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

Hainan Airlines Group (600221:CH)– Trading currently suspended

26 April 2018, China – Mystery, oversized ambitions and everchanging fortunes pervade both HNA Group and its key subsidiary, Hainan Airlines. The once high-flying HNA Group that went on a US$50 Billion worldwide acquisition spree was forced by alarmed regulators and mounting debt to dispose of US$14 Billion of assets in the first four months of 2018 alone.

Trading in Hainan Airlines has been suspended on the Shanghai Stock Exchange since 9th January 2018 with only 6 equity analysts currently covering the stock and 2 with price targets. There is a strong likelihood that Hainan Airlines will have to acquire tourism-related assets from parent HNA Group to ease HNA’s debt burden and depending on the purchase prices, this could prove negative for Hainan Airlines. However, we are cautiously optimistic about Hainan Airlines’ prospects in view of the Chinese Central Government’s recent April announcement that it will allow further liberalisation of trade, tourism and most importantly, gambling in Hainan.

Will Hainan finally be allowed to have casinos?

Hainan’s gambling liberalization only extends to horse racing and sports lotteries for now but it is highly probable that casinos will be allowed in the near future because it goes a long way in alleviating the huge capital outflows caused by Mainland Chinese tourists gambling overseas. The foreign-controlled casino industry in Macau has also made it harder for the Chinese Central Government to manage corruption as evidenced by China’s massive crackdown on corruption from 2014 that has impacted Macau’s gaming revenues till today.

A fully developed homegrown casino industry in Mainland China will not only help solve these problems but also enable Hainan to leverage on the casino industry to transform itself into a global MICE (Meetings, Incentives, Conferences, Exhibitions) hub like Las Vegas.

Most important airline for supporting Hainan province’s tourism and economic development

Hainan Airlines is the primary carrier of passenger and cargo traffic to/from Hainan province and will therefore play an increasingly significant role of boosting air traffic as the government considers relaxing visa requirements and legalizing gambling in Hainan province. Hainan Airlines has the largest market share on domestic and international routes to/from Hainan at 37% based on our estimates.

Domestic operations lucrative; international operations loss-making

Hainan Airlines is far more reliant on domestic traffic than the Big 3 Chinese Airlines.

Domestic business contributed 82% of Hainan Airlines’ total revenue compared to 76% for China Southern Airlines (1055:HK), 67% for Air China (753:HK) and 66% for China Eastern Airlines (670:HK). The domestic operations is also more lucrative – Hainan Airlines earned a gross profit of Rmb6.1B and its gross profit margin was 13.3% in 2017. If the government legalizes casinos in Hainan province, we expect a huge influx of domestic traffic to Hainan which will significantly benefit Hainan Airlines.

Hainan Airlines’ international business was, however, loss-making in 2017, mainly due to its aggressive expansion. International operations contributed only 18% of Hainan Airlines’ total revenue and incurred a gross loss of Rmb404m in 2017.

Chart: Hainan Airlines Group domestic versus international revenue contribution (2017)

Chart: Hainan Airlines Group domestic versus international revenue contribution (2017)

International route network skewed towards long-haul destinations

Notwithstanding its losses, we expect Hainan Airlines to continue to expand its international operations to serve Hainan province’s tourism and economic objectives. Hainan Airlines targets to add 40 new routes in the next 5 years, raising its international network coverage from Hainan to 100 routes.

Hainan Airlines has a disproportionately large exposure to long-haul routes. North American routes account for 40% of its total international route capacity, followed by Europe at 23% and Australia & New Zealand at 16%. We expect Hainan Airlines to boost its network coverage to Asia going forward where it is currently under-represented.

Chart: Hainan Airlines Group international route network distribution (2018)

Chart: Hainan Airlines Group international route network distribution (2018)

Hainan Airlines is the fourth largest carrier in China

Hainan Airlines Group is the fourth largest airline in China. It has a 14% market share on China domestic and international routes, ranking behind China Southern Airlines Group which has 20% share, Air China Group and China Eastern Airlines Group which have 17% market share each based on our estimates.

Chart: Airline market share on China domestic and international routes (2018)

Chart: Airline market share on China domestic and international routes (2018)

Passenger business to remain key revenue driver of Hainan Airlines Group

Hainan Airlines derived 97% of its total revenue from its passenger operations while its cargo segment contributed only 2+% of its total revenue in 2017. Both segments are profitable. Although the further economic liberalization of Hainan province with plans to establish a free trade zone will drive greater trade flows, we still expect the passenger segment to be the dominant revenue driver for Hainan Airlines Group in the longer term.

Chart: Hainan Airlines Group revenue contribution by business segment (2017)

Chart: Hainan Airlines Group revenue contribution by business segment (2017)

Strong passenger and cargo traffic growth in 1Q18

Hainan Airlines’ traffic growth continued to outpace the broader Chinese airline sector in 1Q18. Hainan Airlines’ passenger traffic grew 17% y/y in 1Q18. On domestic and international routes, Hainan Airlines’ passenger traffic rose 17% and 19% y/y respectively while traffic on regional routes declined 6% y/y in 1Q18. Passenger load factor (PLF) fell 1ppt y/y but was still high at 86%, above the industry average level. Domestic passenger load factor fell 1ppt to 89%, regional PLF fell 4ppts to 72% while international PLF held steady at 75% in 1Q18. Cargo traffic growth was equally strong, rising 16% y/y in 1Q18 but system-wide cargo load factor fell slightly by 1ppt y/y to 37% due to its large belly-hold cargo capacity.

Young and fuel-efficient aircraft fleet which helps to mitigate the negative impact of higher fuel prices

As at end Dec 2017, Hainan Airlines has a fleet of 410 aircraft averaging only 4.7 years old, slightly younger than the average fleet age of the Big 3 Chinese carriers Air China, China Eastern Airlines and China Southern Airlines and well below the global sector average level.

The more fuel-efficient aircraft fleet helps to mitigate the negative impact of higher fuel prices has Hainan Airlines is unhedged. Fuel accounts for 28% of Hainan Airlines’ cost. Every 1% rise (drop) in jet fuel price will increase (reduce) Hainan Airlines’ fuel cost by Rmb146 million all other things being equal.

Aggressive aircraft fleet expansion phase has passed but Hainan Airlines Group is likely to need more aircraft than what it currently has on order 

Hainan Airlines Group’s aircraft fleet growth has historically been aggressive, averaging 18% per annum in the past 5 years, above the Chinese airline sector’s overall capacity growth pace.

However, based on the existing aircraft orders, Hainan Airlines Group’s fleet growth is expected to moderate to 9% in 2018 and only 2% per annum in 2019 and 2020, partly reflecting the challenges it faces in accessing attractive financing given its association with HNA Group.

We believe Hainan Airlines Group is likely to need more aircraft than what it has on order, especially from 2020 onwards, either through new aircraft orders or operating leases once there is greater clarity on its financial position following its asset reorganization and acquisitions.

Chart: Hainan Airlines Group aircraft fleet expansion (2013 to 2020)

Chart: Hainan Airlines Group aircraft fleet expansion (2013 to 2020)

Profitability in line with Big 3 Chinese carriers

Hainan Airlines’ profitability is quite similar to the Big 3 Chinese carriers’. Hainan Airlines booked net profit of Rmb3.3B and net profit margin of 5.5% in 2017. Hainan Airlines’ profitability ranks slightly ahead of China Southern and China Eastern Airlines’ but slightly below Air China’s in 2017.

Chart: Top 4 Chinese carriers net profit margin comparison (2017)

Chart: Top 4 Chinese carriers net profit margin comparison (2017)

Generated positive free cash flow in 2017 but risks taking on excessive debt to acquire some of HNA Group’s assets

Hainan Airlines generated positive free cash flow (FCF) of Rmb4B in 2017, an improvement from its negative FCF of Rmb6B in 2016. This raised its gross cash balance to Rmb36B at the end of 2017.

In contrast with its debt-laden parent HNA Group, Hainan Airlines’ financial position is not precarious with a manageable Net debt/EBITDA of 3.5x and Net debt/Equity of 0.6x at the end of 2017.

Hainan Airlines Group has a larger proportion of aircraft on operating leases compared to the Big 3 Chinese carriers at 52%. If we adjust for the capitalization of Hainan Airlines’ aircraft operating leases, its Adjusted Net debt/EBITDA and Adjusted Net debt/Equity would be much higher at 10x and 1.6x respectively but still in line with the Asian airline sector average level.

However, it risks taking on excessive debt to acquire some of HNA Group’s assets. As part of the Hainan Airlines Group’s reorganisation, Hainan Airlines plans to acquire Air Guilin, West Air, a stake in MRO service provider SR Technics as well as hotel assets via a combination of cash and stocks.

Hainan Airlines has been increasing its stakes in several domestic Chinese carriers in the past year

Hainan Airlines has been increasing its stakes in several domestic Chinese carriers in the past year. As at end 2017, Hainan Airlines owns an 87.27% stake in Tianjin Airlines, 61.74% stake in Xinhua Airlines, 72.83% stake in Shanxi Airlines, 71.34% stake in Air Chang’an, 65.22% stake in Fuzhou Airlines, 86.32% stake in Urumqi Air, 73.48% stake in Lucky Air, 70.00% stake in Guangxi Beibu Gulf Airlines.

Among the domestic airlines under Hainan Airlines Group, Tianjin Airlines earned the largest net profit in 2017, followed by China Xinhua Airlines Lucky Air and Air Chang’an. Urumqi Air and Fuzhou Airlines are loss-making.

Chart: Profitability of domestic airlines under Hainan Airlines Group (2017)

Chart: Profitability of domestic airlines under Hainan Airlines Group (2017)

Back to book value prior to shares trading suspension

Hainan Airlines was trading at 1.0x Price/Book prior to its shares trading suspension from 9th January 2018.

Chart: Hainan Airlines Group Price/Book Valuation (2012 to 2018)Chart: Hainan Airlines Group Price/Book Valuation (2012 to 2018)

 

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

 

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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