The share price of China Southern Airlines (“CSA”) has risen by over35% since the end of 2016, outperforming Hang Seng Index and HSCEIby 25% and 27% respectively. In view of its low earnings visibility, wemaintain our cautious view on the counter and set our target price at its7-year P/B ratio, equivalent to HK$5.5 (Previous HK$5.5). In light of thelimited upside potential, we downgrade our recommendation to Hold.
　　2016 results below expectation. CSA’s net profit came in atRmb5,044m, representing an increase of 35.0% YoY, below both themarket and our expectations. Total revenue increased by 3.0% YoY toRmb114,981m, in line with our expectation. CSA declared a 2016 finaldividend of Rmb0.10 per share compared to Rmb0.08 per share in 2015.
　　International traffic drove growth. During 2016, passenger revenuefrom international routes surged by 8.8% YoY to Rmb23,016m,accounting for 20.0% of CSA’s total passenger revenue. CSA launchednew flight routes of Guangzhou–Toronto, Guangzhou–Adelaide,Shenzhen–Sydney, Shenzhen–Wuhan–Dubai during 2016. Lookingahead, CSA will continue to expand its international market, includingforming strategic cooperation with American Airlines Group.
　　Jet fuel cost down lifted profitability. Total jet fuel cost declined by9.4% YoY to Rmb23,799m in 2016. As a result, jet fuel cost as apercentage to total revenue declined by 2.8 ppts YoY to 20.7% in 2016,lifting its net profit by 35% YoY to Rmb5,044m in 2016. Looking ahead,jet fuel cost will remain the key risk for CSA.
　　Earnings still volatile. The financial leverage of CSA is very high withnet debt-to-equity ratio at over 2x as at the end of 2016, highlighting ahigh interest rate risk. Though CSA managed to lower its foreigncurrency exposure, the yuan accounted for 55% of CSA’s total debt,suggesting its earnings will remain volatile amid the fluctuation ofcurrency exchange rate which has been happened over the past fewyears.
　　Downgrade to Hold. CSA’s share price has jumped by over 35% sincethe end of 2016, outperforming Hang Seng Index and HSCEI by 25%and 27% respectively. Given the earnings risk of CSA remains high inthe near future, we set our target price based on its 7-year average P/Bratio of 1.1x, equivalent to HK$5.50. In view of the limited upsidepotential, we downgrade our recommendation from Buy to Hold.
　　Key risks include: 1) depreciation of Renminbi, 2) interest rate hike, 3)fluctuation of oil price, 4) slowdown of the PRC economy, 5) intenseindustry competition and 6) competition from high-speed railway.