Investment Summary

Air China's third-quarter results were lower than expected, resulting in a decrease of 6.4% in net profit for the first nine months of this year. The main reasons are the fuel cost and the exchange losses. According to the latest hypothesis of the oil cost and exchange rate, we revised our estimate 2018/2019 net profit and the target price is adjusted to HKD7.39. “Hold” rating is given. (Closing price as at 20 November 2018)

Earn 30% less yoy in the third quarter

During the first three quarters of 2018, Air China (AC) recorded operating revenue of RMB102.88 billion, up by 12.1% yoy, and a net profit attributable to shareholders of RMB6,937 million, down by 16.2% yoy. On a closer look, during the third quarter, the company recorded operating revenue of RMB38,638 million, up by 12.3% yoy, and a net profit attributable to shareholders of RMB3,469 million, a year-on-year decrease of 30%. During the H1 of this year, AC's revenue and attributable profit grew by 12% and 4.05%, respectively.

Expenditure: rising oil prices and exchange losses dragged down performance

During the third quarter, AC's gross margin was down by approximately 4.8 percentage points, as operating costs increased by RMB4.6 billion, representing a yoy increase of 18%, and this exceeded the revenue growth. The increase in costs was mainly due to the rising fuel costs driven by rising jet fuel prices, resulting in total costs soaring nearly by RMB3.5 billion or 36.5%. Despite the unfavorable conditions of rising oil prices, the company continues to strengthen production management and resource control, reduce production costs and increase efficiency by optimizing productivity, thus bringing down the cost of unit non-aviation oil by 2.3%.

In addition, due to expanding exchange losses caused by the depreciation of RMB, financial expenses have increased substantially and resulted in total expenses up by 129% yoy (equivalent to RMB3.08 billion in value).

Revenue: the price hike effect is emerging, and the operational efficiency continues to be improved

During the third quarter, the company's passenger transport capacity increased by 9.24% yoy, of which domestic, international and regional routes increased by 5.7%, 13.55% and 2.9% yoy, respectively. Passenger turnover increased by 9.41% yoy compared with the same period in 2017. Specifically, domestic, international and regional routes increased by 6.22%, 12.7% and 1.22% yoy, respectively. The passenger load factor was 81.7%, representing a slight yoy increase of 0.13 percentage point.

In an attempt to make full use of the reform opportunity aiming to promote the marketization of domestic civil aviation industry, the company has been adjusting fare prices of more than 100 domestic routes, and increasing the overall fare level in the third quarter by 2 percentage points, as well as continuing to market its value-added products (such as pay for selecting seats and flight upgrade, which contribute to additional sales). The company also strengthened its sales force across various e-commerce channels to increase revenue, expand client base, promote innovations in business model and improve operational efficiency.

It is worth mentioning that during the third quarter, Cathay Pacific, in which the company owns a participating stake, has significantly reduced losses, which contributed to an increase in AC's investment income from RMB485 million to RMB596 million, effectively smoothing the fluctuations in the results.

The external conditions are generally positive in the face of a tight balance between supply and demand

On the supply side, in order to ensure the punctuality rate of flights, the regulatory authorities still maintain strict control over the time limits of civil aviation resources, and could possibly introduce stricter safety standards in the future, which will benefit large-scale aviation enterprises. AC plans to purchase 68 aircraft in 2019, discard 19, amounting to a net increase of 49. At the level of the parent company, AC plans to purchase 40 aircraft, discard 10, amounting to a net increase of 30. Meanwhile, the company will adopt more wide-body aircraft for its core lines so as to earn more tickets income per route. At present, the international oil price has fallen to a new low in the past year, which will greatly ease the pressure on aviation fuel costs. With regards to exchange losses caused by the depreciation of RMB, AC's dollar-denominated debt has dropped from 48.8% to 35%, and the future exchange rate elasticity will continue to decrease as the company reimburses debts.

Valuation & Investment thesis

According to the latest hypothesis of the oil cost and exchange rate, we revised our estimate 2018/2019 net profit of AC to be 6.72/10.23 billion RMB. The target price is adjusted to HKD7.39, estimates 14.2x/9.3x P/E and 1/0.9x P/B in 2018/2019. “Hold” rating is given.

Risk

Traffic demand languished for the deterioration of macro-economy;

The depreciation of the RMB against USD would bring exchange loss;

Oil prices rose exceeded forecast.

War, terrorist attacks, SARS and other emergencies;

Highspeed railway diversion

Financials

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