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Special Report: China Eastern Expands, But Near-Term Outlook is Murky

World’s 7th-largest airline is making deals, investing in new planes and other airlines to take advantage of China’s booming tourism demand.

Mark Melnicoe
    Nov 26, 2017 8:10 AM  PT
Special Report: China Eastern Expands, But Near-Term Outlook is Murky

Partly cloudy skies appear ahead for China Eastern Airlines, as analysts are expressing differing opinions about prospects for the world's seventh-largest air carrier.  

Sixty two percent state-owned, the airline is getting a lift from China's expanding travel market, has ordered new planes and entered into a stock-purchase agreement with Air France KLM.  But all Chinese airlines are facing headwinds, according to Jefferies, which remains bearish on the stock. Conversely, ValuEngine on Nov. 17 rated CEA a strong buy. 

Shanghai-based China Eastern (NYSE: CEA) definitely is not standing still. In September, it announced shareholder approval for a purchase of 10 percent of Europe's Air France-KLM SA, the first such deal by one of China's big three state-owned airlines. The other two are Guangzhou-based China Southern and Beijing-based Air China.

As part of that deal, Delta Airlines is also buying 10 percent of Air France-KLM. Delta, the world's largest airline, owns 3.2 percent of China Eastern. The plan aims at combining overlapping transatlantic joint ventures, with all the deals totaling more than $1 billion. China Eastern's stake in Air France-KLM is worth nearly $450 million.

"The parties will work together to build the China-Europe main routes market," China Eastern said in a July statement, when the deal was announced.

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All of China's big three airlines are rapidly expanding their global routes as China's outbound tourism grows and business ties continue to flower. The central government is encouraging the moves, partly to diversity the troubled state-owned sector but also to facilitate more business, especially for its Belt and Road Initiative that seeks to modernize the ancient Silk Road and facilitate more trade with Europe, Central Asia, and the Middle East.

China Eastern is positioned to capitalize, as Shanghai, with a population of 25 million people, is China's financial center. For its part, Air France-KLM said the alliance would provide European leadership in Shanghai.

For all of China's growth in trade and the tourism sector, China Eastern's profits have barely nudged in recent years, and its margins are tight. Total revenue has been stuck at just over $15 billion for each of the past three years. Net income was $571 million in 2014, $777 million in 2015, and $713 million last year. But it's improving this year. CEA reported Oct. 26 that profits are up 18.2 percent year-over-year for the first nine months of 2017.

Nevertheless, Jefferies sees margins being further squeezed in the short term for all three of China's major airlines.

Looking ahead: a bumpy ride or smooth sailing?

"We estimate sector margins continuing to decline next year with operating margin of only 8.7% next year from 12.5% in 2016 due to higher costs with capacity increases will likely cap ticket price increases," Barrons quoted the firm as saying in a Sept. 7 report. "For example, the three major Chinese airlines are slated to increase the number of planes by 25 percent by end-2019 from end-1H17, primarily passenger planes. Taking 2016 as example, number of passenger planes increased 6.4% with seat capacity increasing 10%."

Jefferies gave an "underperform" rating to China Eastern, China Southern, and Air China, despite noting that these airlines' foreign exchange reserves were boosting profits with the yuan's appreciation. It projected a foreign exchange gain in 2017 of 3.9 billion Chinese RMB ($590 million), compared with an earlier forecast of a $680 million loss. That resulted in Jefferies raising its earnings forecast for the three airlines combined by 32 percent this year.

Based on the favorable exchange rate and growth in the China and broader Asian market, the equity analyst firm ValuEngine raised its rating on CEA from buy to strong buy in a Nov. 17 report.   

The stock received a big pop the day before Thanksgiving, as it rose 10.4 percent to close at $31.36 a share, breaking out of its 52-week trading range. Volume was more than double the daily average, with nearly 31,000 shares trading hands Nov. 22. The company has a market cap of more than $16 billion, with a P/E ratio of 10.6 – a lower valuation than Air China and China Southern. (In holiday-shortened trading on Friday, shares in CEA rose again slightly to $31.55 per share.)

One advantage for China Eastern is that it won't need to be retiring aging planes anytime soon. It boasts one of the youngest fleets of any major airline, operating more than 600 aircraft, with the average age of less than 5½ years old.

The airline also is expanding its range. It has entered into an agreement with authorities in Western Australia to initiate service between Shanghai and Perth, an emerging tourist center on Austalia's west coast, next year.

China Eastern also flies to Sydney and Melbourne, and the move is seen as a strategy to tap Chinese people's increasing thirst for international travel. China Eastern flew 640,000 passengers to Sydney last year. According to the West Australian, a Perth newspaper, tourism operators see the deal as "a game changer as China's wealthy middle-class continues to grow." 

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