Investment summary

Revenue decrease of 40% in the first three quarters

China Southern` revenue in the first three quarters of 2018 was RMB108.89 billion, up 13.3% yoy, and its net attributable profit was RMB4,175 million, down 40.8% yoy. In the third quarter, China Southern reported revenue of RMB41.33 billion, up 15.4% or RMB5.53 billion yoy, while its net attributable profit fell to RMB2,038 million, down 52.4% yoy.

Oil prices hampered results significantly

In the third quarter, the operating cost of China Southern reported an increase of 21.2% or RMB5.97 billion yoy, which is 8 points higher than the increase in revenue, dragging down the gross margin by 3.9 percentage points to 17.7%. Specifically, fuel costs accounted for the largest part, with fuel costs soaring by 48% or RMB3.8 billion in the third quarter, reflecting an increase of about 40% in average fuel prices and an increase of 8% in fuel consumption. However, excluding fuel, the non-oil cost only increased by 11%, and the non-oil cost per ASK decreased by 2.6 percentage points, reflecting that the refined management of the company has yielded impressive results in reducing costs, increasing benefits and raising prices.

Large fluctuation in exchange gain/loss

Since the beginning of this year, the exchange gains and losses caused by the fluctuating RMB exchange rate has greatly impacted the results. In the first and second quarters, China Southern recorded exchange gains of RMB1.37 billion and exchange losses of RMB1.79 billion, respectively. Due to the devaluation of the RMB, China Southern recorded about RMB1.59 billion in exchange losses in the third quarter, compared with RMB690 million in exchange gains in the same period last year. A total of RMB2.01 billion exchange losses occurred in the first three quarters and RMB1.25 billion exchange gains were recorded in the same period last year.

Through such tools as US dollar liability hedging and currency swaps, China Southern plans to continue to reduce the proportion of US dollar liabilities, so as to lessen the impact of exchange gains and losses. Currently, the proportion of dollar liabilities in the company's total interest-bearing liabilities has dropped to 24% from 32% of midyear, and is expected to continue to decline to over 20% by the end of the year.

Accelerated release of transport capacity and steadily increased demand

CSA has accelerated the release of its transport capacity, in which the increase of international and regional air routes is higher than that of domestic air routes, especially during the rush in July/August. Specifically, some of the transport capacity comes from the increased seats due to the modification to cabins. There is a greater demand for domestic air routes. In the first three quarters, CSA's overall available seat kilometers (ASK) increased by 12% Y-o-Y, and its revenue passenger kilometers (RPK) increased by 12.8%. Its passenger load factor (P L /F) was 82.8%, up by 0.5 percentage point Y-o-Y; specifically, the P L /F of the domestic, international and regional air routes was up by 0.65 percentage point, up by 0.29 percentage point, and down by 0.46 percentage point, respectively. According to the plan for the introduction of transport capacity, it is expected that CSA will have a net increase of 39 aircraft in the fourth quarter. In 2019, it will have a net increase of 67 aircraft. The Company plans to invest more newly added transport capacity in domestic air routes, sharing the industry dividend brought by the increased ticket prices in China.

Sharp decrease in fuel prices since 18Q4 conducive to the release of results

In the fourth quarter, the international fuel prices have been decreased by about 30% from the high spot of the third quarter. Compared with the level of the same period last year, the international fuel prices are unlikely to increase largely within this year. Therefore, in the fourth quarter, CSA will have much lower pressure from costs. Meanwhile, the exchange rate of RMB does not continue to be depreciated in the fourth quarter. Instead, the exchange rate maintains a stable trend basically, which will release CSA's pressure from exchange gain/loss.

Before October 27, CSA adjusted the prices of 58 air routes. In the first half year, CSA adjusted the ticket price level of 21 air routes. CSA's P L /F and income level were both satisfactory. After the change from Winter to Spring, there will be 61 air routes to be adjusted and the dividend on the increased ticket prices remain to be released continually.

Investment thesis

As the overall external factors such as fuel price and RMB exchange ratio tend to stabilizing, we expressed cautious optimism for the promotion of the industry next year. The completion of additional issue, CSA's balance sheet had been strengthened. In accordance with the latest data, we adjust the estimate of the Company's EPS to RMB0.37/0.66 in 2018 and 2019. The target price is HK$6.07, equivalent to 14.6/8.2x and 1.02/0.92x estimated P/E ratio and P/B ratio, respectively, in 2018 and 2019. The "accumulate" rating is maintain. (Closing price as at 27 November 2018)

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;

Irrational inter-industrial price war;

Financials

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