Regional Aviation - Potential MERS Outbreak In Korea; Chinese Airlines Have The Most To Lose


Chinese airlines have greater downside risk in the near term, due to potential demand destruction on high-yielding regional routes, in the wake of the MERS outbreak in South Korea. Our earnings estimates have not factored in the potential demand destruction arising from such a scenario, nor has stock price reacted as yet. In contrast, SIA has less downside risk as P/B valuations are close to the low of 0.9x seen during the SARS period. Maintain UNDERWEIGHT.

WHAT’S NEW
Concerns over a potential MERS outbreak in South Korea are likely to hurt North Asian inbound tourism; Chinese airlines have the highest exposure. There have been 30 reported cases of MERS (Middle East respiratory syndrome) and over a thousand are quarantined in South Korea. This has led to cancellations of tours, especially by Chinese travellers. While no countries have issued travel advisories as yet, this could change if fatality rates rise. Prevailing cautious sentiment could spill over to other North Asian countries. Almost 20% of Chinese carriers’ international seat capacity is focused towards South Korea and thus will be most impacted by any demand destruction.

Potential diversion of Chinese traffic from North Asia to Southeast Asia. This remains a distinct possibility as Thailand ranked ahead of South Korea just two years ago. The primary beneficiary of such a move will be Thai Air Asia, which has the second largest capacity to China with no corresponding flights to South Korea.

Steep decline in SIA’s stock price is not due to weakening operating environment or MERS. Very little has changed since the 1Q15 results were released in May, aside from a slight deterioration in the outlook for air freight as capacity growth continued to outweigh demand growth. Fuel prices continue to remain low with jet fuel under US$80/bbl for most of May and June. In addition, the SIA group will be taking delivery of more fuel-efficient aircraft, which will lower overall fuel cost. That said, if MERS becomes more widespread, P/B valuations could head towards 0.9x, matching that of the SARS period.

Lowering our year-end renminbi estimates. We had previously assumed a 2% decline in the renminbi by year end. We now revise this down to a 1% decline, given relatively stable renminbi. Chinese airlines have substantial US dollar-denominated debt and the downward revision will lower MTM forex losses and raise net profit for CSA, CEA and Air China by 14%, 12% and 10% respectively.

ESSENTIALS
Valuations matter now, more than ever. SIA has a comparatively lower P/B multiple than any other stock within our coverage. If we exclude its 79% stake in SIAEC, SIA will be trading at 0.75x forward book value. In a worst-case scenario, we reckon that downside risk for SIA would be limited to S$10.10, or 0.9x book value if we reference the P/B multiple to the SARS period. SIA’s relatively low ROE is also due to the fact that 30% of its book value is cash and near cash. Conversely, Chinese carriers’ 2Q and 3Q quarterly earnings could surprise on the downside as yields could drop sharply following the removal of fuel surcharges. We have assumed that Chinese carriers will be able to offset a third of the decline in fuel surcharges with higher prices. Given this uncertainty and the relatively higher valuations of the Chinese carriers, we believe there is greater downside risk to the Chinese carriers as compared with SIA.


Technical Analysis
Daily Chart
ASSUMPTION CHANGES
We raise our fair value for CEA and CSA by 10% each to Rmb5.30 and Rmb6.10 respectively as we raise our fair value P/B multiple to 1.2x vs 1.1x previously and following the upward revision in earnings. Air China’s fair value P/B remains unchanged at 1.2x but our fair value is raised to HK$7.10 vs HK$7.00 previously. We also lower our suggested entry price of SIA to S$10.50.

RISKS
■ MERS contagion. (Read Report)

Source : UOB KayHian Research

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