Research Report: Japan Airlines (9201:JP) offers more upside than ANA (9202:JP)

ANA Holdings (9202:JP) Fair Value: JPY450
ANA Holdings (9202:JP) Rating: Outperform

Japan Airlines (9201:JP) Fair Value: JPY4222
Japan Airlines (9201:JP) Rating: Outperform

3 August 2017, Japan – We initiate coverage of ANA Holdings (9202:JP) and Japan Airlines (9201:JP) with Outperform ratings and fair values of JPY450 and JPY4222 respectively. JAL has historically traded at a 35% valuation premium to ANA in the past 5 years. However, this gap has closed recently, mainly driven by ANA’s improving profitability. Gleaning from both carriers’ 1st Quarter (April-June 2017) results that have just been released, we expect both carriers’ operating outlook to be broadly favourable which underpins our positive view on the Japanese airline sector. There is greater competition risk and yield pressure on domestic routes while the fare pressure on the long-haul markets could ease. The future direction of the Japanese yen and fuel prices are the other key risks and drivers for the stocks. JAL has raised its full year net profit forecast while ANA has kept its projection unchanged. Based on these profit guidance, JAL could report improving profit margins in the coming quarters (although still down y/y) which could drive some investors to switch from ANA to JAL following ANA’s 15% share price outperformance versus JAL and 18% outperformance versus the Nikkei index year-to-date. 

Chart: Price-to-book valuation range (2012 to 2017)

Chart: Price-to-book valuation range (2012 to 2017)

INDUSTRY CAPACITY GROWTH ON JAPAN DOMESTIC AND INTERNATIONAL ROUTES IS EXPECTED TO BE MUTED

Based on the airline industry’s planned flight schedules, the overall passenger capacity on Japan’s domestic and international routes is expected to grow only 2% y/y in the July-September quarter. This will help keep the industry demand-supply balance in check and support the broadly favourable earnings outlook of ANA Holdings and Japan Airlines.

Competition is likely to increase on Middle East and Oceania routes which is a concern but the benign industry capacity environment of the Japanese carriers’ larger revenue contributors (i.e. Europe, Asia, North America) should help mitigate this.

Notably, the planned capacity on Japan-Europe routes is projected to fall 4% y/y in July-Sep 2017, mainly due to capacity reductions by Turkish Airlines, Lufthansa, Air France-KLM and Alitalia. We expect Japan Airlines, which is boosting its Japan-Europe capacity by 5% y/y, to gain market share in this route region.

Chart: Planned capacity growth on Japan domestic and international routes (July-Sep 2017)

Chart: Planned capacity growth on Japan domestic and international routes (July-Sep 2017)

JAPAN AIRLINES IS MORE LEVERAGED TO LONG-HAUL ROUTES THAN ANA HOLDINGS

North America, Hawaii/Guam and Europe contribute 57% of Japan Airlines’ total international passenger revenue versus 53% for ANA Holdings. Both carriers have the same revenue exposure to Asia & Oceania routes at 43% each.

Chart: Japan Airlines – international passenger revenue breakdown by route region (1QFY18)

Chart: Japan Airlines - international passenger revenue breakdown by route region (1QFY18)

Chart: ANA Holdings – International passenger revenue breakdown by route region (1QFY18)

Chart: ANA Holdings – International passenger revenue breakdown by route region (1QFY18)

 

PASSENGER YIELDS ON INTERNATIONAL ROUTES IMPROVED Y/Y BY THE SAME DEGREE FOR BOTH CARRIERS IN APRIL-JUNE 2017

ANA’s international passenger revenue rose 13% y/y in April-June 2017, boosted by the 9% in passenger traffic and 4% improvement in yield. Passenger demand on Europe (mainly driven by the recovery of outbound leisure travellers to Europe) and Asia & Oceania (excluding China) routes improved significantly, and traffic on North American routes also increased. Only the China routes saw a slight y/y decline in passenger traffic. 

In comparison, JAL’s international passenger revenue rose 6% y/y in April-June 2017, with a 4% improvement in passenger yield as well but only 2% rise in traffic due to its limited capacity expansion. Its Europe and North America routes experienced the strongest passenger revenue growth, up 15% y/y and 12% respectively. In contrast, JAL’s passenger revenue was stable y/y on China and the rest of Asia & Oceania routes.

 

DOMESTIC PASSENGER YIELDS FELL DUE TO STRONGER COMPETITION; JAPAN AIRLINES PERFORMED BETTER THAN ANA HOLDINGS IN APRIL-JUNE 2017

Japan Airlines’ domestic passenger revenue rose 6% y/y in April-June 2017, mainly driven by the 8% rise in domestic passenger traffic as demand rebounded following the aftermath of the Kumamoto earthquake. However, domestic passenger yields declined 2% y/y due to rising competition.

This also drove ANA Holdings’ domestic passenger yields down by 3% y/y which resulted in only a 3% growth in domestic passenger revenue as ANA Holdings’ domestic passenger traffic grew at a slower pace of 6% compared to JAL in April-June 2017. 

The overall planned capacity growth on domestic routes is expected to be 2% in July-Sep 2017, with ANA growing at 2% while JAL is growing at 1% which could put further pressure on domestic passenger yields unless travel demand growth picks up.

 

STRONG CARGO MARKET HELPED TO BOOST ANA’S REVENUE

ANA’s international cargo operations improved with cargo revenue up 31% y/y, driven by the 17% surge in cargo yield and 12% rise in cargo traffic in April-June 2017. Automobile parts shipments from Japan to North America and Europe were strong. Air cargo demand from China and the rest of Asia to Japan was also robust. Cargo traffic from China to North America via Japan also increased.

Meanwhile, the international freighter operations cargo revenue fell 4% y/y, mainly due to the 4% y/y drop in cargo traffic while cargo yield rose 1%. In comparison, Japan Airlines’ cargo revenue rose 2% y/y in April-June 2017.   

 

JAPAN AIRLINES IS STILL THE MORE PROFITABLE CARRIER BUT ANA HOLDINGS’ PROFITABILITY IMPROVED MORE DURING THE 1ST QUARTER

ANA’s operating profit margin improved 2.1ppts y/y to 5.6% while its net profit margin improved 9.5ppts y/y to 11.2% in April-June 2017, boosted by the consolidation of Peach Aviation. ANA Holdings’ ordinary income rose 14% y/y and ordinary profit margin improved 2.9ppts y/y to 5.5%. In comparison, JAL’s operating profit margin improved 0.5ppts y/y to 7.9% while its net profit margin improved 1.3ppts y/y to 6.2% in April-June 2017.

JAPAN AIRLINES HAS RAISED ITS FULL YEAR FORECASTS WHILE ANA HOLDINGS KEPT ITS PROJECTION UNCHANGED

Following their April-June 2017 (1st Quarter of their new financial year) results releases, Japan Airlines has raised its full year (April 2017 to March 2018) net profit forecast by 8% to JPY108B, down 34% y/y while ANA Holdings has kept its full year net profit forecast unchanged at JPY125B, up 26% y/y, boosted by the consolidation of Peach Aviation.

JAL and ANA’s full year net profit margins are expected to be 8.0% and 6.5% respectively while their operating profit margins are expected to be 11.3% and 7.9% respectively. Based on these profit guidance, JAL could report improving profitability in the coming quarters (although still down y/y) which could drive some investors to switch from ANA to JAL following ANA’s 15% share price outperformance versus JAL and 18% outperformance versus the Nikkei index year-to-date.

JAL has also raised its full year dividend forecast by 7% to JPY96 (evenly split between interim and final). This implies a dividend yield of 2%-3% for JAL versus 1%-2% for ANA. Japan Airlines owns 87% of its aircraft fleet compared to 72% for ANA Holdings.

 

JAPAN AIRLINES HAS MORE FUEL HEDGING THAN ANA HOLDINGS BUT BOTH CARRIERS’ EARNINGS SENSITIVITY TO FUEL PRICE IS FAIRLY SIMILAR

ANA Holdings only has fuel hedging in place for its domestic operations but no fuel hedging for its international operations. ANA’s fuel hedge ratio as at June 2017 is at 30% in FY17, 20% in FY18, 10% in FY19 and 5% in FY20. Every US$1/bbl change in fuel price has a JPY3.2B (non-hedge) impact on ANA.

In comparison, Japan Airlines’ fuel hedge ratio is higher than ANA’s as at June 2017 is at 40% in FY17, 15% in FY18 and 5% in FY19. Every US$1/bbl change in crude oil price has a JPY2.6B annual impact (without hedging) on JAL.

 

ANA HOLDINGS’ EARNINGS WILL BE MORE SENSITIVE TO EXCHANGE RATE VOLATILITY THAN JAPAN AIRLINES DUE TO ITS HIGHER LEVERAGE

ANA’s forex hedge ratio as at June 2017 is at 50% in FY17, 30% in FY18, 10% in FY19 and 5% in FY20. Every JPY1/USD change has a JPY4.1B impact (non-hedge) on ANA.

In comparison, Japan Airlines’ forex hedge ratio is lower than ANA’s as at June 2017 is at 40% in FY17, 15% in FY18 and 5% in FY19. Every JPY1/USD change has a JPY1.5B annual impact (without hedging) on JAL.

Interestingly, the Japanese airlines’ share price performance is positively correlated with the US dollar even though they are also short of US dollars. This could be due to market expectations of increased inbound tourism traffic when the Japanese yen weakens. Note that the share price correction in 2008-2009 was also driven by the global financial crisis.

Both ANA and JAL could be suitable stocks to go “long” in a pair trade when the US dollar strengthens against the Japanese yen for investors who are planning to short the other Asian airline stocks when their local currencies weaken against the US dollar.

Chart: ANA Holdings share price versus Japanese yen exchange rate

Chart: ANA Holdings share price versus Japanese yen exchange rate

Chart: Japan Airlines share price versus Japanese yen exchange rate

Chart: Japan Airlines share price versus Japanese yen exchange rate

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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