COMPANY NOTE China Southern Airlines Company Limited [1055.HK; HK$6.29; NOT RATED] Limited upside to earnings

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1 Jan-16 Feb-16 Apr-16 May-16 Jul-16 Aug-16 Oct-16 Nov-16 Jan-17 Feb-17 Apr-17 May-17 COMPANY NOTE Limited upside to earnings June 16, 2017 Event: Ahead of the summer peak season, we look into China s aviation sector. The latest industry data from the Civil Aviation Administration of China (CAAC) and individual airline companies shows accelerating passenger traffic growth and an improving passenger load factor, which should help improve passenger yield and airline companies profitability in E. We selected China Southern Airlines to see how much oil price and FX changes would impact its earnings. The Company is ranked the largest airline company in China s aviation sector in terms of fleet size and passenger traffic. It has the largest market share on domestic routes. Hence, its earnings are the most sensitive to 1) rising peak season passenger traffic, and 2) movement in oil prices and FX. We found that if we assume RMB to be relatively stable this year, the implied jet fuel price based on market consensus suggests limited earnings upside for China Southern Airlines Company Limited Turnover(HK$m, rhs) Price(HK$) Passenger traffic growth exceeded market expectations in 2017E: Weak macro-economic growth slowed down passenger traffic growth for domestic airlines in But there are signs of demand growth re-acceleration in China s aviation sector reported passenger traffic growth of 14.9% YoY in 3M17 vs. growth of 15.0% YoY in With its leading position on domestic routes and the fast ramp-up of its international passenger transportation business, China Southern Airlines delivered higher passenger traffic growth in 5M17 than Air China (753 HK) or China Eastern Airlines (670 HK). China Southern Airlines reported total passenger traffic growth of 12.1% YoY in 5M17 vs. overall passenger traffic growth of 8.7% YoY in Its domestic passenger traffic grew 12.4% YoY in 5M17 compared with 7.0% for Air China and 10.6% for China Eastern Airlines. Its international passenger traffic grew 13.4% YoY in 5M17, while that of Air China and China Eastern Airlines grew 8.6% and 10.7% YoY in 5M17, respectively. Passenger yield likely to recover from 2H17 on: The overall industry supply and demand dynamics remain favourable. As shown in Fig 2, overall industry capacity growth measured in ASK (available seat/kilometre) was below industry demand growth measured in RPK (revenue per passenger kilometre) in This has led to an increasing load factor. But airlines have been adding capacity to international routes, which has led to intensified price competition among airlines on international routes. In the meantime, there is competition between airlines and high-speed railways on routes below 800km. Hence, passenger yield on domestic routes has remained on a downward trend for the past four years. But passenger yield is likely to see growth recovery in The airline passenger ticket price index suggests that airline ticket prices started to move upward in 2016 (Fig 6). Strong passenger traffic growth and rising ticket prices should lead to improving passenger yield for airline companies in In addition, the coastal highspeed railways lifted ticket prices >30% in April 2017, which should reduce the price competition between airlines and high-speed railways. China Southern Airlines, with its larger exposure to domestic routes, should benefit the most from improving passenger yield. But consensus-implied jet fuel price largely factored into the latest oil price movement: Despite improving operations, we see limited upside for 2017 consensus forecast. Assuming a largely stable exchange rate, we ran a sensitivity analysis on China Southern Airlines to see the earnings impact from rising oil prices in 2017E. We calculated consensus-implied oil price assumptions based on consensus earnings estimates for the Company in 2017E. We calculated that the consensus earnings estimates are based on an average jet fuel price of US$59.0/bbl in 2017, suggesting a 10.2% YoY Market Cap: US$11,440m; Free Float: 63.0% Rmb m E 2018E Revenue (m) 108, , , , ,458 Operating profit (m) 4,774 13,438 12,702 8,793 8,624 OPM (%) Net profit (m) 1,777 3,736 5,044 5,021 5,156 NPM (%) EPS ROE (%) Dividend yield (%) PER (x) PBR (x) Source: Bloomberg increase in jet fuel prices in CYTD, the average jet fuel price rose 16% YoY to US$62.5/bbl. To achieve the consensus-implied jet fuel price in 2017, the jet fuel price would have to fall HoH to US$55/ bbl in 2H17. Since June, the jet fuel price has fallen below US$60/bbl. It suggests unless jet fuel price falls sharply, the current market consensus already reflected a relatively optimistic jet fuel price trend in 2H17, which caps the potential for upward earnings revision. Valuation: CYTD, the airline companies outperformed the HSI Index. China Southern Airlines share price has risen 54.2% CTYD, vs. a 3.2% rise in the HSI. The share price outperformance was due to market expectations of largely stable FX and likely falling oil prices in Based on consensus earnings estimates, the stock currently trades at 1.1x 2017E PBR, one standard deviation above its historical average forward PBR of 0.9x (Figure 10). We believe the current valuation is too rich, especially considering the limited upside risk to its 2017E earnings. We don t expect oil prices to come down significantly in 2H17. The production cut agreement among major oil producing countries should limit the downside of oil prices. In addition, the potential reduction of the FED s balance sheet may lead to RMB depreciation late this year. If there is not much earnings upside, the 1.1x PBR does not look cheap based on 10.3% 2017E ROE. We believe investors should gradually take profits in coming summer peak season. 1

2 COMPANY NOTE Figure 1: China aviation sector: passenger traffic growth by different routes % 25.5% 21.2% 14.6% 15.4% 11.0% 13.8% 13.8% 12.2% 15.2% 14.0% 13.6% 11.8% 10.5% 11.0% 6.4% 3.3% 10.6% CYTD -2.3% -5.7% -11.2% Domestic International Regional Source: CAAC, CGIS Research Figure 2: China aviation sector: RPK vs. ASK growth 35.0% % 29.8% 28.2% % 11.7% 9.7% 11.1% 12.0% 11.7% 12.3% 15.0% 14.9% 14.0% 12.7% 5.0% -5.0% 0.1% -0.3% CYTD RPK ASK Source: CAAC, CGIS Research 2

3 COMPANY NOTE Figure 3: Passenger traffic growth comparison for three Chinese airlines 16.0% 14.0% 12.0% 14.6% 14.5% 13.8% 11.0% 8.7% 9.6% 12.1% 10.5% 8.0% 7.0% 6.0% 4.0% 2.0% M2017 China Southern Airline China Eastern Airline Air China Source: Company data, CGIS Research Figure 4: Passenger load factor comparison for three Chinese airlines 82.5% 82.2% 82.0% 81.5% 81.0% 80.5% % 79.0% 81.2% 80.7% 80.4% 80.5% 80.5% 79.9% 81.3% 81.1% 78.5% M2017 China Southern Airline China Eastern Airline Air China Source: Company data, CGIS Research 3

4 COMPANY NOTE Figure 5: China s aviation sector passenger ticket price index % 0.2% -6.9% -2.5% -1.7% -9.9% -9.9% 8.1% 3.0% 0.8% -7.2% -5.2% -13.9% 6.4% 4.9% -2.9% % -45.4% CYTD Domestic International(ex-Asia) Regional Source: WIND data, CGIS Research Figure 6: Oil price sensitivity test on China Southern Airlines 2017E earnings Jet fuel price (US$/bbl) % chg 2017E Change from base 2016 % YoY chg case Net profit (Rmb m) 5,065 5, % 1, % -67.5% % 3, % -33.5% % 5, % % 6, % 34.3% % 8, % 68.3% Source: Company data, CGIS Research 4

5 Jan-16 Feb-16 Apr-16 May-16 Jul-16 Aug-16 Oct-16 Nov-16 Jan-17 Feb-17 Apr-17 May-17 Jan-16 Feb-16 Apr-16 May-16 Jul-16 Aug-16 Oct-16 Nov-16 Jan-17 Feb-17 Apr-17 May-17 COMPANY NOTE Figure 7: Jet fuel price (US$/bbl) Source: Bloomberg, CGIS Research Figure 8: RMB/US$ exchange rate Source: Bloomberg, CGIS Research 5

6 Jun-12 Sep-12 Dec-12 Mar-13 Jun-13 Sep-13 Dec-13 Mar-14 Jun-14 Sep-14 Dec-14 Mar-15 Jun-15 Sep-15 Dec-15 COMPANY NOTE Figure 9: Peer comparison Ticker Mkt cap Price PER EPS growth PEG P/Bk EV/EBITDA Dividend yield ROE US$ m (lc) E 2018E E 2018E 2017E E 2018E E 2018E E 2018E E 2018E H-share airline companies Air China 753 HK 18, % 4.0% 10.8% % 1.2% 1.4% 10.5% 9.7% China Southern Airline 1055 HK 11, % -2.0% 4.2% % 1.2% 1.3% 11.5% 10.3% China Eastern Airline 670 HK 12, % 17.6% 4.6% % 1.4% 1.4% 9.7% 10.4% 10.1% Cathay Pacific 293 HK 6, % 69.9% % % 0.2% 0.6% -1.0% -1.8% 1.5% A-share airline companies Air China CH 18, % 3.6% 11.8% % 1.0% 1.1% 10.5% 9.8% 10.1% China Southern Airline CH 11, % -23.3% 0.8% % 1.0% 1.1% 11.5% 8.1% 7.4% China Eastern Airline CH 12, % 2.4% % 1.0% 0.9% 9.7% 9.2% 8.4% Spring Airline CH 3, % 17.5% 24.0% % 0.5% 0.7% 13.0% 13.2% 14.0% Hainan Airline CH 8, % 14.3% 7.1% na na na 1.6% na na 6.9% 7.5% 7.4% Source: Bloomberg, CGIS Research, Note: based on closing prices on 15 June 2017 Figure 10: China Southern Airlines PBR band PB Average +1 Stdev -1 Stdev Source: Bloomberg, Company data, CGIS Research 6

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