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Morningstar | Fine-Tuning Long-Term Assumptions on China Southern, FVE Maintained at HKD 7.80

No-moat China Southern reported solid first-quarter results and provided some guidance for the remainder of 2019. The carrier’s first-quarter earnings featured higher adjusted operating margin, up 130 basis points year over year, driven primarily by strong cost management efforts. We have revisited our assumptions after incorporating the probability-weighted impact on the carrier from the ongoing conflict between China and the U.S. After fine-tuning our long-term forecasts, we maintain our fair value estimate for China Southern at HKD 7.8 (CNY 6.80), shares of the group remain fairly valued.

During the first three months of 2019, China Southern experienced declining yield on both domestic and regional markets. We suspect declining yields are the result of the carrier’s aggressive expansion strategy. After taking into account management’s guidance of lower yield on international routes, we now expect overall revenue per available seat-kilometer, or RASK, to post a 1.7% drop for 2019. Over the longer term, management cited an increasing percentage of leisure and Internet-savvy customers as factors weighing down on ticket pricing. While the carrier’s near-term capacity growth will be matched by strong demand for air travel, we do not see any more upside in yield over the next five years considering Morningstar forecasts of a total 15% drop in Brent by 2022.

We also fine-tuned our long-term assumptions for Chinese airlines after incorporating the probability-weighted impact from the ongoing conflict between China and the U.S. Given that airlines are exposed to consumption and carry higher income elasticity of demand, we now see slightly slower passenger growth for China Southern.

On a high level, we see an average 60-basis-point reduction in real consumption over the next 10 years. Slower consumption growth will negatively affect demand for goods and services, especially ones that are more sensitive to changes in incomes. According to studies by the International Air Transport Association, developing countries like China have estimated price elasticity of air passenger demand around 1.8. Multiplying 0.6% by 1.8, we see a 1.1% annual reduction in underlying passenger demand growth or a total of 11% over the next 10 years.

A slowdown in demand for air travel will not be felt uniformly across the big three Chinese carriers. Lesser business activity, coupled with consumption downgrades, will weigh proportionally more on demand for business and first-class travel. Since China Southern generates the least amount of sales from premium-class demand relative to peers, its business will be less affected by the U.S.-China conflict. We believe the resulting losses in passenger traffic will be permanent unless the two countries reach a face-saving settlement where economic activities return to the status quo.

The adverse impact on consumption, however, should be partially offset by the expected reduction in ticket prices resulted from the State Council’s recently announced plans to halve infrastructure levy charges. Assuming the levy cut will be applied equally across all routes, the per-passenger fee will be lowered to CNY 25 from CNY 50 for domestic and to CNY 45 from CNY 90 for international flights. Resulted reductions will amount to roughly 3% of average domestic and international ticket prices. We think the cuts in infrastructure levy will make air travel more affordable, boosting demand and somewhat offsetting the negative impact on China airlines from the U.S.-China conflict.