Air China (753:HK) Initiation Research Report 2017: Top choice among the Chinese airlines

4th April 2017, China – Air China (753:HK)’s H share price has risen 14% but underperformed the Hong Kong Stock Exchange Hang Seng China Enterprises Index (HSCEI) by 3% in the past 12 months. Its underperformance versus the market is mainly driven by investors’ concerns about the negative impact of passenger yield pressure (-5% y/y in 2016), foreign exchange losses from the weaker Renminbi (-6% y/y), rising jet fuel prices (+29% y/y) and Cathay Pacific’s weak financial performance on Air China’s profitability.

Fair value: HK$7.70

Rating: Outperform

The recent stabilization of the Renminbi and spot jet fuel prices should help allay some of these investors’ concerns near term. Going forward, we expect Air China’s earnings outlook to improve, especially from 2018 onwards as the impact of these key negative drivers abate. Based on their scheduled new aircraft deliveries, we expect the Chinese airline sector’s capacity growth to moderate, improving the industry’s demand and supply balance, thus reducing the pressure on the Chinese airlines to discount to fill up their planes compared to previous years. The slot constraints at the major airports in China also limit the scope of aggressive capacity expansion for these airlines and at the same time serve as barriers to entry for foreign and other domestic competitors from accessing viable take-off/landing airport slots at Air China’s main air hub in Beijing in the next two years, thus mitigating the level of competitive pressure faced by Air China compared to previous years until the new airport in Beijing is open.

In addition, Air China has been reducing its US dollar debt exposure significantly which will result in smaller foreign exchange translation losses should the Renminbi weaken further. Air China’s balance sheet will continue to strengthen as we expect it to generate rising free cash flows in the next three years and it has also significantly increased its proportion of fixed rate debt to hedge its exposure against rising interest rates. Although Air China has not hedged its fuel consumption, it now operates one of the youngest aircraft fleets in the world and its fuel efficiency is expected to improve further with the delivery of the new generation aircraft which will mitigate the impact of higher fuel prices to some extent. Better industry demand-supply balance will also increase its pricing power, enabling Air China to pass on more of the fuel price increase to its passengers and shippers. Air China’s competitive unit cost advantage versus its global airline peers will enable the airline to continue to gain market share on international routes and provide the most effective defense against its airline competitors.

We view Air China as the highest quality carrier leveraged on the Chinese airline sector’s bullish long-term growth prospects among the listed Chinese airlines and initiate coverage on Air China with a fair value of HK$7.70 and Outperform rating.

Chart: Air China Limited – Crucial Perspective Scorecard (Full marks = 100 points)

Air China Initiation Research Report 2017: Scorecard

Chart: Air China Limited – Financial Summary

Air China Initiation Research Report 2017: Financial Summary

KEY POSITIVE DRIVERS FOR AIR CHINA (753:HK) OUTLOOK

+ Strong profitability, helped by better yield management and unit cost reductions

Air China’s profitability has improved and ranks ahead of the Chinese airlines in its unit cost reductions and yield management in the past five years. It is the most profitable carrier among the Big 3 Chinese airlines and one of the most profitable airlines in the global airline sector. Air China’s financial position is also stronger than most of the listed Chinese airlines.

Chart: Chinese airlines EBITDAR margin comparison (2011 to 2016)

Air China Initiation Research Report 2017: EBITDAR

Chart: Chinese airlines net debt-equity ratio comparison (2011 to 2016)

Air China Initiation Research Report 2017: Net Debt-Equity Ratio

Air China’s passenger yields have declined to a lesser extent compared to the other Chinese carriers in the past five years, reflecting its more moderate capacity growth and better revenue management.

Chart: Chinese airlines passenger yield trend comparison (2011 to 2016)

Air China Initiation Research Report 2017: Passenger Yield Trend

At the same time, Air China’s unit cost and ex-fuel unit cost have declined to a larger extent in the past 5 years compared to the other Chinese carriers although this gap is narrowing, with China Eastern Airlines achieving a larger ex-fuel unit cost decline y/y in 2016.

Chart: Chinese airlines unit cost per ATK trend comparison (2011 to 2016)

Air China Initiation Research Report 2017: Unit Cost per ATK

Chart: Chinese airlines ex-fuel unit cost per ATK trend comparison (2011 to 2016)

Air China Initiation Research Report 2017: Ex-fuel unit cost per ATK trend

+ Strongest balance sheet among the Chinese carriers

Air China has been deleveraging in recent years. Its net debt-equity ratio was 1.4x at the end of 2016 from 1.7x five years ago at the end of 2012. We expect Air China to generate rising positive free cash flows in the next three years. This, plus its recent A share non-public issuance, will further reduce its net debt-equity to 0.7x by the end of 2019. As a state-owned flag carrier of China, Air China is also deemed to be a fairly low-risk credit to financial institutions, enabling it to maintain its low cost of borrowing.

+ Origin & destination traffic is sufficient to support the sector’s long-term growth given China’s large population base, still low travel penetration and rising per capita income

International air travel penetration remains low in China at 0.09 trips per capita per annum, well below the 2.0 trips per capita per annum of developed markets, and has good growth potential as per capita income continues to rise over time. China’s air passenger traffic has been growing at 14% CAGR in the past 25 years, 1.5 times China’s real GDP growth. In January-February 2017, China’s passenger traffic growth remained strong at 15% y/y. 

Chart: China air passenger traffic versus China real GDP growth (1992 to 2016)

Air China Initiation Research Report 2017: Passenger Traffic vs GDP

Going forward, we forecast the Chinese airline sector’s passenger travel demand growth to moderate but still at a healthy expansionary pace of 12% in 2017 and 9%-10% per annum from 2018 to 2021, mainly driven by rising per capita income and its large and still fairly untapped travel market. This will continue to drive Air China’s international business growth and it is well-positioned to do so given its home carrier advantage and access to the domestic market as well as competitive cost structure.

+ Well-positioned to capture China’s growing outbound travel demand given its dominant market position on long-haul routes to/from China

As China’s flag carrier, Air China is well-positioned to continue to leverage on this outbound traffic growth, helped by its dominant market position on long-haul routes to/from China. Increased traffic feed from Cathay Pacific (which has a cross shareholding with Air China), Lufthansa (enhanced by the new joint venture cooperation) and its Star Alliance airline partners will continue to drive Air China’s connecting traffic growth. Following American Airlines’ announced investment in China Southern Airlines last week and Delta Airlines’ investment in China Eastern Airlines in 2015, we expect Air China and United Airlines to work towards deepening their cooperation in the Transpacific route region where they still have the most dominant combined market share of 39% versus 26% for China Eastern Airlines and Delta Air Lines combined and 18% for China Southern Airlines and American Airlines combined. Air China’s competitive cost structure also makes it challenging for other airlines including low cost carriers to compete with Air China for market share.

+ Most dominant Chinese carrier on long-haul routes to/from China

Air China is the largest and second largest carrier in the China-Europe and China-United States route regions respectively. It is therefore well-positioned to leverage on the fast-growing Chinese outbound travel demand in these markets. The number of inbound Chinese tourists to the United States has been growing rapidly. China ranks the fifth largest in terms of the total number of visitor arrivals into the United States and second largest among the Asian countries, after Japan. In Jan-August 2016, Chinese visitor arrivals to the United States grew 15% y/y. Air China plans to launch flights to Astana, Barcelona and Zurich this year. Air China is expected to be the only carrier flying the Shanghai-Barcelona route and one of two carriers flying the Beijing-Astana and Beijing-Zurich routes.

Chart: Airline market shares on China-Europe flights (1Q17) – Air China is the largest carrier in this route region

Air China Initiation Research Report 2017: Market shares China-Europe

Chart: Airline market shares on China-United States flights (1Q17) – Air China is second largest carrier in this route region

Air China Initiation Research Report 2017: Mkt shares China-US

+ Potential long-term yield upside from increasing its share of premium traffic

As Air China continues to improve its cabin product and services and increases its international flight frequencies and network reach, we expect the airline to attract more premium traffic in the longer term. Premium class revenue only contributed 17% of Air China’s passenger revenue, below the Asian airline average of 25% and well below premium carriers’ Cathay Pacific and Singapore Airlines’ 45% passenger revenue contribution from the front end.

+ Operating outlook on the China-Europe route region, which has been a drag last year, is expected to improve

Planned capacity growth y/y on China-Europe routes is much more benign at 5% in 1H17 compared to 11% in 2016 based on the current flight schedules. This, together with rising travel demand, should help lift Air China’s passenger load factors and aid yield improvement. Air China is trimming capacity by 5% y/y in the China-Europe route region.

+ Deploys one of the youngest aircraft fleets in the world due to fleet renewal and fleet simplification programme

Following its aircraft fleet renewal in recent years, Air China operates one of the youngest aircraft fleets globally at 6.5 years old on average, much newer than the global airline sector average fleet age of 12 years. Air China has also simplified the number of aircraft types in its fleet. This improved aircraft fleet strategy will continue to drive operating costs lower, especially with the deployment of new-generation aircraft B787s and A350s which are more fuel efficient.   

+ Continued rise in direct sales will drive further sales commissions cost reductions and boost ancillary income

We expect Air China’s sales commissions costs to continue to trend down this year as it continues to increase its proportion of direct sales. Direct sales accounted for 41% of total sales in 2016 versus 30% in 2015. The revenue drivers of Air China’s direct E-commerce (which grew 54% y/y) was 30% website, 15% mobile app and 55% flagship store in 2016. Air China’s income from mobile app grew 125% y/y in 2016.

Increased direct sales will also facilitate the marketing of more ancillary products and services which should help boost Air China’s ancillary income over time. Air China’s ancillary income rose 26% y/y in 2016.

+ Least exposed to domestic high-speed rail competition among the Chinese carriers

Due to Air China’s more limited domestic route network compared to China Southern Airlines and China Eastern Airlines, with a sizeable portion of its capacity covering the central and western parts of China where the domestic hi-speed rail services are not available, Air China is therefore less exposed to the risk of traffic diversion from air to rail transport compared to the other more domestically-focused Chinese airlines.

+ Global airline sector’s capacity growth is expected to moderate in the coming years, improving the industry’s demand-supply balance which will help support and potentially lift passenger yields

The global airline industry capacity growth is expected to become more moderate and manageable in the next 5 years. Based on the scheduled aircraft deliveries after taking into account capacity reduction from aircraft retirement and seat reconfiguration, we forecast the global airline industry’s capacity to grow around 7% y/y in 2017, moderating to 6% per annum from 2018 to 2020 and 5% in 2021. The more moderate and manageable capacity would be favourable for the industry, mitigating the pressure on airlines to discount fares to fill up their seats from 2018 compared to previous years.

Chart: Global Airline Sector Seat Capacity Growth

Air China Initiation Research Report 2017: Seat Capacity Growth

+ Moderating capacity growth in the Asia Pacific airline sector

We expect the Asia Pacific airline industry’s seat capacity growth to moderate to more benign levels from 2018, gradually easing competitive pressure. Based on the scheduled new aircraft deliveries and after taking into account capacity reduction from aircraft retirement and seat reconfiguration, we forecast the Asia Pacific airline industry’s seat capacity to grow around 8% y/y in 2017, moderating to 6% per annum from 2018 to 2020 and 5% in 2021. Given the major aircraft manufacturers’ Airbus and Boeing’s order backlog, there is limited room for the capacity growth to exceed these levels in the next 1-2 years in our view. In addition, most airlines tend to have longer term fleet plans and their aircraft orders placed tend to be for delivery at least 3 years forward.

This should help mitigate yield pressure in the industry and enable the Asian airline industry to improve their profitability from 2018 as the industry’s demand-supply environment gradually becomes more balanced over time.

+ Potential aircraft supply shortage in China if travel demand continues at such a strong pace

We believe the Chinese airlines have under-ordered aircraft and air travel demand growth is expected to outpace airline capacity growth in the next 5 years. China alone accounts for 36% of the Asia Pacific aviation sector’s total capacity and is therefore the single, most important driver of the industry’s overall demand-supply growth balance. Following its double-digit capacity growth in the past decade, 2017 will be the last year of double-digit capacity growth, with the Chinese aviation sector’s seat capacity growth decelerating to 10% in 2017 before moderating sharply to 3%-4% per annum from 2018 to 2021. The Chinese airlines are likely to continue to announce new aircraft orders going forward (and we learnt that Boeing has aircraft orders for unidentified customers that could be delivered to the Chinese) and/or lease aircraft from third party lessors outside of China and we will continue to monitor these developments closely. However, we are unlikely to be too concerned as China will need to double its existing aircraft orders in order to keep the industry oversupplied in the coming years. We are also not too concerned about the impact of China’s economic slowdown and rebalancing on air travel demand given its low travel penetration.

Chart: Airline Capacity Share (%) – Asia Pacific region

Air China Initiation Research Report 2017: Capacity Share APAC

Chart: Airline Sector demand and supply analysis – China and the Asia Pacific regionAir China Initiation Research Report 2017: Demand Supply

+ Slot constraints at the major Chinese airports serve as barriers to entry for foreign carrier competitors and new domestic airline start-ups in the next two years which could help mitigate yield pressure on international routes

A major concern that investors have is continued decline in passenger yields. Part of the reason why yields have fallen is because of the removal/reduction of airline fuel surcharges following the sharp decline in fuel prices. In addition, the Chinese airline sector had gone through a period of aggressive ordering of new aircraft for expansion which put pressure on yields, particularly on international routes due to the aggressive capacity expansion of Middle Eastern airlines and Asian low cost carriers.

However, going forward, we expect pressure on yields to ease gradually, helped by better industry demand-supply balance as well as slot constraints at the major airports in China. The limited airport slots at the major airports in China serve as barriers to entry for international carriers and even newer Chinese airline start-ups to compete aggressively with new flight services and frequencies at their key hubs. This should support load factor improvements and yields in the next two years. The Chinese airlines can upsize their capacity by substituting with more wide-body aircraft but only to a certain extent as 85% of their aircraft fleet are narrow-body aircraft and fairly new (and thus unlikely to be replaced in large numbers near term) on top of airport infrastructure and operational constraints.

+ Potential merger with or acquisition of Cathay Pacific which will significantly up the ante of Air China’s global branding and international route network

We believe it would make sense for Air China to acquire or merge with Cathay Pacific in the longer term. Air China already owns a 29.99% stake in Cathay Pacific and Air China could significantly elevate its international expansion and access to premium travellers by leveraging on Cathay Pacific’s much broader international route network, more established branding and service reliability. Cathay Pacific provides a strong international platform (in terms of network, operations, branding) for Air China to accelerate its international route expansion as it would take much longer for Air China to build this up organically. Moreover, Air China’s cooperation with Cathay Pacific seems to have reached a plateau in recent years and both are also constrained to some extent due to their membership in different global airline alliances as well as different management cultures. Cathay Pacific is a member of the Oneworld Alliance while Air China joined the larger Star Alliance.

The key “push factors” for Swire Pacific Limited (which owns 45% of Cathay Pacific) and the minority shareholders would be the rising capital costs needed to grow and upgrade Cathay Pacific’s aircraft fleet, persistently intense industry competition as some of the weak carriers continue to be supported by their governments and profit margins tend to be razor-thin. Cathay Pacific’s earnings have been highly cyclical with limited long-term growth and its profit margins have been declining in the past 10 years. The airline is operating in a structurally more challenging competitive landscape as Cathay Pacific is likely to lose more traffic to direct flights between China and the rest of the world. In addition, the oversupply in the global air cargo market is likely to continue near term and Cathay Pacific faces stiff competition from Emirates, other major cargo airlines as well as the growing belly-hold cargo capacity of the global passenger aircraft fleet.

However, the key hurdles are: 1) Swire has owned Cathay Pacific for the past 69 years since 1948 and may be reluctant to sell its stake due to legacy reasons, 2) it may be politically sensitive to sell Cathay Pacific, which is iconic to Hong Kong, to a Chinese state-owned enterprise at present in our view, 3) there could be controversy regarding the allocation and eligibility of international traffic rights if Cathay Pacific becomes 100%-owned by a Chinese carrier, 4) Air China may be reluctant to pay cash to acquire Cathay Pacific as this would increase Air China’s financial leverage meaningfully and 5) Swire Pacific may not agree to a share swap agreement given that Air China (1.0x P/B) is trading at a 20% premium to Cathay Pacific (0.8x P/B).

It would be interesting to monitor Kingboard Chemical Holdings Limited’s future role in driving Cathay Pacific’s strategy following its recent increase in its stake in Cathay Pacific to 6.11% on 22nd March 2017.

KEY NEGATIVES AND DOWNSIDE RISKS FOR AIR CHINA (753:HK) OUTLOOK

+ Further foreign exchange translation losses should the Renminbi weaken against the US dollar

The strengthening of the US dollar against the Renminbi is negative for Air China (and generally all the Chinese and Asian carriers) as it has more USD-denominated costs than USD-denominated revenue and aircraft capex is also paid in USD and often financed with USD debt or USD leases.

As the Chinese airlines used to fund their capex with a sizeable level of USD debt, this results in unrealized foreign exchange translation losses (gains) that the airlines are required to mark to market and book at the end of each reporting period when the US dollar strengthens (weakens) against their local currencies.

This forex loss (gain) tends to be disproportionately larger than their recurring earnings impact from the stronger (weaker) US dollar. Although it is a non-cash item and could potentially reverse if the local currency rebounds against the US dollar in the future, the stock market tends to react negatively (positively) to Air China (and the Asian airline stocks) when the US dollar strengthens (weakens) against their local currencies.

However, Air China has pared down its USD debt significantly in the past two years, resulting in a much smaller negative earnings impact when the Renminbi weakens against the US dollar. Every 1% weakening (strengthening) of the Rmb will cut (boost) Air China’s 2017 net profit by 8% (3% operational impact + 5% forex translation) on a full year basis based on our estimates.

The recent stabilization of the Renminbi implies that Air China is unlikely to book foreign exchange losses this year and could potentially even book forex gains if the Renminbi strengthens further.

+ Sharp spike in spot jet fuel prices

Air China does not have any fuel hedging in place, like the other Chinese carriers. While this is not a competitive disadvantage on domestic routes given Air China’s young aircraft fleet averaging only 6.5 years old and all the other Chinese carriers it competes with do not have fuel hedging either, Air China’s lack of fuel hedging could be a disadvantage on international routes when competing with foreign carriers with substantial fuel hedging should jet fuel prices spike up sharply. Every US$1/bbl increase (decrease) in jet fuel price will cut (raise) Air China’s 2017 net profit by 2% on a full year basis based on our estimates.

+ Weaker than expected financial results of 29.99%-owned Cathay Pacific

We expect Cathay Pacific outlook to stay gloomy near term. Based on our forecasts, Cathay Pacific is likely to incur further losses of HK$989m this year as its average blended fuel price is expected to increase. We have not included any potential restructuring charges in our estimates, pending further information from Cathay Pacific on its transformation plan. Management commented that they will provide specific financial targets of Cathay Pacific’s business transformation plan in the coming months.

However, we expect Cathay Pacific’s earnings outlook to improve longer term as it focuses on cutting its unit cost ex-fuel and simplifying its fleet structure, targeting to earn returns above its cost of capital. We forecast Cathay Pacific to return to profitability in 2018 with a small net profit of HK$931m, helped by lower average hedged fuel prices, and earn a larger net profit of HK$3.5B and ROE of 6.2% by 2019 when most of its expensive fuel hedges have finally rolled over. Moreover, we believe the risk of Cathay Pacific raising equity is relatively low, unless it incurs higher than expected losses.

+ Rising interest rates

Every 10bps increase (decrease) in interest rates will cut (raise) Air China’s 2017 net profit by 0.5% on a full year basis based on our estimates. Air China has increased its fixed rate debt proportion from 35.93% of interest-bearing debt at the end of 2015 to 54.07% at the end of 2016. This will help reduce the earnings impact from a rise in interest rates longer term.

+ Domestic airports’ fee hike

The increase in the Chinese airports’ fees will raise Air China’s costs by around Rmb400m and cut Air China’s 2017 net profit by around 4% based on our estimates. This earnings impact is likely to be lower than the impact on China Eastern Airlines and China Southern Airlines. The effective impact could be lower as we expect the Chinese airlines to pass part of this cost increase to passengers via higher ticket prices over time when the industry demand and supply balance improves. Air China is likely to have a higher chance of passing this fee hike to its customers given its more moderate capacity growth plans compared to its sector peers.

+ Traffic rights constraints could limit Air China’s international expansion in certain markets near term

The Chinese airlines have already utilized a substantial portion of their allocated traffic rights in key markets based on the existing bilateral air services agreements and will need to wait for the Chinese government to conclude expanded air services agreements and allocate the incremental traffic rights to them in order to expand in such markets. However, the counterparty countries may have less urgency to do so given that their home carriers may not have utilized all their traffic rights to China as they are constrained by the current limited availability of viable airport slots in China.

+ Beijing Capital International Airport’s current capacity constraints; opening of the new airport in Beijing is a double-edged sword

Beijing Capital International Airport (BCIA)’s slot constraints will impede Air China’s expansion in the next two years until the new airport is scheduled for completion in late 2019. The opening of the new airport in Beijing is a double-edged sword for Air China. While it will enable Air China and its Star Alliance partner airlines to expand more rapidly at the current BCIA, Air China’s key airline competitors (such as China Southern Airlines) will be moving to the new, more operationally efficient new airport and will have the scope to expand more aggressively and compete with Air China at its main air hub in Beijing.

+ Rising low cost carrier penetration in Asia

There will be more low cost carrier (LCC) start-ups in North Asia which will fly into China on international routes and even domestic low cost carrier start-ups which could have lower cost structures than Air China. Although Air China has invested in new regional Chinese airlines, they are not strictly low cost carrier business models compared to AirAsia. As such, like Cathay Pacific, Air China may be missing out on this future growth market and also lack a defensive strategy against its future low cost competitors in the longer term, unlike the more progressive China Eastern Airlines which has converted China United Airlines into an LCC.

+ Yield pressure is likely to continue in the China-US and China-Australia route regions where Air China is the second and third largest carrier with 19% and 17% market share respectively

Planned capacity is expected to grow 15% y/y and 25% y/y in the China-US and China-Australia route regions in 1H17 based on the current airline flight schedules. This capacity expansion is excessive and likely to outpace market demand growth in our view and likely to put continued pressure on Air China’s passenger yields on these routes even though Air China has trimmed back its own planned capacity on China-US routes by 7% y/y and is growing its planned capacity on China-Australia routes at 10% y/y in 1H17.

AIR CHINA (753:HK) EARNINGS OUTLOOK

We expect Air China’s net profit to grow 7% y/y in 2017 as the stronger passenger revenue growth and lower sales commissions costs are likely to be partially offset by the negative impact of higher jet fuel prices, domestic airport fee hikes and expected share of losses from Air China’s stake in Cathay Pacific. Air China’s 2017 EPS is expected to decline 4% y/y due to the increased number of shares outstanding following its recent non-public A share issuance. However, we expect Air China’s earnings growth to accelerate from 2018 with net profit growing 14%-15% y/y and ROE of 9%-10% in 2018 and 2019 as the industry demand-supply balance improves with moderating new aircraft deliveries, enabling Air China to increase its pricing power in pass on the higher fuel and airport charges to its passengers and shippers. We expect Air China to generate positive free cash flows which will drive its financial leverage lower to 73% by the end of 2019. 

VALUATIONS FOR AIR CHINA LIMITED (753:HK)

We value Air China at HK$7.70 which is based on 1.2x P/B, assuming ROE of 10% and 3% long-term growth. This is at a 15% discount to Air China’s historical average valuation since listing and 33% below our estimated “break-up” value assessment of HK$11.50 per share for Air China.

Chart: Air China Gordon growth valuation model 

Air China Initiation Research Report 2017: Gordon Valuation

Chart: Air China “Liquidation” value

Air China Initiation Research Report 2017: Liquidation Value

STOCK CATALYSTS FOR AIR CHINA LIMITED (753:HK)

Air China’s H share price has risen 14% but underperformed the Hong Kong Stock Exchange Hang Seng China Enterprises Index (HSCEI) by 3% in the past 12 months. Its underperformance versus the market is mainly driven by investors’ concerns about the negative impact of passenger yield pressure (-5% y/y in 2016), foreign exchange losses from the weaker Renminbi (-6% y/y) rising jet fuel prices (+29% y/y) and Cathay Pacific’s weak financial performance on Air China’s profitability.

The recent stabilization of the Renminbi and spot jet fuel prices should help allay some of these investors’ concerns near term. Going forward, we expect Air China’s earnings outlook to improve, especially from 2018 onwards as the impact of these key negative drivers abate. Based on their scheduled new aircraft deliveries, we expect the Chinese airline sector’s capacity growth to moderate, improving the industry’s demand and supply balance, thus reducing the pressure on the Chinese airlines to discount to fill up their planes compared to previous years. The slot constraints at the major airports in China also limit the scope of aggressive capacity expansion for these airlines and at the same time serve as barriers to entry for foreign and other domestic competitors from accessing viable take-off/landing airport slots at Air China’s main air hub in Beijing in the next two years, thus mitigating the level of competitive pressure faced by Air China compared to previous years until the new airport in Beijing is built.

In addition, Air China has been reducing its US dollar debt exposure significantly which will result in smaller foreign exchange translation losses should the Renminbi weaken further. Air China’s balance sheet will continue to strengthen as we expect it to generate rising free cash flows in the next three years and it has also significantly increased its proportion of fixed rate debt to hedge its exposure against rising interest rates. Although Air China has not hedged its fuel consumption, it now operates one of the youngest aircraft fleets in the world and its fuel efficiency is expected to improve further with the delivery of the new generation aircraft which will mitigate the impact of higher fuel prices to some extent. Better industry demand-supply balance will also increase its pricing power, enabling Air China to pass on more of the fuel price increase to its passengers and shippers. Air China’s competitive unit cost advantage versus its global airline peers will enable the airline to continue to gain market share on international routes and provide the most effective defense against its airline competitors.

We view Air China as the highest quality carrier leveraged on the Chinese airline sector’s bullish long-term growth prospects among the listed Chinese airlines and initiate coverage on Air China with a fair value of HK$7.70 and Outperform rating.

CRUCIAL PERSPECTIVE FORECASTS

Chart: Air China Limited – Profit & Loss Statement

Air China Initiation Research Report 2017: Profit Loss

Chart: Air China Limited – Balance Sheet

Air China Initiation Research Report 2017: Balance Sheet

Chart: Air China Limited – Cash Flow Statement

Air China Initiation Research Report 2017: Cash Flow

Note: Stocks with upside of more than 10% based on our fair value (versus the closing share price on the date of our report) 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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