Analysing China Southern (1055:HK) share placement: In line with Crucial Perspective predictions

China Southern Airlines (1055:HK) Fair Value – HK$6.30 

28 June 2017, China – China Southern Airlines (1055:HK) has just announced plans to issue new A and H shares, gross proceeds to be raised from the shares issue will be up to Rmb12.737 Billion. We analyse the implications and update our earnings forecasts in light of this proposed new share placement.

China Southern Airlines (CSA) share placement was predicted in our earlier report on 10th April 2017

Read: China Southern Airlines Initiation Research Report (10th April 2017) 

CSA has the highest financial leverage among the Big 3 Chinese carriers and substantial capex commitments. CSA’s shares issuance is also proportionately larger than Air China and China Eastern Airlines’ placements done last year.

We believe China Southern Airlines (and China Eastern Airlines) could potentially do another round of equity-raising in the coming years, in order to fund their significant buildout of their additional air hub at the new Beijing Daxing International Airport which is scheduled to open in 2019.

Following the share placement, CSA’s A share public float will rise while its H share public float will fall. This could potentially narrow the CSA’s A-H share valuation gap – we expect China Southern Airlines’ A share price to decline while its H share price is likely to remain steady.

This equity-raising will help to reduce CSA’s financial leverage to 1.6x by the end of 2017 and fund its aircraft fleet expansion. Moreover, 75% of China Southern Airlines’ new share issue is based on A shares which are trading at a 54% valuation premium versus the H shares and will help mitigate the impact of dilution.

CSA H share issue price of HK$6.27 is in line with Crucial Perspective’s Fair Value (HK$6.30) for CSA

Since we initiated coverage on China Southern Airlines on 10th April 2017 with a Fair Value of HK$6.30 and Outperform Rating, CSA’s H share price has performed in line with our predictions, rising 19% to HK$6.56 and outperforming the Hang Seng China Enterprises Index (HSCEI) by 17%.

Chart: China Southern Airlines H share price performance since Crucial Perspective’s coverage initiation on 10th April 2017

Chart: China Southern Airlines H share price performance since Crucial Perspective’s coverage initiation on 10th April 2017

For the A share issue, 100% cash from parent company CSAHC’s subscription would have been better than transferring MTU Maintenance Zhuhai to CSA. The key risk is that MTU Maintenance Zhuhai will face the challenge of falling engine MRO demand in the longer term when the Airbus A319/A320/A321 aircraft as well as their accompanying engines are gradually phased out and replaced by the Airbus A320neo family which are powered by LEAP-1A or Pratt & Whitney PW1000 GTF engines. MTU Maintenance Zhuhai will therefore need to acquire new capabilities to service newer engine types in the longer term. However, this risk is already discounted in our view considering that MTU Maintenance Zhuhai is being transferred to China Southern Airlines at valuations below the MRO sector’s average valuations and could complement CSA’s 50%-owned Guangzhou Aircraft Maintenance Engineering Company (GAMECO). 

NEW A AND H SHARE PLACEMENT IS SUBSTANTIAL – AMOUNTS TO 24% OF EXISTING SHARES OUTSTANDING, PROPORTIONATELY LARGER THAN AIR CHINA AND CHINA EASTERN AIRLINES’ SHARE ISSUANCE LAST YEAR

China Southern Airlines (CSA) has announced that it plans to issue new A and H shares.

A shares issue

CSA plans to issue up to 1.8B new A shares to not more than 10 specific investors (including its parentco China Southern Air Holding Company CSAHC). CSAHC will subscribe to no less than 31% of the new A shares.

CSAHC will finance its subscription of China Southern Airlines’ new A shares using its 50% stake in MTU Maintenance Zhuhai (MTU) which is valued at Rmb1.674B and the remainder consideration with cash. 

H shares issue

China Southern Airlines also plans to issue up to 590m new H shares via a private placement to Nan Lung which is a wholly owned subsidiary of CSAHC.

CSA EQUITY-RAISING COMES AS NO SURPRISE AND WE HAD PREVIOUSLY FLAGGED THIS

China Southern Airlines’ new share placement is in line with our expectations given its high financial leverage and future expansion plans. Please refer to our previous report for more details:

Read: China Southern Airlines Initiation Research Report (10th April 2017) 

The gross proceeds to be raised from the shares issue will be up to Rmb12.737B.

Part of the A share placement proceeds will be used to fund China Southern Airlines purchase of 41 aircraft (up to Rmb7.7B is to be used for the total 41 aircraft investment amount of Rmb40.7B) and the selection & installation of lightweight seats for its Airbus A320 aircraft (up to Rmb104.8m is to be used for the total investment amount of Rmb132.3m). The remainder will be used to fund CSA’s energy conservation and emissions reduction projects and working capital needs. The H share placement proceeds will be used to supplement the general operating funds for China Southern Airlines.

China Southern Airlines’ share placement is more significant than Air China and China Eastern Airlines’ previous placements last year. In 2016, Air China and China Eastern Airlines issued new shares equivalent to 11% and 13% of their existing number of shares outstanding versus 24% for China Southern Airlines.

There is a 36 months’ lock-up period for parentco CSAHC and Nan Lung which will reduce the impact of potential share overhang. In any case, we do not expect CSAHC and Nan Lung to pare down their stake in China Southern Airlines since their combined shareholding in CSA is only 50.1% following the new share placement.

SUBSCRIPTION SHARE PRICES ARE FAIR

The H share issue price of HK$6.27 is in line with our fair value of HK$6.30 for China Southern Airlines and at an 8% discount to its closing H share price prior to this share placement announcement. This implies 2017E 15x P/E, 1.1x P/B and 8x Adjusted EV/EBITDAR post money.

The A share issue price has not yet been determined:

1) 90% of the average trading price of the A shares in the 20 trading days immediately prior to the Price Benchmark Date (which is the first day of the issuance period of the new A shares) and

2) the most recent net assets value per share of China Southern Airlines, whichever is higher. China Southern Airlines’ reported net asset value was Rmb4.56 per share at the end of March 2017 and its closing A share price prior to this announcement was Rmb9.05.

Having 75% of China Southern Airlines’ new share issue based on A shares is positive for the H share investors given that the A shares are trading at a 54% valuation premium versus the H shares and will help mitigate the impact of dilution.

100% CASH FROM PARENTCO CSAHC’S SUBSCRIPTION WOULD HAVE BEEN BETTER; HOWEVER, MTU MAINTENANCE ZHUHAI IS BEING TRANSFERRED AT BELOW SECTOR AVERAGE VALUATIONS

MTU Maintenance Zhuhai is the market leader in aircraft engine maintenance, repair & overhaul (MRO) in China which specialises in maintaining the International Aero Engines V2500-A5 and CFMI CFM56-3, -5B and -7 engines which mainly power the Airbus A319/A320/A321 aircraft. It is a 50:50 joint venture between CSAHC and MTU Aero Engines (MTX:GR).

The key risk is that MTU Maintenance Zhuhai will face the challenge of falling engine MRO demand in the longer term when the Airbus A319/A320/A321 aircraft as well as their accompanying engines are gradually phased out and replaced by the Airbus A320neo family which are powered by LEAP-1A or Pratt & Whitney PW1000 GTF engines. MTU Maintenance Zhuhai will therefore need to acquire new capabilities to service newer engine types in the longer term.

However, this risk is already discounted in our view considering that the transaction values MTU Maintenance Zhuhai at valuations of only at 4.7x P/E and 1.1x Price/NAV based on MTU Maintenance Zhuhai’s net profit of Rmb355m (steady y/y) and net asset value of Rmb1.5B in 2016. These are below the MRO sector average valuations.

Although not apple-to-apple-comparables, the listed Asian MRO service providers which also provide engine overhaul services SIA Engineering (SIE:SP), HAECO (44:HK) and ST Engineering (STE:SP) are trading at much higher valuations of 14x, 9x, 24x P/E and 3.0x, 1.5x, 5.1x P/B respectively. This joint venture’s other shareholder MTU Aero Engines (MTX:GR) is trading at 20x P/E and 4.0x P/B. The transaction valuation is also close to parentco CSAHC’s original acquisition cost of MTU Maintenance Zhuhai of Rmb1.61B.

Based on 2016 financials, MTU Maintenance Zhuhai’s net profit would amount to 7% to China Southern Airlines’ 2016 net profit. However, its effective profit contribution to China Southern Airlines will be smaller since MTU Maintenance Zhuhai also services CSA’s engines. MTU Maintenance Zhuhai will also be complementary to China Southern Airlines’ 50%-owned Guangzhou Aircraft Maintenance Engineering Company (GAMECO). 

FINANCIAL POSITION WILL BECOME STRONGER

Prior to its new share placement, 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.

Following this share placement, we expect China Southern Airlines’ net debt-equity to fall to 1.6x by the end of 2017 (from 2.3x prior to the share placement based on our previous forecasts), still higher than Air China’s 1.0x but lower than China Eastern Airlines’ 2.0x net debt-equity.

We believe China Southern Airlines and China Eastern Airlines could potentially do another round of equity-raising in the coming years, in order to fund their significant buildout of their additional air hub at the Beijing Daxing International Airport which is scheduled to open in 2019.

CSA’S H SHARES PUBLIC FLOAT WILL FALL WHILE ITS A SHARES PUBLIC FLOAT WILL RISE; A-H VALUATION PREMIUM COULD NARROW

Following the share placement and after taking into account American Airlines’ equity investment in China Southern Airlines (see our previous report below for the details) assuming the maximum number of 1.8B A shares and 590m H shares are issued, China Southern Airlines’ proportion of A shares public float will increase by 3.5ppts to 34% while the proportion of H shares public float will decrease by 3.7ppts to 14%.

Parentco CSAHC and CSAHC’s wholly owned subsidiary Nan Lung’s combined stake in China Southern Airlines will drop slightly by 1ppt to 50.1%. American Airlines’ stake in China Southern Airlines will be 2.17%. See our previous report for more details:

American Airlines’ China Southern investment positives could be a long-term negative for Cathay Pacific

This could potentially narrow the valuation premium between China Southern Airlines’ A share and H share price over time. China Southern Airlines’ A share price is at a 54% premium to its H share price currently. In this case, we expect China Southern Airlines’ A share price to decline while its H share price is likely to remain steady. CSA’s A-H valuation premium is larger than Air China’s 41% but lower than China Eastern Airlines’ 65%.

Chart: China Southern Airlines existing shareholding structure

Chart: China Southern Airlines existing shareholding structure

Chart: China Southern Airlines’ shareholding structure after its new share placement and American Airlines’ equity investment

Chart: China Southern Airlines’ shareholding structure after its new share placement and American Airlines’ equity investment

Chart: China Southern Airlines H share and A share price history

Chart: China Southern Airlines H share and A share price history

TRIMMING OUR EARNINGS FORECASTS AND RATING

We update our earnings forecasts to factor in the impact of this share placement.  We expect China Southern Airlines’ reported and recurring EPS to decline 15% and 48% y/y this year, mainly driven by the higher fuel prices, domestic airport fees hike and increased shares outstanding following its new shares issuance. 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 3% and 7% in 2018 and 2019, delivering an ROE of 9%-10% between 2017 and 2019.

We forecast China Southern Airlines’ net debt-equity to trend lower to 1.4x 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 Daxing International Airport (which is scheduled to open in September 2019) and build up a significant air hub presence in Beijing. As such, we believe China Southern Airlines could potentially raise more equity again in the coming years.

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

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

Chart: China Southern Airlines Company Limited – Financial Summary

Chart: China Southern Airlines Company Limited – Financial Summary

VALUATIONS FOR CHINA SOUTHERN AIRLINES

We value China Southern Airlines at HK$6.30 which is based on 1.1x P/B, assuming ROE of 10% and 5% 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 well supported by our estimated “liquidation” value assessment of HK$7.00 per share for China Southern Airlines.

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

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

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

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

CRUCIAL PERSPECTIVE FORECASTS

Chart: China Southern Airlines Company Limited Profit & Loss Statement

Chart: China Southern Airlines Company Limited Profit & Loss Statement

Chart: China Southern Airlines Company Limited Balance Sheet

Chart: China Southern Airlines Company Limited Balance Sheet

Chart: China Southern Airlines Company Limited – Cash Flow Statement

Chart: China Southern Airlines Company Limited – Cash Flow Statement

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.

Related Articles:

Read: China Southern Airlines Initiation Research Report (10th April 2017) 

American Airlines’ China Southern investment positives could be a long-term negative for Cathay Pacific

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

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

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