Airways’ huge loss will have a significant impact on its financial results in 2017
We expect Air China to report a net profit of Rmb1.7B in 1H 2017, down 52% y/y, mainly dragged down by the higher fuel costs, international yield pressure and the recognition of huge losses from 29.99%-owned Cathay Pacific. See our report below on Cathay Pacific for more details.
We still expect Cathay Pacific to remain loss-making in 2H17, raising its full year net loss to HK$4.3B, which will continue to dampen Air China’s 2H 2017 earnings. However, we forecast Cathay Pacific to turn around in 2018 with a small net profit of HK$377m and stronger net profit of HK$2.5B in 2019. Our full year 2017 EPS forecast for Air China is 40% below consensus average estimate.
OVERALL PASSENGER LOAD FACTORS IMPROVED Y/Y ON THE BACK OF STRONG TRAFFIC GROWTH IN 1H 2017, WITH CHINA SOUTHERN AIRLINES TAKING THE LEAD AND HAINAN AIRLINES LAGGING BEHIND
China airline sector’s overall passenger traffic growth remained robust in 1H 2017, rising 15% y/y, ahead of their 13% capacity expansion. This lifted passenger load factor by 1ppt y/y to a high of 82%. Long-haul passenger traffic grew more rapidly than short-haul.
Chart: China Airline Sector – Operating Summary of Major Listed Chinese Airlines (1H 2017)
China Southern Airlines reported the strongest improvement in passenger load factor in 1H 2017, up 2ppts y/y to 82%, followed byy Air China (+1ppt y/y to 81%) and Juneyao Airlines (+1ppt y/y to 87%). China Eastern Airlines’ loads held steady y/y at 81%.
Spring Airlines continued to lead in terms of passenger load factor at 92% in 1H 2017 although this was 1ppt lower y/y. Hainan Airlines suffered a 2ppts y/y decline in passenger load factor to 87% which is not surprising given its aggressive capacity expansion of 53% in 1H 2017.
DOMESTIC FLIGHTS WERE FULLER THAN EVER, FAVOURABLE FOR DOMETIC PASSENGER YIELDS
Passenger load factors on domestic routes generally improved in 1H 2017, rising 2ppts y/y to 84% for the sector. The biggest carrier China Southern Airlines led (+3ppts y/y), followed by China Eastern Airlines (+2ppts y/y) and Juneyao Airlines (+1ppt).
This is favourable for domestic passenger yields and profitability, implying that the airlines with larger domestic revenue exposure are likely to have better profit margins than more internationally-focused carriers. This partly explains why Air China’s share price has underperformed the more domestically focused carriers’.
Spring Airlines (-1ppt y/y) and Hainan Airlines (steady) lagged but note that their domestic loads are already high at 94% and 90% respectively.
Chart: China Airline Sector – Domestic Route Region Performance (1H 2017)
MOST CARRIERS SUFFERED Y/Y DECLINES IN INTERNATIONAL PASSENGER LOAD FACTORS, PUTTING PRESSURE ON YIELDS
Hainan Airlines’ over-aggressive capacity expansion, drove its passenger load factors on international routes 6ppts y/y lower to 75% in 1H 2017.
The 3 Shanghai-based carriers Spring Airlines, Juneyao Airlines and China Eastern Airlines all suffered a 2ppts y/y decline in their passenger load factors on international routes.
Only Air China and China Southern Airlines managed to raise their passenger load factors by 2ppts and 1ppt y/y on international routes in 1H 2017.
Chart: China Airline Sector – International Route Region Performance (1H 2017)
CAPACITY CUTS CONTINUED ON REGIONAL FLIGHTS TO/FROM HK, MACAU AND TAIWAN
The regional routes remained fairly soft markets and the Chinese carriers have cut their passenger capacity by 7% y/y in 1H 2017 in aggregate.
Only Spring Airlines and China Eastern Airlines grew their capacity on these routes by 16% and 2% y/y respectively. Passenger traffic fell 6% y/y. Passenger load factor rose 1ppt y/y to 76% on the regional routes for the sector. This should help mitigate the decline in regional yields.
Chart: China Airline Sector – Regional Route Region Performance (1H 2017)
ROBUST CARGO MARKET IN 1H 2017 WILL BOOST CARGO REVENUE
The Chinese airline sector’s cargo traffic grew 10% y/y and their cargo load factor improved 1ppt y/y to 46% in 1Q 2017. Hainan Airlines suffered the largest decline in cargo load factor, down 6ppts y/y to 38%. Spring Airlines and Juneyao Airlines reported the strongest improvement in cargo load factor, up 4ppts y/y but their respective load factors of 37% and 21% were still below the sector average. Air China has the largest revenue exposure to cargo among the Chinese carriers.
Chart: China Airline Sector – Cargo Performance (1H 2017)
DECLINE IN PASSENGER YIELDS LIKELY TO DAMPEN PASSENGER REVENUE GROWTH IN 1H 2017
We expect the stronger traffic growth to lift the Chinese airlines’ total revenue in 1Q 2017 although partially offset by yield declines given the stiff competition on international routes, especially for carriers with aggressive capacity expansion and declining travel demand on regional routes as well as on China-South Korea flights.
SIGNIFICANTLY HIGHER FUEL PRICES WILL EAT INTO PROFIT MARGINS
The 28% y/y increase in spot jet fuel prices will hurt the Chinese airlines’ profit margins as they do not have fuel hedging in place and we do not expect them to pass on the higher fuel cost increase completely to their customers.
REBOUND IN RENMINBI H/H COULD DRIVE FOREX GAINS
The Renminbi strengthened by 2.4% h/h at the end of June 2017. This could potentially yield some foreign exchange gains for the Chinese airlines in 1H 2017 and potentially in 2H2017 as well should the Renminbi continue to strengthen.
Chart: Air China Limited Financial Summary
Chart: China Eastern Airlines Financial Summary
Chart: China Southern Airlines Financial Summary
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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