Some mispricing in Chinese airlines equity valuations

Air China (753:HK) Fair value: HK$12.5
Air China (753:HK) Rating: Outperform

China Eastern Airlines (670:HK) Fair value: HK$7.3
China Eastern Airlines (670:HK) Rating: Outperform

China Southern Airlines (1055:HK) Fair value: HK$11.0
China Southern Airlines (1055:HK) Rating: Outperform

2 May 2018, China – Now that all the Chinese airlines have reported their 1Q18 financial results under PRC accounting standards, we evaluate how their current equity valuations stack up against their profitability. Interestingly, the equity markets appear to be valuing the Chinese airlines quite efficiently from a P/E valuation perspective. However, there appears to be some mispricing when we compare the Chinese airlines’ P/B and P/FCF valuations versus their ROEs and free cash flow generation. Overall, the Big 3 Chinese carriers Air China, China Eastern Airlines and China Southern Airlines are looking more attractively valued compared to the rest of the airline sector in China.

The most profitable Spring Airlines is also the most highly valued on a P/E basis among the listed Chinese airlines

Low-cost carrier Spring Airlines (601021:CH) was the most profitable among the listed Chinese airlines, delivering a net profit margin of 12% in 1Q18 after deducting non-recurring items under PRC accounting standards. This was followed by another relatively new full service carrier Juneyao Airlines (603885:CH) whose net profit margin was 11%.

Among the Big 3 Chinese carriers, Air China (753:HK) had the highest net profit margin at 8%, closely followed by China Eastern Airlines (670:HK) and China Southern Airlines (1055:HK). Shandong Airlines (200152:CH), which is 22.8% owned by Air China, lagged with a 4% net profit margin albeit a 1ppt y/y improvement from the previous year.

Interestingly, the equity markets appear to be valuing the Chinese airlines quite efficiently from a P/E valuation perspective. Spring Airlines, which is the most profitable, also has the highest P/E valuation of 20x among the listed Chinese carriers. Shandong Airlines, which is the least profitable, has the lowest P/E valuation of 8x. The rest of the Chinese carriers’ P/E valuations also correspond with their net profit margin levels more or less.

Chart: Chinese airlines P/E valuations versus net profit margins (1Q18)

Chart: Chinese airlines P/E valuations versus net profit margins (1Q18)

 

Juneyao Airlines and Spring Airlines are trading at significant Price/Book valuation premiums to the Big 3 Chinese carriers even though their annualized ROEs are comparable

However, from a Price/Book valuation perspective, there appears to be some mispricing in the Chinese airline stocks. Both China Southern Airlines and Juneyao Airlines achieved annualized ROE of 18% in 1Q18 but Juneyao Airlines is trading at 3.0x Price/Book, a 67% premium to China Southern Airlines’ valuation. Spring Airlines, whose annualized ROE of 13% is comparable to the ROEs of Air China and China Eastern Airlines in 1Q18, is trading at 2.5x Price/Book, a 42% valuation premium to Air China and China Eastern Airlines’ current valuations.

Chart: Chinese airlines Price/Book valuations versus Return on Equity (1Q18)

Chart: Chinese airlines Price/Book valuations versus Return on Equity (1Q18)

 

Higher equity valuations should be ascribed given that the Big 3 Chinese carriers generated positive free cash flows (FCF) while the rest of the sector were FCF negative in 1Q18

From a cash flow generation perspective, the Big 3 Chinese carriers have also done better. They generated substantial positive free cash flows (FCF) while the other Chinese carriers were essentially FCF negative during 1Q18.

Specifically, China Southern and Air China each generated Rmb3.3 billion positive free cash flows while China Eastern Airlines generated Rmb2.2 billion FCF in 1Q18. By contrast, Spring Airlines and Hainan Airlines incurred large negative free cash flows of Rmb2.7 billion and Rmb1.5 billion respectively.

From a valuation standpoint, the Big 3 Chinese carriers are only trading at 10x Price/FCF on average and should arguably be ascribed higher equity valuations given their strong cash flows. China Southern Airlines is currently the most attractively valued at 7x Price/FCF while China Eastern Airlines and Air China are also trading at undemanding valuations of 10x and 12x Price/FCF respectively.

Chart: Chinese airlines Free cash flow generation (1Q18)

Chart: Chinese airlines Free cash flow generation (1Q18)

 

Chart: Chinese airlines Price/FCF valuations versus Free cash flow generation (1Q18)

Chart: Chinese airlines Price/FCF valuations versus Free cash flow generation (1Q18)

 

Note: Stocks with upside of more than 10% based on our fair value 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 Reports:  

 

Air China Initiation Research Report 2017: Top choice among the Chinese airlines

 

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

 

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

 

Is HNA Group’s crown jewel Hainan Airlines a good gamble? – Research Report 2018        

 

Robust China outbound travel to exceed Chinese airlines capacity growth for next 5 years

 
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Independent Research Declaration: Crucial Perspective does not own any position in the equities featured in this report nor have we received any compensation for writing this report. 

 

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