Summary

Driven by the strong domestic market demand, Air China's total revenue grew by 24% yoy to RMB73.2 billion from January to September of 2011. But the net profit declined by 20% yoy to 7,862 billion due to the weak international and cargo business, and dramatically shrinking fuel hedging gains and investment gains.

But we noticed that international passenger demand of Air China showed signs of recovery in the third quarter, as the Company reported slightly increase in its international passenger load factor, in which the Europe, and the Japan-South Korea routes has improved while the North American routes still remain weak.

We believe that the future recovery of international demand is the key driver of Air China's results, but the target is unlikely to get soon.

The drawback of FY2011 result is cast so we revised our EPS forecast of 2011 and 2012 to be RMB 0.76 and 0.74 yuan. Air China is trading at 7.0x FY11e P/E and 7.2x FY12e P/E. Based on a comprehensive consideration for the Company, we conservatively give P/E 7.5 x 2012E EPS, 12-month target price at HK$6.77, 5% higher than the last close, therefore Hold rating.

The first three quarters` net profit down 20% yoy

From January to September of 2011, the Company's total revenue grew by 24% yoy to RMB73.2 billion (under PRC accounting), cost of operations increased by 27.2% to 5.61 billion, and net profit attributable to equity holders of the Company decreased by 1,998 million, or 20.26% yoy, to 7.862 billion. EPS stood 0.65yuan.

Set out below are the main reasons for the less-than-expected result:

1），Strong domestic market Vs weak international and cargo market

For the first 3 quarters of 2011, the growth ratio of total revenue (+24%) was 10 ppts higher than the growth ratio of total traffic turnover (+14%), which is mainly due to the strong demand of domestic market.

But the weak international demand and the tumbled cargo fare since this year affected Air China most because of its highest contribution of international business and cargo among the China big-3 carriers. As a result the main business EBT down 7%.

2），Rising fuel cost

The highest contribution of international routes also made Air China most exposed to the rising international fuel prices. The Company's operation cost increased by 27.2% yoy to 56.1 billion (higher than the revenue's growth of 24%) , in which due to a surge of jet fuel price, the jet fuel cost increased by 8.1 billion. The gross margin declined by 2 ppts yoy to 23.4% in the first 3 quarters and declined by 3.1 ppts yoy to 27.8% in the third quarter.

3），Dramatically shrinking fuel hedging gains and investment gains offset the positive news of increased exchange gain.

Since 2011, the RMB has appreciated by about 4%, which increased Air China's net exchange gains by 1330 million due to a substantial change in the exchange rates. So the financial cost decrease by 1098 million yoy, representing an increase of 0.08 yuan in EPS.

As there was a decrease in the balance of the unsettled fuel derivative contracts for the current period, gains from movements in fair value shrunk from 1.1billion to 77 million, down 92.95% yoy. What's more, the JV Cathay Pacific reported a better-than-expected 59 percent fall in first-half net profit, reflecting the weak international demand and the soaring fuel costs, which led to a reduction of investment income of 1564 million to 1224 million during the first 3 quarters according to Air China's Financial Statement . The two items cut EPS by 0.19yuan together, completely offset the positive impact of the RMB appreciation.

4）Impair losses of assets grew by 308% yoy to 515 million while the main impair losses of assets of 2010 generated in Q4.

The international routes showed an upward turn, yet headwinds still remain

On traffic data, in the first 3 quarters of 2011, the ASK (Available Seat Kilometers) and the RPK (Revenue Passenger Kilometers) grew by 16% and 19% yoy respectively. The ATK (Available Tonnage Kilometers) and RTK (Revenue Tonnage Kilometers) increased by 12% and 14% yoy. Passenger load factor lifted by 1.86 ppts yoy to 82.1% and the Freight load factor grew by 1.14 ppts to 73.1%. Total output is greater than input, load factor continued to increase qoq, reflecting the improvement in operational efficiency.

As for the passenger service, if excluding the effect of the consolidation of Shenzhen Airlines, the domestic routes performed well as the passenger load factor surged by 4.05 ppts to 83.8% in the first 3 quarters of 2011. Yet the international routes recorded a dropped passenger loads factor of 80.7%, down 1.67 ppts yoy, due to the fiercer competition of more aircraft capacity from other carriers.

As for the Shenzhen Airlines, the synergistic effect after consolidation begins to be shown gradually as its passenger load factor grew by 2.51 ppts to 82.5%.

The JV Air China Cargo was hit by the weak demand and tumbled cargo fare as its freight load factor declined by 1.18 ppts to 58.5% in the first 9 months of 2011.

But we noticed that international passenger demand of Air China showed signs of recovery in the third quarter, as the Company reported slightly increase in its international passenger load factor, in which the Europe, and the Japan-South Korea routes has improved while the North American routes still remain weak.

We believe that the future recovery of international demand is the key driver of Air China's results, but the target is unlikely to get soon, which mainly due to: 1) fiercer competition as the capacity for international market is increasing, not only from China Eastern Airlines China Southern Airlines (the once participants of international routes with low shares), but also from the foreign airlines who are optimistic about Asia-Pacific aviation market especially China market. 2) Uncertainty of the global economy recovery.

Its hub/network expansion strategy continued

Facing the competition of high-speed rail and other airlines, Air China's continued to strengthen its hub/network strategy, by further consolidation with Shenzhen Airlines and Cathay Pacific Cargo, and active participation in the establishment of Beijing Airlines, Dalian Airlines and Tibet Airlines, to expand market share.

By 2011, the Company(including Shenzhen Airlines) will introduce 52 new aircrafts, and clean 21 out, representing an net increase of 31 aircrafts or 10% in seats. Among which, 12 will be wide-body aircrafts, which will be applied to long-route market within 3-5 hours.

Valuation

According to its 2011Q3 results, the drawback of FY2011 result is cast. We believe that the future recovery of international demand is the catalyst of Air China's stock performance for its dual effect on its main business and investment income from Cathay Pacific. We revised our EPS forecast of 2011 and 2012 to be RMB 0.76 and 0.74 yuan. Air China is trading at 7.0x FY11e P/E and 7.2x FY12e P/E. Based on a comprehensive consideration for the Company, we conservatively give P/E 7.5 x 2012E EPS, 12-month target price at HK$6.77, 5% higher than the last close, therefore Hold rating.

Risk

Economic recession dampens transportation demand;

Crude oil prices fluctuate violently;

RMB depreciation cause foreign exchange loss;

War, terrorist attacks, pandemic and other emergencies;

Competition through price-cuts may accelerate;

High-speed railway competitions.

Finance Forecast

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