Research Report: EVA Airways (2618:TT) & China Airlines (2610:TT) valuations to remain rangebound until China-Taiwan relations thaw

EVA Airways (2618:TT) Fair value: NT$15.80
EVA Airways (2618:TT) Rating: In-line

China Airlines (2610:TT) Fair value: NT$10.50
China Airlines (2610:TT) Rating: In-line

15 August 2017, Taiwan – We initiate coverage of EVA Airways (2618:TT) and China Airlines (2610:TT) with In-line ratings and fair values of NT$15.80 and NT$10.50 respectively. We expect the Taiwanese airline stocks to remain fairly range-bound until travel demand on the more lucrative China-Taiwan routes recover when cross-straits relations thaw. Meanwhile, the aggressive capacity expansion on long-haul routes between Taiwan and North America/Europe is likely to put continued pressure on passenger yields, offsetting the stronger revenue contribution from the improving air cargo market. Between the two Taiwan airlines, we see greater upside in China Airlines than EVA Airways due to its larger cargo revenue exposure and earnings improvement.

VALUATION GAP COULD NARROW

Investors have been indifferent between EVA Airways and China Airlines with both stocks underperforming the market significantly year-to-date. The share price performance of both EVA Airways and China Airlines have been flat ytd, underperforming the Taiwan Stock Exchange Weighted Index (TWSE) by 23% so far this year. However, this could change going forward.

However, EVA Airways’ historical valuation premium versus China Airlines could narrow. EVA Airways has historically traded at a 20% valuation premium to China Airlines on a Price/Book basis in the past 10 years. This valuation premium has narrowed to 13% currently. China Airlines’ markedly improved financial results and larger revenue exposure to the stronger cargo market could potentially close this gap further in our view even though EVA Airways has historically had the stronger profitability track record and international branding.

Chart: Taiwan airlines – Price/Book valuation (2008 to 2017)

Chart: Taiwan airlines – Price/Book valuation (2008 to 2017)

CHINA AIRLINES’ PROFITABILITY IMPROVEMENT IS MORE SIGNIFICANT

China Airlines’ profitability caught up with EVA Airways’ in 2Q17. EVA Airways’ financial results are still stronger than China Airlines’ in 1H17 but it is interesting to note that China Airlines caught up with EVA Airways in 2Q17 after its dismal 1Q17 performance. In 2Q17, China Airlines turned around y/y with a net profit of NT$1.85B, even higher than EVA Airways’ net profit of NT$1.82B which was 30% higher y/y. Both carriers had a net profit margin of 5% in 2Q17 although EVA Airways’ pre-tax profit margin was 1ppt higher than China Airlines’. Due to China Airlines’ huge loss in 1Q17, EVA Airways’ profitability still ranks ahead in 1H17, with net profit of NT$1.24B, down 52% y/y and net profit margin of 2% compared to China Airlines’ NT$1.86B net loss and 3% net loss margin. However, if the global air cargo market continues its strong growth momentum and yield improvement in 2H17, China Airlines could potentially outperform EVA Airways in the 2H17 financial results y/y.

Chart: Taiwan airlines – 2Q17 and 1H17 Results at a Glance

Chart: Taiwan airlines – 2Q17 and 1H17 Results at a Glance

ROBUST AIR CARGO MARKET PROVIDES STRONGER TAILWIND FOR CHINA AIRLINES

The strong global air cargo market will benefit China Airlines more than EVA Airways. China Airlines has greater revenue exposure to cargo than EVA Airways which has been downsizing its cargo operations in recent years and is therefore more leveraged to the improving air cargo industry. Cargo revenue contributes 28% of China Airlines’ total revenue versus only 19% of EVA Airways’ total revenue.

Chart: China Airlines (2610:TT) – revenue breakdown by business segment (2017)

Chart: China Airlines (2610:TT) - revenue breakdown by business segment (2017)

Chart: EVA Airways (2618:TT) – revenue breakdown by business segment (2017)

Chart: EVA Airways (2618:TT) - revenue breakdown by business segment (2017) 

CHINA AIRLINES’ CAPACITY GROWTH IS MORE MODERATE COMPARED TO EVA AIRWAYS’

China Airlines’ more moderate capacity growth is helping to support its passenger yields. Passenger yields fell less y/y than EVA Airways in 1H17. What’s positive is that we are seeing a y/y improvement in passenger yield for China Airlines of 3% in July 2017. In contrast, EVA Airways’ passenger yield is still 7% lower y/y in July.  China Airlines’ cargo yield improvement of 12% is also slightly ahead of EVA Airways’ 11% in July.

LONG-HAUL PASSENGER YIELDS COULD REMAIN SOFT IN 2H17

Key risk for the Taiwanese airlines is that passenger yield pressure on long-haul routes is expected to continue, with EVA Airways likely to feel more pain than China Airlines. Based on the current flight schedules, the planned capacity growth between Taiwan and North America/Europe remains excessive at 24% y/y and 26% y/y respectively in 3Q17, even higher than the 21% and 24% capacity growth in 1H17. This will continue to put pressure on passenger yields on long-haul routes. Nearly half of the Taiwanese airlines’ passenger revenue is derived from long-haul routes. North America and Europe routes contribute 38% and 10% of EVA Airways’ passenger revenue and 30% and 11% of China Airlines’ passenger revenue based on our estimates in 1H17. A strong rebound in jet fuel prices would also be detrimental to the Taiwan airlines’ earnings given their large long-haul route exposure.

THAWING OF CROSS-STRAITS RELATIONS WILL BE STRONG POSITIVE CATALYST FOR BOTH CARRIERS

Meanwhile, the anaemic inbound visitor arrival numbers from China continues to be a drag for both carriers. Chinese outbound traffic to Taiwan has been weakening since 2Q16 following Taiwan’s Presidential Elections and the Chinese government’s decision to cut the travel quota for tour groups to Taiwan. China routes contribute only 11% of EVA Airways and China Airlines’ revenue currently from 15% when cross-straits relations were warmer. China Airlines and EVA Airways’ share prices have corrected 15% and 13% in 2016, partly due to this impact. The number of Chinese outbound tourists to Taiwan remains weak, falling 40% y/y in 1H17, versus its 16% decline in full year 2016. The thawing of cross-straits relations will be the strongest positive catalyst for both airline stocks given the pent-up demand and historically high-yielding nature of Taiwan-China routes.

Chart: China outbound tourists to Taiwan (2014 to 2017)

Chart: China outbound tourists to Taiwan (2014 to 2017)

Chart: Taiwan airlines share price performance (2014 to 2017)

Chart: Taiwan Airlines Share Price Performance (2014 to 2017)

CONVERTIBLE BOND ISSUANCE IN THE PIPELINE

There will be more fund-raising and dilution ahead for the Taiwanese airlines. EVA Airways recently announced its plans to issue up to NT$7B 5-year convertible bonds. This could imply a dilution of 12% based on our estimates. We believe China Airlines could potentially look to issue more convertible bonds as well to fund its future expansion.

NEW COMPETITOR STARLUX COULD BE DETRIMENTAL TO AN ALREADY CROWDED SPACE

New entrant StarLux could raise competitive pressure from 2020: In the longer term, a new risk for EVA Airways and China Airlines is the launch of StarLux. StarLux is targeting to launch commercial operations at the end of 2019. StarLux plans to operate a fleet of 24 aircraft during the first 6 years of operation, raising its fleet size to 50 aircraft in the next 6 years of operation. The new carrier plans to deploy new generation aircraft which could include the Airbus A321neo, A350, Boeing B787 and B777X planes. StarLux is targeting to launch services to Asian cities including Bangkok, Hong Kong, Japan, Kuala Lumpur, Macau and Singapore as well as long-haul flights to North America. StarLux could compete for higher-yielding premium traffic from EVA Airways and China Airlines. Although the near term impact will be limited until StarLux gains scale and greater market distribution, the widespread newsflow of increased competition could dampen market sentiment on these two incumbent airline stocks. Moreover, we believe the Taiwan aviation market demand is not large enough to support three large profitable Taiwan-based carriers longer term. 

 

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.

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