China Southern Airlines Initiation Research Report 2017 – Strong domestic drivers tempered by funding needs

10th Apr 2017, China – China Southern Airlines’ stock price has outperformed China Eastern Airlines’ but underperformed Air China’s in the past 12 months – its H share price has risen only 5% and underperformed the Hong Kong Stock Exchange Hang Seng China Enterprises Index (HSCEI) by 11%. CSA’s underperformance versus the market is mainly driven by investors’ concerns about the negative impact of passenger yield pressure (down 6% y/y in 2016, worse than Air China’s 5% decline but better than China Eastern Airlines’ 7% decline), foreign exchange losses from the weaker Renminbi (-6% y/y), rising jet fuel prices (+29% y/y) and concerns over the impact of reduced group travel demand on its China-Korea routes as CSA has the second highest capacity exposure (1% of its total capacity) to China-Korea routes among the Big 3 Chinese airlines.

Fair value: HK$6.30

Rating: Outperform

Going forward, we expect China Southern Airlines’ EPS to decline this year, mainly driven by the higher fuel prices, domestic airport fee hikes and increased shares outstanding following its H shares issue to American Airlines but resume its earnings growth from 2018 onwards as the impact of some of the above 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. CSA will also gain significant access to the Beijing-Hebei-Tianjin catchment area when the new Beijing airport opens as one of the hub airlines there. This could be a game-changer for China Southern Airlines in the longer term, reversing its historical disadvantage of being based in the weakest hub (Guangzhou) among the Big 3 Chinese carriers. We expect CSA’s growth to become more exciting from 2020 onwards. China Southern Airlines’ strategic partnership with American Airlines will also boost its traffic feed, strengthening its market position on China-U.S. routes and enhance its expertise in driving greater ancillary income longer term.

The recent stabilization of the Renminbi should help allay some of these investors’ concerns near term. In addition, China Southern Airlines has been reducing its US dollar debt exposure the most aggressively among the Big 3 Chinese carriers which will result in smaller foreign exchange translation losses compared to its historical years should the Renminbi weaken further. Although China Southern Airlines has not hedged its fuel consumption, it now operates one of the youngest aircraft fleets in the world at 6.6 years old on average. CSA’s fuel efficiency is expected to improve further with the delivery of more new generation aircraft (including the A320neo, B737 MAX, B787-900 planes) which will mitigate the impact of higher fuel prices to some extent. Better industry demand-supply balance will also increase its pricing power, enabling China Southern Airlines to pass on more of the fuel price increase and domestic airport fees hike to its passengers and shippers. CSA’s economies of scale and relatively competitive cost structure versus its global airline peers will enable the airline to continue to grow its international revenue and provide the most effective defense against its airline competitors, particularly on domestic routes.

We initiate coverage on China Southern Airlines with a fair value of HK$6.30 and Outperform rating. The key risk is potential dilution as we expect China Southern Airlines to raise more equity, in order to fund its future aircraft and related infrastructure capex given its plans to substantially develop its hub operations at the new Beijing airport and to strengthen its balance sheet. The implementation of IFRS 16 Leases accounting standard (with effect from 1st January 2019) will have the most significant impact on China Southern Airlines due to its higher proportion of aircraft on operating leases (35% of its total aircraft fleet) among the Big 3 Chinese carriers.

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

China Southern Airlines Initiation Research Report 2017: Crucial Perspective Scorecard

Chart: China Southern Airlines Company Limited – Financial Summary

China Southern Airlines Initiation Research Report 2017: Financial Summary

KEY POSITIVE DRIVERS FOR CHINA SOUTHERN AIRLINES OUTLOOK

+ China Southern Airlines has a more dominant market position at its main hub in Guangzhou compared to China Eastern Airlines and Air China’s market positions at their respective main hubs in Shanghai and Beijing

China Southern Airlines (together with 55%-owned Xiamen Airlines) has a more dominant market share of 49% at its main hub in Guangzhou compared to Air China and Shenzhen Airlines’ combined market share of 40% at Air China’s main hub in Beijing and China Eastern Airlines (CEA) and Shanghai Airlines’ combined market share of 42% at CEA’s main hub in Shanghai.

Having said that, the combined market share decline of China Southern Airlines (CSA) and Xiamen Airlines at CSA’s main hub in Guangzhou has declined 7ppts between 2006 and 2016. While this is smaller than the 10ppts combined market share decline experienced by China Eastern Airlines and Shanghai Airlines at their main hub in Shanghai Hongqiao and Pudong airports between 2006 and 2016, CSA is worse off than Air China and Shenzhen Airlines which managed to retain their combined market share of 40% at Air China’s main hub in Beijing between 2006 and 2016. We would therefore monitor the risk of further market share erosion closely going forward.

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

China Southern Airlines Initiation Research Report 2017: Hub Mkt share

+ Substantial unit cost reductions achieved in recent years, beating China Eastern Airlines’ but lagging Air China’s

China Southern Airlines’ unit cost and ex-fuel unit cost have declined more significantly than China Eastern’s but lagged Air China’s in the past 5 years. This positions China Southern Airlines well to compete against other global airlines on international routes and provides the best defensive strategy against domestic competitors. However, we note CSA’s 1% ex-fuel unit cost increase y/y in 2016 and would be concerned if this continues to trend higher.

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

China Southern Airlines Initiation Research Report 2017: Unit cost ATK

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

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

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

We expect China Southern 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 43% of CSA’s passenger revenue in 2016. Specifically in 2016, CSA’s online direct sales rose 58% y/y to Rmb28.8B, mobile terminal sales rose 142% y/y to Rmb4.86B while social media sales rose 262% y/y to Rmb550m.

Increased direct sales will also facilitate the marketing of more ancillary products and services which should help boost China Southern Airlines’ ancillary income over time. CSA’s ancillary income rose 179% y/y to Rmb550 million in 2016.

+ Operates one of the youngest aircraft fleets in the world, driven by its fleet renewal programme

Following its aircraft fleet renewal in recent years, China Southern Airlines now operates one of the youngest passenger aircraft fleets globally at 6.6 years old on average (similar to Air China’s average fleet age of 6.5 years but slightly older than China Eastern Airlines’ 5.4 years), much newer than the global airline sector average fleet age of 12 years. This aircraft fleet renewal strategy will continue to drive operating costs lower, with the delivery of more new generation aircraft (including the A320neo, B737 MAX, B787-900 planes), helping to mitigate the impact of higher fuel prices to some extent. China Southern Airlines also has the best safety track record among the Chinese airlines.

+ Opening of the new airport in Beijing could be a game changer for China Southern Airlines, providing access to a better air hub, widening its catchment area and route network

China Southern Airlines will be one of the hub airlines at the new Beijing airport which is scheduled to open in September 2019, 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. This will be a new significant growth driver for China Southern Airlines in the longer term, boosting its business and leisure traffic growth, especially between the Beijing-Hebei-Tianjin and the Pearl River Delta regions from 2020 onwards.

+ 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 Southern Airlines 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 remain 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 Southern 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.

+ Positive impact from American Airlines’ investment in China Southern Airlines and the two carriers’ strategic partnership

China Southern Airlines plans to issue 270.6 million new H shares, amounting to a 2.68% stake in CSA to American Airlines, Inc. The subscription price is HK$5.74 per share, amounting to a total cash consideration of HK$1.553B and the net proceeds after deducting expenses will be HK$1.548B. The subscription price represents a 7% premium to the average closing H share price of CSA in the last 5 trading days prior to the subscription agreement date.

Chart: China Southern Airlines’ existing shareholding structure prior to the new H share issue

China Southern Airlines Initiation Research Report 2017: Existing Shareholding Structure

Chart: China Southern Airlines’ new shareholding structure following the new H share issue

China Southern Airlines Initiation Research Report 2017: Structure after issue

China Southern Airlines is the last of the Big 3 Chinese carriers to join the “foreign airline investment bandwagon”. Recall Cathay Pacific has an 18% stake in Air China while Delta Air Lines invested a 3% stake in China Eastern Airlines in 2015.

This strategic partnership will help widen CSA’s international route network and boost traffic feed. China Southern Airlines has the lowest revenue exposure to international routes among the Big 3 Chinese carriers. International routes contributed 22% of CSA’s total passenger revenue versus 31% for China Eastern Airlines and 28% for Air China in 2016. Forming a strategic partnership with American Airlines, which is the largest carrier in the world, can help expand China Southern Airlines’ network reach and frequency options for its customers.

Both carriers’ have dominant domestic operations and their route networks are highly complementary. For China Southern Airlines, its China-US flights are mainly from/to its main hub in Guangzhou (as well as Wuhan plus Shenzhen and Fuzhou operated by its 55%-owned subsidiary Xiamen Airlines) while American Airlines operates flights to Beijing and Shanghai from its hubs in Chicago, Dallas and Los Angeles.

Both carriers are targeting to launch their codeshare and interline agreements later this year. China Southern Airlines’ passengers will gain access to nearly 80 destinations in North and South America beyond Los Angeles, San Francisco and New York. For the codesharing routes, both carriers’ passengers can earn and redeem AAdvantage® Miles, through-bag checking and single-ticket booking. For routes under the interline agreement, both carriers’ passengers will be able to check their bags through to their final destinations. American Airlines currently operates daily flight services from Dallas to Hong Kong, Beijing and Shanghai, from Los Angeles to Hong Kong and Shanghai and from Chicago to Beijing and Shanghai.

China Southern Airlines’ market share is only 10% (or 12% including its 55%-owned subsidiary Xiamen Airlines) in the China-U.S. route region. Partnering American Airlines will raise the two carriers’ combined market share to 18% (or 20% including its 55%-owned subsidiary Xiamen Airlines) in the China-U.S. route region. Both carriers can offer more flight frequency and destination options to their travelers and potentially gain new market share. However, their combined market share will still lag that of United Airlines and Air China. United Airlines’ individual market share is 20% while Air China’s is 19% and both carriers are part of the Star Alliance in the China-U.S. route region. China Eastern Airlines’ own market share is already 18% and its combined market share with Delta Air Lines total 26%. In comparison,

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

China Southern Airlines Initiation Research Report 2017: China-US

It is uncertain whether China Southern Airlines will leave the SkyTeam airline alliance to join Oneworld alliance or reap the benefits of both global airline alliances by staying in SkyTeam while deepening its partnership with American Airlines which is a founding member of Oneworld. If China Southern Airlines’ partnership with American Airlines results in significant cooperation and synergies, it could potentially consider leaving the SkyTeam airline alliance and joining Oneworld since two of the Big 3 Chinese carriers (CSA and China Eastern Airlines) are in the SkyTeam alliance. Alternatively, CSA could adopt the same alliance strategy as Air China which is a member of the Star Alliance even though Cathay Pacific (part of Oneworld) has an 18% stake in Air China. Moreover, the Oneworld alliance already has Cathay Pacific among its members whose hub in Hong Kong is located close to CSA’s hub in Guangzhou and the Pearl River Delta region. The Oneworld alliance is also the smallest among the three global airline alliances.

China Southern Airlines is targeting to boost its ancillary income and can learn from American Airlines’ experience in driving ancillary income growth, as well as general yield, cost and network management through the sharing of management expertise.

+ Potential disposal of cargo business

We believe China Southern Airlines operates a sub-optimal cargo business and should consider disposing the asset and focus on growing its passenger airline business, similar to the transaction done by China Eastern Airlines recently. This would be a positive development in our view given that the global air cargo industry is likely to remain oversupplied and China Southern Airlines’ cargo load factors have consistently been low, averaging 49% in the past 10 years, due to its large and growing bellyhold cargo capacity. Many of CSA’s passenger flights are on routes where there is limited air cargo transport demand. 

+ 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 Southern Airlines Initiation Research Report 2017: Seat Capacity

+ 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 Southern Airlines Initiation Research Report 2017: Asia Pacific

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

China Southern 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 Southern 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 SOUTHERN AIRLINES OUTLOOK

+ Least profitable among the Big 3 Chinese carriers

China Southern Airlines is the least profitable among the Big 3 Chinese carriers. Although CSA’s EBITDAR margin has improved 6ppts in the past 5 years, this improvement is half of the 12ppts EBITDAR margin improvement achieved by Air China and China Eastern Airlines during the same period.

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

China Southern Airlines Initiation Research Report 2017: EBITDAR

+ Balance sheet is the weakest among the Big 3 Chinese airlines

China Southern Airlines has the highest financial leverage among the Big 3 Chinese carriers. Unlike China Eastern Airlines and Air China which have reduced their gearing in the past 5 years, China Southern Airlines’ net debt-equity ratio has risen 0.7ppts in the past five years to 2.4x at the end of 2016.

Notwithstanding this, China Southern Airlines is still deemed to be a fairly low-risk credit to financial institutions given its state-owned enterprise status, enabling the carrier to maintain its low cost of borrowing. As such, we do not see any imminent credit risk near term.

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

China Southern Airlines Initiation Research Report 2017: Net debt-equity

+ Rising interest rates due to CSA’s high financial leverage

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

+ IFRS 16 will have the largest balance sheet impact on China Southern Airlines among the Big 3 Chinese carriers

China Southern Airlines has the highest proportion of aircraft on operating leases at 35% among the Big 3 Chinese carriers versus 31% for Air China and 24% for China Eastern Airlines and is therefore more significantly impacted by the new IFRS 16 Leases accounting standard.

The scheduled implementation of IFRS 16 Leases accounting standards is from 1st January 2019. We estimate that China Southern Airlines’ reported 2019 net debt-equity could potentially rise from 2.0x to 3.3x after adjusting for the capitalization of aircraft operating leases. As such, China Southern Airlines could potentially consider raising more equity to strengthen its balance sheet and reduce its net debt-equity in our view.

+ Potential need for further equity-raising

We expect China Southern Airlines to increase its aircraft capex spending (on top of its announced planned capital expenditure of Rmb105B 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. As such, China Southern Airlines could potentially consider raising more equity to fund its future aircraft capex in our view.

+ Passenger yield pressure persists

China Southern Airlines has suffered the largest decline in passenger yields among the Big 3 Chinese carriers in the past five years. However in 2016, China Southern Airlines’ passenger yield fell less than China Eastern Airlines’ which is positive if this trend can continue for CSA.

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

China Southern Airlines Initiation Research Report 2017: Passenger Yield

+ 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 Southern Airlines Initiation Research Report 2017: China outbound 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 Southern Airlines has the flexibility of re-deploying some of the China-Korea capacity on other routes to mitigate the earnings impact.

+ 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 Southern 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 Southern Airlines (and the Asian airline stocks) when the US dollar strengthens (weakens) against their local currencies.

However, China Southern Airlines has pared down its USD debt most aggressively among the Big 3 Chinese carriers in the past two years, resulting in a much smaller negative earnings impact when the Renminbi weakens against the US dollar compared to its historical years. 39% of CSA’s total debt was in US dollars at the end of 2016, lower than Air China’s 49% and China Eastern Airlines’ 45%. Every 1% weakening (strengthening) of the Rmb will cut (boost) China Southern Airlines’ 2017 net profit by 9% (4% operational impact + 5% forex translation) on a full year basis based on our estimates versus 8% for Air China and 7% for China Eastern Airlines.

The recent stabilization of the Renminbi implies that China Southern 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 Southern 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 Southern Airlines’ young aircraft fleet averaging only 6.6 years old (similar to Air China’s average fleet age of 6.5 years but slightly older than China Eastern Airlines’ 5.4 years) and all the other Chinese carriers it competes with do not have fuel hedging either, CSA’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 Southern Airlines’ 2017 net profit by 3% on a full year basis based on our estimates, higher than Air China’s and China Eastern Airlines’ 2% impact.

+ Largest impact from the domestic airports’ fee hike

The increase in the Chinese airports’ fees is likely to cut China Southern Airlines’ profit after tax by around Rmb600m or 10%. This earnings impact is likely to be higher than Air China’s estimated Rmb400m impact and China Eastern Airlines’ estimated Rmb400m-Rmb500m impact due to China Southern Airlines’ larger domestic capacity exposure. 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. China Southern Airlines could have a higher chance of passing this fee hike to its customers if it maintains its current moderate capacity growth plans.

+ Traffic rights constraints could limit China Southern 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 Southeast and Northeast 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 Southern Airlines, driving increased competition on short-haul routes.

+ Yield pressure is likely to continue in the China-Australia and China-U.S. route regions where China Southern Airlines is the largest and fourth largest carrier with 31% (or 37% including 55%-owned Xiamen Airlines) and 10% (or 12% including Xiamen Airlines) market share respectively

China Southern Airlines is the largest carrier in the China-Australia route region and fourth largest carrier in the China-United States route region. The planned airline capacity growth is expected to be 15% y/y and 25% y/y in the China-U.S. 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 is likely to put continued pressure on China Southern Airlines’ passenger yields. China Southern Airlines’ own planned capacity is more moderate, expanding capacity by 6% y/y on the China-U.S. routes while keeping capacity steady y/y on the China-Australia routes in 1H17.

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

China Southern Airlines Initiation Research Report 2017: China-Australia

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

China Southern Airlines Initiation Research Report 2017: China-US

CHINA SOUTHERN AIRLINES EARNINGS OUTLOOK

We expect China Southern Airlines’ EPS to decline 13% y/y this year, mainly driven by the higher fuel prices, domestic airport fees hike and increased shares outstanding following its H shares issue to American Airlines. These negative drivers are expected to more than offset CSA’s stronger passenger revenue growth and lower sales commissions costs. We expect China Southern Airlines’ net profit to grow again subsequently, at 10%-11% per annum in 2018 and 2019, delivering an average ROE of 10% between 2017 and 2019.

We forecast China Southern Airlines’ net debt-equity to trend lower to 2.0x by the end of 2019 from 2.4x in 2016. However, China Southern Airlines’ financial leverage could potentially end up higher than our current forecasts as we expect CSA to increase its aircraft capex spending (on top of its announced planned capital expenditure of Rmb105B 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 Southern Airlines considers raising more equity.

VALUATIONS FOR CHINA SOUTHERN AIRLINES COMPANY LIMITED

We value China Southern Airlines at HK$6.30 which is based on 1.16x P/B, assuming ROE of 10% and 3% long-term growth. This is at a 15% premium to China Southern Airlines’ historical average valuation since listing given its improved profitability in recent years and 46% below our estimated “liquidation” value assessment of HK$11.70 per share for China Southern Airlines.

Chart: China Southern Airlines Company Limited – Gordon growth valuation model

China Southern Airlines Initiation Research Report 2017: Gordon growth valuation

Chart: China Southern Airlines Company Limited – Estimated “liquidation” value

China Southern Airlines Initiation Research Report 2017: Liquidation Value

STOCK CATALYSTS FOR CHINA SOUTHERN AIRLINES COMPANY LIMITED

China Southern Airlines’ stock price has outperformed China Eastern Airlines’ but underperformed Air China’s in the past 12 months – its H share price has risen only 5% and underperformed the Hong Kong Stock Exchange Hang Seng China Enterprises Index (HSCEI) by 11%. CSA’s underperformance versus the market is mainly driven by investors’ concerns about the negative impact of passenger yield pressure (down 6% y/y in 2016, worse than Air China’s 5% decline but better than China Eastern Airlines’ 7% decline), foreign exchange losses from the weaker Renminbi (-6% y/y), rising jet fuel prices (+29% y/y) and concerns over the impact of reduced group travel demand on its China-Korea routes as CSA has the second highest capacity exposure (1% of its total capacity) to China-Korea routes among the Big 3 Chinese airlines.

Going forward, we expect China Southern Airlines’ EPS to decline this year, mainly driven by the higher fuel prices, domestic airport fee hikes and increased shares outstanding following its H shares issue to American Airlines but resume its earnings growth from 2018 onwards as the impact of some of the above 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. CSA will also gain significant access to the Beijing-Hebei-Tianjin catchment area when the new Beijing airport opens as one of the hub airlines there. This could be a game-changer for China Southern Airlines in the longer term, reversing its historical disadvantage of being based in the weakest hub (Guangzhou) among the Big 3 Chinese carriers. We expect CSA’s growth to become more exciting from 2020 onwards. China Southern Airlines’ strategic partnership with American Airlines will also boost its traffic feed, strengthening its market position on China-U.S. routes and enhance its expertise in driving greater ancillary income longer term.

The recent stabilization of the Renminbi should help allay some of these investors’ concerns near term. In addition, China Southern Airlines has been reducing its US dollar debt exposure the most aggressively among the Big 3 Chinese carriers which will result in smaller foreign exchange translation losses compared to its historical years should the Renminbi weaken further. Although China Southern Airlines has not hedged its fuel consumption, it now operates one of the youngest aircraft fleets in the world at 6.6 years old on average. CSA’s fuel efficiency is expected to improve further with the delivery of more new generation aircraft (including the A320neo, B737 MAX, B787-900 planes) which will mitigate the impact of higher fuel prices to some extent. Better industry demand-supply balance will also increase its pricing power, enabling China Southern Airlines to pass on more of the fuel price increase and domestic airport fees hike to its passengers and shippers. CSA’s economies of scale and relatively competitive cost structure versus its global airline peers will enable the airline to continue to grow its international revenue and provide the most effective defense against its airline competitors, particularly on domestic routes.

We initiate coverage on China Southern Airlines with a fair value of HK$6.30 and Outperform rating. The key risk is potential dilution as we expect China Southern Airlines to raise more equity, in order to fund its future aircraft and related infrastructure capex given its plans to substantially develop its hub operations at the new Beijing airport and to strengthen its balance sheet. The implementation of IFRS 16 Leases accounting standard (with effect from 1st January 2019) will have the most significant impact on China Southern Airlines due to its higher proportion of aircraft on operating leases (35% of its total aircraft fleet) among the Big 3 Chinese carriers.

CRUCIAL PERSPECTIVE FORECASTS

Chart: China Southern Airlines Company Limited – Profit & Loss Statement

China Southern Airlines Initiation Research Report 2017: Profit Loss

Chart: China Southern Airlines Company Limited – Balance Sheet

China Southern Airlines Initiation Research Report 2017: Balance Sheet

Chart: China Southern Airlines Company Limited – Cash Flow Statement

China Southern Airlines Initiation Research Report 2017: Cashflow

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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