China Eastern Airlines (670:HK) Fair value: HK$7.30
China Eastern Airlines (670:HK) Rating: Outperform
2 April 2018, China – We attended China Eastern Airlines’ post 2017 financial results management briefing. The key highlight is that China Eastern Airlines, the only Big 3 Chinese carrier to have launched its own LCC, is starting to reap the rewards of its progressive low-cost carrier strategy. Its 100%-owned low-cost carrier China United Airlines’ net profit surged 73% y/y to Rmb810 million with a net profit margin was 16% in 2017, ranking it among the most profitable LCCs in Asia. In addition, China Eastern Airlines has started to focus on its digitalization strategy which can potentially boost its net profit by Rmb5.8B million per year and raise its fair value to HK$14.50 if it can successfully collect and monetize its Big Data on our estimates. This is 2.5 times China Eastern Airlines’ current H share price and 1.6 times its current A share price! We remain bullish on China Eastern Airlines and maintain our Outperform rating and fair value of HK$7.30 on the stock.
The only Big 3 Chinese airline to launch a low-cost carrier and this strategy is paying off as China United Airlines’ profits surge in 2017
China Eastern Airlines (670:HK) is the only airline among the Big 3 Chinese carriers to launch its own low-cost carrier China United Airlines. This progressive strategy will position it better to leverage on the budget travel market longer term while serving as a defensive strategy against other LCC competitors. In addition, China Eastern Airlines (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 with a target market share of 40%. Its LCC China United Airlines will also move to the new Beijing airport which will provide greater opportunities for growth.
Low cost carrier China United Airlines has grown its fleet to 39 aircraft and its net profit surged 73% y/y to Rmb810 million with 16% net profit margin. This ranks China United Airlines as one of the most profitable low-cost carriers in Asia. Interestingly, China United Airlines’ aircraft fleet amounts to 6% of China Eastern Airlines Group fleet but its net profit amounts to 13% of Group net profit.
Direct sales accounted for 75% of China United Airlines’ total sales, +8.5ppts y/y in 2017. There is still significant upside in China United Airlines’ ancillary income which, although up 23% y/y in 2017, accounts for only 6% of China United Airlines’ total revenue, well below the 20% average ancillary income contribution of the more established low-cost carriers in Asia.
Chart: China United Airlines’ net profit margin versus listed low-cost carriers in Asia (2017)
Successful passenger data monetization can potentially boost China Eastern Airlines’ net profit by Rmb5.8B per year and raise its fair value to HK$14.50 per share
China Eastern Airlines has started to focus on its digitalization strategy and increasing automation. This, along with rising direct sales (which accounted for 51% of CEA’s passenger revenue in 2017), will facilitate the collection and monetization of passenger data and improve cost efficiency. China Eastern Airlines had the most number of aircraft installed with onboard Wi-Fi capability. As at end 2017, internet access was available in all of CEA Group’s 74 wide-body aircraft covering destinations in Europe, US, Australia and China. China Eastern Airlines’ domestic and international self-service check-in ratios have also risen to 71% and 23% respectively in 2017. CEA’s integrated products revenue rose 113% y/y and its Eastern Miles Mall revenue rose 149% y/y in 2017.
Recall in our previous report, we estimate that the collection and monetization of Inflight Passenger Data is worth US$100 billion additional revenue per year for the global airline industry, a number that will dramatically increase with advances in Internet of Things (IoT) technology. This could potentially boost the global airlines’ enterprise value by at least US$120 billion (based on the airlines’ current valuations) to as much as US$500 billion. See our previous 5th Dec 2017 report:
China Eastern Airlines can potentially raise its revenue by Rmb16.7B per year, boosting its net profit by Rmb5.8B million per year (versus its recurring profit of Rmb2.6B in 2017), if it can successfully collect and monetize its Big Data based on our estimates. This will enable China Eastern Airlines to achieve Rmb8.4B net profit a year which would be a significant positive share price driver for China Eastern Airlines.
Investors will begin to value China Eastern Airlines like a growth stock given its improved long-term revenue and earnings growth prospects. Valuing CEA at 20x P/E would imply a fair value of HK$14.50 per share. This is 2.5 times China Eastern Airlines’ current H share price of HK$5.70 and 1.6 times its current A share price of Rmb7.19!
Chart: Airlines are sitting on US$100 Billion Inflight Big Data Goldmine
Rising front end and codeshare revenue
Meanwhile, China Eastern Airlines’ premium class revenue is increasing which will help improve its passenger yield. China Eastern Airlines’ premium class passenger load factor rose 3ppts y/y and its premium class revenue rose nearly 18% y/y in 2017. Revenue from cooperation with foreign airlines increased 22% y/y in 2017, driven by its code-sharing agreement with 28 airlines in 1028 routes.
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 5.5 years old on average, much newer than the global airline sector average fleet age of 12 years.
China Eastern Airlines has also simplified its fleet in recent years to 5 aircraft types. 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, and another 6 B787s and 5 A350s in 2019, replacing CEA’s older B767 and A330 aircraft.
Moderate planned capacity growth this year should help support yield improvement
China Eastern Airlines’ planned capacity growth will be moderate this year. Overall capacity will grow only 9.4% y/y in 2018 – domestic +10.7%, international +7.5%, regional +6.1%. This should help support its domestic as well as international passenger yield improvement.
Robust China outbound travel demand will exceed China Eastern Airlines’ moderate aircraft fleet expansion plans in the coming years
Like Air China, China Eastern Airlines Group’s gross aircraft fleet expansion plans will be moderate in the next three years. It is scheduled to add 67 aircraft to its fleet and retire 15 aircraft in 2018, 62 in 2019 (with no aircraft retirements) and 61 aircraft in 2020 and retire 10, implying a net 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:
High fuel price is the key earnings risk as China Eastern Airlines remains unhedged
Fuel cost is China Eastern Airlines’ largest cost component and constitutes 25% of CEA’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 China Eastern Airlines 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 CEA operates one of the youngest aircraft fleets globally, averaging only 5.5 years old, which is more fuel efficient.
Further forex gains in 2018 but lower exposure to US dollar volatility going forward
China Eastern Airlines’ US dollar debt exposure has fallen further to 28% in 2017 from 45% in 2016. We expect CEA to book further forex gains in 2018 as the US dollar has weakened further since Dec 2017. However, CEA’s overall earnings will be less leveraged to US dollar volatility going forward.
2017 financial results are in line with our expectations
China Eastern Airlines’ net profit rose 41% y/y to Rmb6.3 billion, in line with our forecasts, mainly driven by stronger passenger traffic (+9% y/y), slight improvement in passenger yields (+1%) in 2017. The results were also boosted by Rmb1.8B disposal gains from the divestment of Eastern Logistics and Rmb2.0B forex gains from the stronger Renminbi. Excluding these, recurring profit was Rmb2.6B in 2017 based on our estimates.
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