A Big Climb for China's Airlines

Shares have soared on word Beijing may inject $2.6 billion into the mainland's three largest carriers. A strong yuan and lower oil prices help, too

Chinese airline shares have seen plenty of lift so far this year. On Jan. 17, China Eastern Airlines (CEA) jumped 13.11%, and is up 33.80% since the beginning of 2007, while China Southern Airlines (ZNH) climbed 5.72% the same day, and is up 25% this year.

Their shares soared after reports that the mainland government was contemplating an injection of up to $2.6 billion into the state-owned parents of China's three biggest carriers (in terms of passengers), China Southern, flag carrier Air China (which trades in London and Hong Kong), and China Eastern. While the three companies have denied receiving formal notification of any forthcoming funds, investors are betting that the money would be used to pay down debt or refinance jet leases between parent companies and carriers.

But before you undo your safety belts, consider this: On Jan. 18 in Hong Kong, where the bulk of these two companies' shares trade, stocks hit some serious turbulence after the government also announced a reduction in the surcharges airlines can charge passengers for extra fuel costs. China Southern shares fell 5.7%, Air China's 4%, and China Eastern 0.8%.

"The Sweet Spot"

Overall, though, the picture looks good for these carriers. China cut the price of jet fuel by $23 per ton to $748 on Jan. 1, and again by $11.50 on Jan. 14. This has provided a particularly important boost for China Southern, which is primarily a domestic carrier, deriving 80% of its traffic from local routes. Chinese carriers can only hedge their fuel costs on purchases of international fuel, not domestic fuel.

Chinese carriers are also getting a big lift from the strengthening yuan, which has gained 6% since the dollar peg was abandoned in July, 2005. The government has indicated it will allow the yuan appreciation to accelerate this year, and economists expect as much as a 7% appreciation in 2007. "The airlines are in the sweet spot with plunging oil prices and the stronger yuan," says Jing Ulrich, head of China equity research at JP Morgan (JPM) in Hong Kong.

China is already the second largest passenger market in the world after the U.S., and the gap is closing fast, thanks to rising domestic incomes and strong international passenger growth as China continues to liberalize its economy. During the first 11 months of 2006, mainland airlines carried 160 million people, up 15.9%, according to the Civil Aviation Authority of China. Cargo grew 11.5% over the same period.

Debt Weighs Down

Strong growth in domestic travel has helped China Southern return to profitability after several years of losses. Guotai Junan (Hong Kong) Securities aviation analyst Alan Lam forecasts China Southern will make a profit of $85 million—including extraordinary gains and sale and leaseback arrangements—on sales of $6.6 billion in 2006, compared with a $237 million loss on revenues of $4.87 billion in 2005. For 2007, he forecasts profit of $51 million on sales of $6.6 billion.

Prospects at China Eastern don't look as rosy, he says. The company is sagging with a debt that is 8.5 times as large as its equity, compared with 3.8 at China Southern, 1.2 at Air China, and 0.7 at Hong Kong-based Cathay Pacific. Based in Shanghai, China Eastern also faces higher maintenance costs as well as greater competition from foreign carriers flying Shanghai routes, and scrappy local carrier Shanghai Airlines. Lam forecasts losses of $116 million on sales of $4.6 billion in 2006, and 2007 losses of $65.5 million on sales of $5.2 billion.

Ironically, China Eastern's heavy financial leverage is helping drive its stock price up. Speculators are betting that if the $2.6 billion government handout to the three airlines is for real, then China Eastern has the most to gain by reducing its debt. Still, Lam says that won't help turn things profitable in 2007. The other thing driving its stock price is market speculation of a possible tieup with regional heavyweight Singapore International Airlines.

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