Chinese airline sector:Earnings downside risk from weak Rmb

The yuan has depreciated to 6.86 against the US dollar recently, from 6.67 atend Sept, vs our assumptions of 6.60/6.48 for FY16E/17E, in line with ourhouse forecasts. Based on our sensitivity analysis, a 1% Rmb depreciationwould lead to a 9-10% decline in FY17E reported profit for the big threeChinese carriers, disregarding negative impact on consumers’ appetite totravel overseas. China Eastern Airlines (670 HK), by our estimates, is mostsensitive to a weaker yuan.

    We remain bearish on the Chinese airline sector. Besides currencyheadwinds, we expect ongoing price competition and fast growth from airportsat lower-tier cities will continue to drag passenger yield. We expect anotheryear of yield decline in 2017E. Our FY17E PAT estimates are 0-11% belowconsensus after a 14-21% cut to consensus earnings post 3Q16 results.

    Currency operational headwinds from weaker Rmb. We estimate a 2-3%decline in FY17 profits purely from operations from a 1% depreciation in Rmb,with China Eastern Airlines (670 HK) being the most sensitive to Rmbweakness. US$-denominated expenses include operating lease expenses,fuel uplifted for international operations, take-off and landing charges andmaintenance expenses. Domestic fuel consumption are priced in Rmb.

    An additional 7-8% profit decline from translational losses from a 1%weaker yuan. Air China currently has the largest US$-denominated debt,standing at US$10bn as of 1H16. The big-3 Chinese airlines have taken actionsto reduce USD debt exposure to 41-59% mix in 1H16, from 74%-93% in 2014,to alleviate the impact from currency movements. However, an acceleratedRMB depreciation would still incur large forex loss, given the sizable US$-denominated debt of US$6-10bn for the big-3 carriers as of 1H16.

    Our sensitivity analysis excludes the impact of a potential weaker outboundmarket as a result of the lower purchasing power. As detailed in A journey justbegun, our consumer team found a slight positive correlation betweencurrency and outbound tourism. A weakening JPY since 2014 hassuccessfully boosted Chinese tourist arrivals; similar stories can be found inSouth Korea, Australia, Thailand, the US, etc. The correlation of MoM growthin Chinese tourists to Japan with the JPY/CNY is ~+0.3 with a five-month lag.

    Reiterate our bearish view on the sector. Our investment thesis ispremised on weaker yields for longer, as airlines are pushed to growsecondary routes to meet ambitious capacity targets.

    We have Underperform ratings on China Eastern Airlines (CEA) andChina Southern Airlines (CSA). We are Neutral on Air China. CEAcurrently trades at 7.2x FY17E EV/EBITDAR, a 31% and 16% premium toAir China and CSA.