China Eastern Airlines Initiation Research Report 2017: Rapid improvement but aggressive expansion risk abounds

10 April 2017, China – During our 16 years covering the Chinese airlines sector, we have seen the greatest improvement in China Eastern Airlines. Its net profit has risen 22% CAGR in the past 16 years. From falling into negative equity in 2008, CEA’s financial position has improved significantly in recent years, with its net debt-equity reduced to 2.3x at the end of 2016. China Eastern Airlines’ investor relations materials and general company disclosures have also become more comprehensive and informative, particularly in the past 5 years, which should help raise investors’ confidence in this airline in the longer term. We initiate coverage on China Eastern Airlines with a fair value of HK$5.30 and Outperform rating. The key risk is that China Eastern Airlines’ expansion could be overly aggressive, preventing the carrier from further improving its profitability and deleveraging. 

Fair value: HK$5.30

Rating: Outperform

China Eastern Airlines has been the worst performer among the Big 3 Chinese carriers in the past 12 months – its H share price has risen only 1% and underperformed the Hong Kong Stock Exchange Hang Seng China Enterprises Index (HSCEI) by 17%. CEA’s underperformance versus the market is mainly driven by investors’ concerns about the negative impact of passenger yield pressure (down 7% y/y in 2016, worse than Air China’s 5% decline and China Southern Airlines’ 6% decline), foreign exchange losses from the weaker Renminbi (-6% y/y), rising jet fuel prices (+29% y/y), competition at its backyard from listed carriers Spring Airlines and Juneyao Airlines whose hubs are also in Shanghai and concerns over the impact of reduced group travel demand on its China-Korea routes as CEA has the highest capacity exposure (amounting to 2% of its total capacity) to China-Korea routes among the Big 3 Chinese airlines, although its exposure is lower than Spring Airlines’ 3%. The recent stabilization of the Renminbi should help allay some of these investors’ concerns near term.

Going forward, we expect China Eastern Airlines’ earnings outlook to improve, with above sector average net profit growth this year, boosted by gains from the disposal of its cargo business. 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. China Eastern Airlines is the only airline among the Big 3 Chinese carriers to have launched its own low cost carrier subsidiary China United Airlines and will be better-positioned to leverage on the budget travel market longer term while serving as a defensive strategy against other LCC competitors. In addition, CEA will gain significant access to the Beijing-Hebei-Tianjin catchment area when the new Beijing airport opens as one of the hub airlines there.

In addition, China Eastern Airlines has been reducing its US dollar debt exposure significantly which will result in smaller foreign exchange translation losses should the Renminbi weaken further. Although China Eastern Airlines has not hedged its fuel consumption, it now operates the youngest aircraft fleet among the Big 3 Chinese carriers and one of the youngest aircraft fleets in the world. CEA’s fuel efficiency is expected to improve further with the delivery of the new generation aircraft from 2018 which will mitigate the impact of higher fuel prices to some extent. Better industry demand-supply balance will also enable China Eastern Airlines to pass on more of the fuel price increase to its passengers and shippers. The key risk is that China Eastern Airlines’ expansion could be overly aggressive, preventing the carrier from further improving its profitability and deleveraging.

Chart: China Eastern Airlines Corporation Limited – Crucial Perspective Scorecard (Full marks = 100 points)

China Eastern Airlines Initiation Research Report 2017: Crucial Perspective Scorecard

Chart: China Eastern Airlines Corporation Limited – Financial Summary

China Eastern Airlines Initiation Research Report 2017: Financial Summary

KEY POSITIVE DRIVERS FOR CHINA EASTERN AIRLINES OUTLOOK

+ Balance sheet has improved the most significantly among the Big 3 Chinese airlines

China Eastern Airlines has shown the largest improvement in its balance sheet strength among the Big 3 Chinese carriers, a marked rebound from its negative equity position back in 2008 during the global financial crisis when it booked substantial fuel hedging losses. CEA’s net debt-equity ratio was 2.3x at the end of 2016 from 3.4x at the end of 2011. As a state-owned enterprise, China Eastern Airlines is also deemed to be a fairly low-risk credit to financial institutions, enabling it to maintain its low cost of borrowing.

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

China Eastern Airlines Initiation Research Report 2017: Net debt-equity ratio

+ Profit margins have expanded as much as Air China’s in the past 5 years

China Eastern Airlines is a more profitable carrier than China Southern Airlines but still lags Air China in terms of profitability. What is encouraging is that its EBITDAR margin has risen 12ppts in the past 5 years, as much as the margin improvement achieved by Air China and double that of China Southern Airlines’ 6ppts EBITDAR margin improvement during the same period.

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

China Eastern Airlines Initiation Research Report 2017: EBITDAR

+ CEA has the largest passenger revenue exposure to international routes; 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. 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)

China Eastern Airlines Initiation Research Report 2017: Traffic vs China 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 given its low travel penetration. China’s trips per capita per annum is only 0.09, well below the 2.0 trips per capita of developed markets and has strong growth potential as per capita incomes continue to rise.

This will continue to drive China Eastern Airlines’ 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. China Eastern Airlines has the largest passenger revenue exposure to international routes among the Big 3 Chinese carriers. International routes contributed 31% of CEA’s passenger revenue in 2016 compared to 28% for Air China and 22% for China Southern Airlines.

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

As China Eastern Airlines 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 contributes around 15% of China Eastern Airlines’ passenger revenue based on our estimates, 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. The number of frequent flyers rose 11% y/y to 29.2 million in 2016.

+ Operates the youngest aircraft fleet among the Big 3 Chinese carriers and one of the youngest aircraft fleets in the world, driven by its fleet renewal and fleet type simplification programme

Following its aircraft fleet renewal in recent years, China Eastern Airlines now operates the youngest aircraft fleet among the Big 3 Chinese carriers and one of the youngest passenger aircraft fleets globally at 5.4 years old on average, much newer than the global airline sector average fleet age of 12 years. China Eastern Airlines has also simplified the number of aircraft types in its fleet in recent years. This improved aircraft fleet strategy will continue to drive operating costs lower, especially when it starts to take delivery of new-generation aircraft B787s and A350s which are more fuel efficient from 2018. 4 B787s and 2 A350s are scheduled for delivery in 2018, replacing CEA’s older B767 and A330 aircraft.   

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

We expect China Eastern Airlines’ sales commissions costs to continue to trend down this year as it continues to increase its proportion of direct sales. Direct sales accounted for 49% of CEA’s passenger revenue in 2016 versus 36% in 2015. New E-commerce users rose 351% y/y to 13.9 million in 2016.

Increased direct sales will also facilitate the marketing of more ancillary products and services which should help boost China Eastern Airlines’ value added services revenue over time. CEA’s value-added services revenue rose 46% y/y to Rmb2.2B in 2016.

+ Opening of the new airport in Beijing will broaden China Eastern Airlines’ catchment area and route network

China Eastern Airlines will be one of the hub airlines at the new Beijing airport, enabling the carrier to gain greater access the Beijing-Hebei-Tianjin catchment area and broaden its route network. The Chinese government plans to build a new special economic zone in Xiongan which is close to the new Beijing airport and will be a new significant traffic growth driver for China Eastern Airlines in the longer term.

Apart from being able to tap on increased business traffic, especially between the Beijing-Hebei-Tianjin and the Yangtze River Delta region, China Eastern Airlines is well-positioned to capture more domestic leisure traffic between these two regions (such as Shanghai Disneyland visitors). Shanghai Disneyland has already received 8 million visitors since its opening in June 2016 and is expected to achieve 10 million visitor arrivals during its first year of operations. This is likely to continue to boost China Eastern Airlines’ domestic leisure traffic growth in the coming years.

+ 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 in the longer term

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 (2016 to 2021)

China Eastern Airlines Initiation Research Report 2017: 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

China Eastern Airlines Initiation Research Report 2017: APAC market share

Chart: Airline Sector demand and supply analysis – China and the Asia Pacific region

China Eastern Airlines 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.

KEY NEGATIVES AND DOWNSIDE RISKS FOR CHINA EASTERN AIRLINES OUTLOOK

China Eastern Airlines’ passenger yields have declined to a larger extent compared to Air China and China Southern Airlines in the past five years, mainly due to its more aggressive capacity expansion. This remains a key risk as China Eastern Airlines’ future expansion could be overly aggressive, preventing the carrier from further improving its profitability and deleveraging. 

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

China Eastern Airlines Initiation Research Report 2017: Passenger Trends

+ Competition from listed carriers Juneyao Airlines and Spring Airlines which are also based in Shanghai

The combined market share of China Eastern Airlines and Shanghai Airlines at their main hub in Shanghai Hongqiao and Pudong airports has declined 10ppts from 52% to 42% between 2006 and 2016. During this period, the market shares of listed carriers Spring Airlines and Juneyao Airlines have risen to 7% and 8% respectively in 2016 following their launch in 2005 and 2006 respectively. The 10ppts market share decline experienced by China Eastern Airlines and Shanghai Airlines at their main hub in Shanghai between 2006 and 2016 is more significant than the combined market share decline of 7ppts from 56% to 49% experienced by China Southern Airlines (CSA) and Xiamen Airlines at CSA’s main hub in Guangzhou. Meanwhile, Air China and Shenzhen Airlines’ combined market share in 2016 is unchanged at 40% versus their combined market share back in 2006.

Chart: Airline market shares at their main hubs in Shanghai, Beijing and Guangzhou (2016 vs 2006)

China Eastern Airlines Initiation Research Report 2017: Hub Market share

+ China’s travel curbs on Korea

The China National Tourism Administration (CNTA) has issued a travel advisory on 3rd March 2017 advising its residents to exercise caution when choosing their international travel destination following the rise in the number of incidents of Chinese residents being denied entry in Jeju island (source: Financial Times, 3rd March 2017). In addition, Korea Joongang Daily reported on 4th March 2017 that the Chinese government has instructed the travel agencies to stop selling tour packages to South Korea starting from 15th March 2017 in the latest retaliation against the deployment of the United States’ Terminal High Altitude Area Defense (THAAD) system in South Korea. Chinese travelers can still visit Korea if they do direct ticket bookings and free-and-easy trips.

Air travel demand has already decelerated and is likely to decline on China-Korea routes near term due to the impact of China travel curbs to South Korea. The growth of Chinese outbound traffic to South Korea, which is one of the most popular travel destinations for Chinese outbound tourists, had already started slowing since 4Q16. The number of Chinese outbound tourists to South Korea grew only 7% y/y in 4Q16, a sharp deceleration from its 45% growth y/y in 9M16.

This follows the Chinese government’s advisory to travel agencies back in October 2016 to reduce the number of group tours to Korea by more than 20% from November 2016 to April 2017 (source: Bloomberg). This will negatively impact outbound Korean traffic to China near term.

In 2016, 4 million of the 8.1 million Chinese who visited South Korea were on tour packages. There could therefore be as much as a 4 million drop in Chinese visitor arrivals to South Korea on an annual basis. We estimate that the Chinese and Korean airlines will need to cut their seat capacity on China-Korea routes by as much as 33% in order to maintain existing passenger load factors.

However, in reality, the decline in traffic is likely to be less than 4 million as some Chinese visitors would still try to circumvent the China travel curbs on travel to South Korea, most likely by opting for free-and-easy travel to South Korea. Furthermore, the share of package tours has been declining in recent years.

Chart: China outbound tourists to South Korea (4Q14 to 4Q16)

China Eastern Airlines Initiation Research Report 2017: China outbound to S. Korea

The Chinese airlines’ capacity exposure to China-Korea routes is relatively smaller compared to Asiana and Korean Air. Korea-China routes drive 22% of Asiana’s passenger revenue and 15% of Korean Air’s passenger revenue. Nevertheless, we expect them to be negatively impacted by the China travel curbs to South Korea as the China-Korea routes are high-yielding ones for the Chinese airlines. Among the listed carriers, Spring Airlines has the largest exposure to China-Korea routes which account for 3% of its total passenger capacity, followed by China Eastern Airlines at 2% and China Southern Airlines at 1%.

China Eastern Airlines’ management commented during their results briefing on 31st March 2017 that one mitigating factor is that although passenger bookings have fallen around 30% y/y on China-Korea routes, the average passenger yields have improved around 15%-16% y/y. In addition, CEA has re-deployed this capacity to its domestic routes and travel demand is being diverted from China-Korea routes to other route regions which should help to partially offset this negative earnings impact. 

+ Aggressive capacity expansion on China-Europe route region could put pressure on load factors and yields

China Eastern Airlines is the second largest carrier on China-Europe routes with 12% market share after Air China (which has a 25% market share). We are concerned about China Eastern Airlines’ aggressive planned capacity growth on China-Europe routes of 41% y/y in 1H17 versus the 5% overall capacity growth for this route region. This could put continued pressure on China Eastern Airlines’ passenger load factors and yields on China-Europe routes.

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

China Eastern Airlines Initiation Research Report 2017: China-Europe

+ Yield pressure is likely to continue in the China-US and China-Australia route regions where China Eastern Airlines is the third and second largest carrier with 18% and 27% market share respectively

China Eastern Airlines is the third and second largest carrier in the China-United States and China-Australia route regions. The planned airline capacity growth is expected to be 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. Such capacity expansion looks excessive and likely to outpace market demand growth in our view and could put continued pressure on China Eastern Airlines’ passenger yields. China Eastern Airlines’ own planned capacity is also quite substantial at 11% y/y on China-US routes and 32% y/y on China-Australia routes in 1H17.

Chart: Airline market shares on China-United States flights (1Q17) – China Eastern Airlines is the third largest carrier in this route region

China Eastern Airlines Initiation Research Report 2017: China US flights

Chart: Airline market shares on China-Australia flights (1Q17) – China Eastern Airlines is the second largest carrier in this route region

China Eastern Airlines Initiation Research Report 2017: China Australia flights

+ Unit cost reduction has lagged Air China and China Southern Airlines

China Eastern Airlines’ unit cost and ex-fuel unit cost have declined to a smaller extent in the past 5 years compared to the other Chinese carriers although this gap is narrowing. China Eastern Airlines achieved the largest ex-fuel unit cost decline y/y in 2016 which is encouraging.

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

China Eastern Airlines Initiation Research Report 2017: Unit cost per ATK

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

China Eastern Airlines Initiation Research Report 2017: Ex-fuel unit cost per ATK

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

The strengthening of the US dollar against the Renminbi is negative for China Eastern Airlines (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 China Eastern Airlines (and the Asian airline stocks) when the US dollar strengthens (weakens) against their local currencies.

However, China Eastern Airlines 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. 45% of CEA’s total debt was in US dollars at the end of 2016, lower than Air China’s 49% but higher than China Southern Airlines’ 39%. Every 1% weakening (strengthening) of the Rmb will cut (boost) China Eastern Airlines’ 2017 net profit by 7% (3% operational impact + 4% forex translation) on a full year basis based on our estimates versus 8% for Air China and 9% for China Southern Airlines.

The recent stabilization of the Renminbi implies that China Eastern Airlines 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

China Eastern Airlines does not have any fuel hedging in place, like the other Chinese carriers. While this is not a competitive disadvantage on domestic routes given China Eastern Airlines’ young aircraft fleet averaging only 5.4 years old and all the other Chinese carriers it competes with do not have fuel hedging either, CEA’s lack of fuel hedging could be a disadvantage 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) China Eastern Airlines’ 2017 net profit by 2% on a full year basis based on our estimates, similar to Air China’s 2% impact but lower than China Southern Airlines’ 3% impact.

+ Rising interest rates

Rising interest rates are negative for China Eastern Airlines given its high financial leverage. Every 10bps increase (decrease) in interest rates will cut (raise) China Eastern Airlines’ 2017 net profit by 0.6% on a full year basis based on our estimates, higher than Air China’s 0.5% impact but lower than China Southern Airlines’ 0.8% impact.

+ Potential need for further capital-raising

We expect China Eastern Airlines to increase its aircraft capex spending (on top of its announced planned capital expenditure of Rmb123B as at Dec 2016) and related operational costs, as well as moving costs, in the coming years as the carrier plans its move from Beijing Capital International Airport to the new Beijing airport which is scheduled to open in September 2019.

In addition, with the scheduled implementation of IFRS 16 Leases accounting standards from 1st January 2019, China Eastern Airlines’ reported 2019 net debt-equity could potentially rise from 1.6x to 2.1x after adjusting for the capitalization of aircraft operating leases. As such, China Eastern Airlines could potentially consider raising more equity to fund its future aircraft capex and to strengthen its balance sheet in our view.

+ Domestic airports’ fee hike

The increase in the Chinese airports’ fees will raise China Eastern Airlines’ costs by around Rmb400m-Rmb500m and cut CEA’s 2017 net profit by around 5% based on our estimates. This earnings impact is likely to be higher than Air China’s 4% impact but lower than China Southern Airlines 8% impact. 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. 

+ Traffic rights constraints could limit China Eastern Airlines’ 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 country 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 limited availability of viable airport slots in China.

+ 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 China Eastern Airlines. To counter this, China Eastern Airlines has converted its subsidiary China United Airlines into a low cost carrier, enabling it to leverage on the budget travel market’s future growth and serving as a defensive strategy against its LCC competitors. This is a progressive move and only CEA has undertaken this strategy among the Big 3 Chinese carriers.

CHINA EASTERN AIRLINES EARNINGS OUTLOOK

We expect China Eastern Airlines’ net profit to grow 66% y/y in 2017, boosted by the gains from the disposal of its cargo business. 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 discontinued profits from its cargo entity. Due to the high base in 2017 boosted by asset disposal gains, we expect China Eastern Airlines’ net profit to decline 12% y/y in 2018 before resuming its growth of 14% y/y in 2019 as travel demand continues to grow and the airline industry’s demand and supply balance improves. We expect China Eastern Airlines to deliver a 13% ROE in 2017, bumped up by disposal gains and 10% ROE in 2018 and 2019.

We expect China Eastern Airlines’ net debt-equity to trend lower to 1.6x by the end of 2019 from 2.3x in 2016. However, China Eastern Airlines’ financial leverage could potentially end up higher than our current forecasts as we expect CEA to increase its aircraft capex spending (on top of its announced planned capital expenditure of Rmb123B as at Dec 2016) and related operational costs, as well as moving costs, in the coming years as the carrier plans its move from Beijing Capital International Airport to the new Beijing airport which is scheduled to open in September 2019, unless China Eastern Airlines considers raising more equity.

VALUATIONS FOR CHINA EASTERN AIRLINES CORPORATION LIMITED

We value China Eastern Airlines at HK$5.30 which is based on 1.1x P/B, assuming ROE of 10% and 3% long-term growth. This is at a 15% discount to China Eastern Airlines’ historical average valuation since listing and 40% below our estimated “liquidation” value assessment of HK$8.80 per share for China Eastern Airlines.

Chart: China Eastern Airlines Corporation Limited – Gordon growth valuation model

China Eastern Airlines Initiation Research Report 2017: Gordon growth valuation

Chart: China Eastern Airlines Corporation Limited – Estimated “liquidation” value

China Eastern Airlines Initiation Research Report 2017: Liquidation Value

STOCK CATALYSTS FOR CHINA EASTERN AIRLINES CORPORATION LIMITED

China Eastern Airlines has been the worst performer among the Big 3 Chinese carriers in the past 12 months – its H share price has risen only 1% and underperformed the Hong Kong Stock Exchange Hang Seng China Enterprises Index (HSCEI) by 17%. CEA’s underperformance versus the market is mainly driven by investors’ concerns about the negative impact of passenger yield pressure (down 7% y/y in 2016, worse than Air China’s 5% decline and China Southern Airlines’ 6% decline), foreign exchange losses from the weaker Renminbi (-6% y/y), rising jet fuel prices (+29% y/y), competition at its backyard from listed carriers Spring Airlines and Juneyao Airlines whose hubs are also in Shanghai and concerns over the impact of reduced group travel demand on its China-Korea routes as CEA has the highest capacity exposure (amounting to 2% of its total capacity) to China-Korea routes among the Big 3 Chinese airlines, although its exposure is lower than Spring Airlines’ 3%. The recent stabilization of the Renminbi should help allay some of these investors’ concerns near term.

Going forward, we expect China Eastern Airlines’ earnings outlook to improve, with above sector average net profit growth this year, boosted by gains from the disposal of its cargo business. 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. China Eastern Airlines is the only airline among the Big 3 Chinese carriers to have launched its own low cost carrier subsidiary China United Airlines and will be better-positioned to leverage on the budget travel market longer term while serving as a defensive strategy against other LCC competitors. In addition, CEA will gain significant access to the Beijing-Hebei-Tianjin catchment area when the new Beijing airport opens as one of the hub airlines there.

In addition, China Eastern Airlines has been reducing its US dollar debt exposure significantly which will result in smaller foreign exchange translation losses should the Renminbi weaken further. Although China Eastern Airlines has not hedged its fuel consumption, it now operates the youngest aircraft fleet among the Big 3 Chinese carriers and one of the youngest aircraft fleets in the world. CEA’s 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 enable China Eastern Airlines to pass on more of the fuel price increase to its passengers and shippers. We initiate coverage on CEA with a fair value of HK$5.30 and Outperform rating. The key risk is that China Eastern Airlines’ expansion could be overly aggressive, preventing the carrier from further improving its profitability and deleveraging. 

CRUCIAL PERSPECTIVE FORECASTS

Chart: China Eastern Airlines Corporation Limited – Profit & Loss Statement

China Eastern Airlines Initiation Research Report 2017: Profit Loss

Chart: China Eastern Airlines Corporation Limited – Balance Sheet

China Eastern Airlines Initiation Research Report 2017: Balance Sheet

Chart: China Eastern Airlines Corporation Limited – Cash Flow Statement

China Eastern Airlines 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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