1.About China Eastern Airlines
Headquartered in Shanghai, China Eastern Airlines Corporation Limited (“CEA”) is a Chinese airline that provides passenger and cargo air transportation services with a fleet size of 642 aircrafts as at 30 Jun 18. CEA is one of the world’s largest airlines by passenger volume, having carried 111m passengers in 2017 with a passenger load factor of around 81%.
CEA was established in 1957 under the Civil Aviation Administration of China (“CAAC”) and the Chinese government remains the biggest shareholder today. The company’s ultimate parent is the State Council’s State-Owned Assets Supervision & Administration Commission (“SASAC”), which owns a majority stake of 56.37% (as at 31 Dec 17) in CEA via China Eastern Air Holding Company Limited (“CEA Holding”).
It is the first Chinese airline to be triple-listed on the New York Stock Exchange, Hong Kong Stock Exchange, and Shanghai Stock Exchange. At the close of yesterday, CEA had a market cap of USD 10.5 billion (HKD 82.3 billion or CNY 72.1 billion).
2.Business and Geographical Segments
CEA’s largest business segment is airline operations which contributed around 96% of its total revenue in 2017. This segment mainly provides air transportation services for passengers, and cargo and mail delivery.
Geographically, CEA operates in three main areas (see Chart 1): Domestic (PRC excluding Hong Kong, Macau and Taiwan), Regional (Hong Kong, Macau and Taiwan) and International.
Chart 1: Geographical breakdown of CEA’s revenue
3.Strong government ties
CEA’s senior management team is filled with people who had worked in state agencies in various roles. Chairman Mr Liu Shaoyong was formerly director general of Flight Standard Department of CAAC, while President Mr Ma Xulun was previously deputy director general of the finance department at CAAC.
Besides that, CEA has a strong track record of government support in times of need. We list below instances of government support since 2008:
- In 2008, CEA received about RMB 7 billion of equity injection from the state-owned entity (“SOE”) CEA Holding. That financial aid came after CEA recorded a net loss of RMB 2.3 billion in the nine months ended September 2008, and was facing enormous financial pressure in the aftermath of the global financial crisis.
- In 2013, CEA received ~RMB3.62 billion of equity injection from CEA Holding, which was used to repay debt.
- In 2015, CEA raised about RMB8.54 billion (net proceeds) through a shares placement to a number of investors, including China National Aviation Fuel Holding Company (invested ~RMB 3 billion), a SOE. CEA used the proceeds raised to purchase aircrafts and pay off loans.
4. Higher passenger traffic volume led to improved profitability in 1Q18
In the first quarter ended 31 Mar 18, CEA’s revenue was up by 9.04% YoY to RMB26.8 billion, driven by an increase in passenger traffic volume that was also up by 9.08% from the previous corresponding quarter. The increasing demand for air transport and expanding number of routes have supported the company’s revenue growth over the years (see Chart 3). However, the increase in passenger traffic did not help to boost passenger load factor, which remained relatively flat at 81.7% in 1Q18.
Chart 2: CEA’s passenger traffic volume
CEA’s reported operating profit of RMB 2.58 billion in 1Q18 was up by 8.4% YoY from RMB 2.38 billion in 1Q17. But we note that the company’s operating profits in 1Q18 included government grants for operating in certain routes, while 1Q17 results comprised of a non-recurring investment gain (RMB 1.75 billion) arising from the sale of Eastern Air Logistics Co., Ltd. Excluding these items to allow better comparability, we find adjusted operating profit for 1Q18 at RMB 1.2 billion, much improved from an adjusted operating loss of RMB 0.7 billion in 1Q17.
In line with the increased revenue, CEA’s operating cost climbed 9.7% higher to RMB 23.6 billion in 1Q18 (1Q17: RMB 21.5 billion). Likely due to higher fuel prices, gross profit margin dropped slightly to 11.9% in 1Q18 from 12.4% in 1Q17.
CEA’s operating profit margin of 9.6% (unadjusted) was fairly constant from 9.7% in 1Q17, and shown improvement from its five-year average (2013-2017) of 7.1%. Having said that, the company’s operating profit margin in FY17 was the lowest among China’s “Big Three” airlines (the other two being China Southern Airline and Air China), and also lagged behind Bloomberg’s Asian Airline Index (see chart 2).
Chart 3: CEA’s profitability fell behind its peers in recent years
5. Potential roadblocks ahead
Higher fuel costSimilar to many other airlines, CEA’s biggest single expense comes from fuel. In 2017, the company’s total aircraft fuel costs was RMB25.1 billion, or 25% of its operating expenses (FY16: 21%). Therefore, its profitability could be squeezed by rising fuel prices. As of this writing, Brent crude spot at around US$73 per barrel, up nearly 44% from a year ago.
Despite an uptrend in oil prices (see Chart 4), CEA chose not to hedge against fuel price risk—it had no open crude oil option contracts as at 31 Dec 17. That left the airline vulnerable to fuel prices that were climbing at a faster pace than ticket prices.
Nonetheless, we note that CEA announced in early June that it will apply a fuel surcharge to domestic routes, which could offset some of the fuel purchase costs. Starting 5 Jun 18, the airline collects RMB10 in fuel surcharge from each domestic passengers, except for children and disabled military and police personnel. CEA could also benefit from the recently-launched yuan-denominated oil futures—the airline has reportedly said that it would consider locking in fuel hedges by using the domestic crude futures1.
Chart 4: Crude Spot (USD/barrel)
Weakening yuan
CEA has significant exposure to foreign currency risk as it sells air tickets in various currencies, depending on routes served, whilst a large part of its liabilities including borrowings and aircraft leases is denominated in USD. Foreign exchange risks have recently rose following the recent slump in the Chinese yuan, due to the tit-for-tat trade war between the US and China. At the end of 2017, CEA’s outstanding FX forward contracts for selling RMB and purchasing USD (expiring in 2018) had a notional value of RMB 5.4 billion, against RMB 29.3 billion of USD-denominated finance leases and RMB 7.6 billion of USD borrowings.
An escalating US-China trade war
The US-Sino trade war has not only caused yuan to depreciate, but also potentially other repercussions that could harm CEA’s business. These would include decrease in demand for US-China flights—as happened before with South Korea and Taiwan when geopolitical relations deteriorated in recent years.
Trade tensions could also disrupt CEA’s aircraft orders and route frequency plans. As reported by Reuters in April, CEA’s chief marketing officer Dong Bo said, “We will make some adjustment to our fleet if passenger numbers fall on China-US routes, for example by switching the Boeing 777 to the Airbus A330-200. If the impact is more severe, we may make adjustments to airline frequency.”2
Finally, future aircraft acquisitions might be more expensive, as the prices of aluminium—a key material in aircraft manufacturing—could rise following US’s increased tariffs on aluminium imports.
6. Leverage is high after adjusting for leases
CEA’s credit ratios were stable in 1Q18 as we estimate that net gearing (net debt/equity) was flattish at ~1.0x (4Q17: 1.0x). However, obligations under finance leases seemed heavy at RMB 66.9 billion at the end of 2017. The company does not disclose this number for its quarterly statements. Taking its long-term payables (RMB 63.8 billion as at 31 Mar 18) as proxy for finance leases, and treating them as debt, we estimate adjusted net gearing at 2.1x (4Q17: 2.2x).
The airline also had commitments under operating leases (mostly aircraft-related) of RMB 20.94 billion as at 31 Dec 17. Adjusted net gearing would further rise to 2.5x in 1Q18 if we include this off-balance sheet item, albeit slightly lower than 4Q17’s 2.6x.
We estimate that CEA’s debt-to-assets ratio stood at 0.3x at the end of March, unchanged from the previous quarter (0.3x). Most of the company’s assets are fixed assets (predominantly aircrafts and related equipment), which totalled RMB 164.7 billion as of 1Q18 (4Q17: RMB 163.1 billion).
Assuming the portion of fixed assets held under finance lease remained unchanged between December to March, we estimate CEA to have RMB83.67 billion of fixed assets held under finance lease. That would translate to a finance lease-to-underlying asset ratio of around 0.76x.
We like that CEA’s cash flow from operations (“CFO”) more than doubled to RMB 6.38 billion in 1Q18 from previous corresponding quarter’s RMB 2.58 billion. However, its liquidity position remained tight with a cash balance of RMB 2.89 billion, against short-term borrowings and notes payable of RMB 24.6 billion.
The group swung to a net finance income of RMB465m in 1Q18 versus net finance expenses of RMB507m in 1Q17, primarily due to a spike in realised foreign exchange gains to RMB1.46 billion in 1Q18 (1Q17: RMB188m). Removing these FX gains, we find CEA’s CFO (before tax)-to-net finance expenses coverage ratio at ~7.6x (1Q17: 5.1x)
7. Agressive fleet expansion could pressure credit profile
CEA plans to add 67 aircrafts and retire 15 old ones this year to reach a fleet size of 679 (4Q17: 627, excluding ten held under trust). The company intends to introduce another 62 airplanes in 2019 and 61 in 2020 (retiring ten). As at 30 Jun 18, CEA has reached a fleet size of 642 airplanes.
In monetary terms, CEA’s ambitious fleet expansion plan translates to a total expected cost of RMB 87.03 billion over the next three years, including RMB 28.32 billion, RMB 27.52 billion and RMB 19.27 billion respectively from 2018 to 2010. The company had spent just RMB4.1 billion in investing activities during the three months ended March.
While the heavy capital expenditure (“capex” needs may weigh on its credit metrics, CEA has already been actively seeking financing channels outside of borrowings. Last month, the group proposed a private placement of its A shares to JuneYao Group and the Chinese government-backed Structural Reform Fund. CEA intends to raise RMB 11.8 billion from the transaction, which would be used to purchase 18 aircrafts and related equipment.
In the same July announcement, CEA also said it will be placing H shares to Juneyao Airlines to raise HKD 3.55 billion (~RMB 3 billion). Proceeds from the H shares issuance will be used for working capital purposes.
8. The CHIEAS 2.8% ’20s offer fair value
At its indicative ask price of 99.38, the CHIEAS 2.800% 16Nov2020 Corp (SGD) offers a yield to maturity (“YTM”) of 3.085% (Z-spread: 110bps), against a remaining tenor of ~2.25 years. We think the CHIEAS 2.8% ’20s compensate fairly for CEA’s credit profile and its associated risks described above. The notes offer a 66bps yield pickup from Singapore Airline’s (net gearing: 12%) SIASP 3.220% 09Jul2020 Corp (SGD), which is trading at an ask YTM of 2.41% (Z-spread: 63bps).
CEA’s credit metrics look stretched if we adjust for its aircraft leases and take into account its heavy capex requirements. But our credit opinion has incorporated a high likelihood of sovereign support from the Chinese government, which is rated A+ by the three major credit rating agencies. Also, CEA enjoys tremendous market power as one of the big three air carrier in China, a market with burgeoning demand for air travel and high profitability.
We note that the bond documentation contains a change-of-control (“CoC") clause, which provides investors the option to sell the bonds back to CEA at 101% if SASAC owns less than 50% stake in CEA. Therefore, investors are protected against the unlikely event of CEA losing its strong parental backing.
In short, we have a balanced view on the CHIEAS 2.8% ‘20s. The 3.085% yield on the notes reflect the state ownership and the importance of the aviation industry to the government, but also provide a fair premium for CEA’s highly-levered balance sheet.
References:
1 Freed, Bryan. (2018, April 4). Airlines adjusting hedges, fares, capacity and fleet as oil price jumps.. Reuters (Sydney). Retrieved from https://www.reuters.com/article/us-airlines-iata-hedging/airlines-adjusting-hedges-fares-capacity-and-fleet-as-oil-price-jumps-idUSKCN1J014K
2 Reuters Staff. (2018, April 4). China Eastern Airlines says trade war may prompt route adjustments. Reuters (Hong Kong). Retrieved from https://www.reuters.com/article/us-china-eastern-results/china-eastern-airlines-says-trade-war-may-prompt-route-adjustments-idUSKCN1HB08T
Declaration:
For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report holds a NIL position in the abovementioned securities.
