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Morningstar | Despite Posting Strong Q4 Results, Air China's Outlook Remains Dim; FVE Lowered to HKD 7.0. See Updated Analyst Note from 29 Mar 2019

We lower our fair value estimate for no-moat Air China to HKD 7.0 from HKD 7.3 following fourth-quarter results and new guidance for 2019, because the impact of slower capacity expansion was offset by markedly stronger yield. 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. Adverse effects from the upcoming opening of Beijing’s second airport are set to hit Air China’s profitability. We also believe the indefinite grounding of Boeing 737 MAX 8 planes will hit Air China’s capacity expansion in 2019, and the exact effects of this will depend on the outcome of investigations. The shares of the carrier are overvalued in our view.

During the second half, the flagship carrier grew overall available-seat-kilometers, or ASK, by 8.5%, led by 11.3% on the international front. Demand, on the other hand, trailed supply by only 70 basis points. During the first two months of 2019, we see the carrier holding back its ASK deployment, lending itself to improved load factor on the passenger side. Air China and its peers have benefited from close ties with the government and each other, which should enable them, collectively, to keep overall capacity growth rates in line with demand over the long-term. We therefore expect to see a stable load factor for Air China over the next five years.

On the flip side, the average fare paid will start to decline. Beijing, Air China’s main hub, is set to open a second airport in late 2019. The plan is for Air China to remain in the old Beijing Capital Airport, while all of China Eastern and China Southern’s operations move to the new Beijing Daxing Airport. This will not be a market-driven move because one of the government’s main goals is to ensure the new airport gets used. With authorities offering various incentives to airlines that move ahead of schedule, we expect Air China’s rivals to offer big discounts to attract passengers flying in and out of the new airport. While this might be positive for travellers, the same cannot be said about Air China’s shareholders. Taking into account our oil price forecast of a total 15% drop in Brent over the next five years, we now expect Air China’s yield to decline by a total of 980 basis points over the next five years, in line with the carrier’s historical performance.

Further, with more airports being built in China’s tier-two cities, Beijing’s position as an international transfer hub will also diminish. At the end of 2018, as many as 21 airports in tier-two Chines cities operated international flights, up from only three airports in 2009. Coupled with the rise of domestic low-cost-carriers like Spring Airlines and loosening of the regulations in the overall aviation industry, we believe legacy carriers will find it difficult to control as many slots in the new airports, as they did in tier-one hubs. We therefore believe that legacy carriers', such as Air China, longer-term capacity expansion will be below that of the market.

When it comes to the issue of the grounding of 737 MAX aircraft, we think it will take about two months for Boeing to repair the MCAS software, certify the aircraft, and train pilots. At the end of 2018, 747 MAX 8 aircraft made up 3% of the group’s current fleet and almost half of its 2019 deliveries. While Air China can slow their planned 17 aircraft retirements to fill some of the void left by delays in 32 MAX 8 deliveries, it is nowhere close to offsetting the adverse effects completely. Therefore, we now see Air China expanding its capacity by merely 8.4% in 2019, lagging management’s 10% guidance.

Lastly, the company’s results have been helped by a turnaround at Cathay Pacific, a Hong Kong-based carrier in which Air China holds a 30% stake. While the market reacted positively to Cathay’s 2018 full-year results announcement, probably because of higher-than-expected supply growth guidance for 2019, we do not believe new supply will be matched by demand in the near term. We have a fair value estimate of HKD 12.20 for Cathay Pacific, and Air China’s 30% stake in Cathay translates into about 11% of the firm’s intrinsic value.