China/Hong Kong China Transportation China Transportation Update 15 February 2011 Sector Rating: Neutral Still on track for now (maintained) The removal of PRC Ministry of Railways (MoR) head Liu Zhijun has stoked concern in the market over the massive investment program in China’s high-speed rail (HSR) over which he has Market capitalization declines since November presided since 2003. We would be cautious about any rally in Chinese airlines or expressways based on their potentially 0% benefiting from such a change. (5)% HSR to move forward, though there are economic concerns (10)% While Liu has been closely identified with HSR plans, the (12)% leadership change is not likely to have an impact on the (15)% (14)% nationally strategic HSR program. This is supported by the new minister’s statements and government media reports. (20)% Any airline/expressway rally would be premature, in our (25)% view, but would be more substantive if the government reviewed the HSR program in light of its economics. We do (30)% (28)% Big 3 PRC airlines Asia-Pacific airlines Global airlines not view any reassessment as imminent, but if realized it would be a tailwind for other transport sector beneficiaries. Source: Bloomberg, CCBIS However, there are other reasons to be more positive on PRC airlines based on valuations and outlook, in comparison with the regional and global industry picture. Chinese airlines appear more attractive again Share price corrections of 30-35% over the last three months have brought PRC airline valuation multiples to attractive levels generally below regional averages. While not as strong as 2010, we believe operational performance should be solid if PRC GDP growth remains above 8%; CCBI forecast is for 9.5%. January results were a strong start, and supply/demand looks better in China. Renminbi gains should continue, improving balance sheets. Potential wild card from any real deceleration in the HSR program. The newsflow delta should only be positive: either HSR investment slows down, which is good for airline shares, or it does not, in which case it is generally priced in. Key risks to the Chinese airlines in 2011 Travel demand in a tightening environment. Negative “wealth effect” from inflation and PRC property/equity markets on discretionary travel demand in a very price-sensitive market. Fuel prices. PRC airlines are exposed with little hedging Tim Bacchus, CFA internationally and none domestically. Consensus upward (852) 2532 2549 revisions to fuel prices are likely. [email protected] Overcapacity. PRC airlines are forecast to take 223 net aircraft and 290 gross in 2011, representing 16% net and Cheng Xing 21% gross of global totals and in unit terms is 14% growth. (86 10) 6652 3738 [email protected] Please read the analyst certification and other important disclosures on last page China Transportation Update 15 February 2011 We believe any rally in Chinese airlines and expressway shares is premature, at least if viewed only through the lens of the news regarding the recent removal of the railways minister. However, separately, the Chinese airlines have fallen by around one-third in the last three months, bringing valuations into more attractive territory. Influential Minister of Railways removed… Mr. Liu Zhijun has reportedly been removed from his position as head of the Ministry of Railways (MoR) over alleged corruption charges and is under investigation for a “serious violation of discipline”, according to the Xinhua news agency. Other domestic media have reported he may have accepted millions of yuan in bribes. Liu has been in his post since 2003 and has overseen the planning and build-out of the high-speed rail network, a program that is to spend RMB300t through 2020. While we have no comment on the potential charges or investigation into Liu, we note that with the significant sums of money involved and large contracts to build the railways, the scope for corruption is certainly there. His dismissal is also being linked by some media reports to the investigation into Shanxi businesswoman Ding Shumiao, whose Boyou Investment company has benefited significantly from the country’s high-speed rail investment program and who was detained by investigators last month. We also note that Liu’s younger brother was convicted of corruption in 2006 when he was a lower-level railways official. Liu has been replaced by an official with a non-railway background, Mr. Sheng Guangzu, who is currently commissioner of the customs agency. …but national HSR goals should remain on track While Liu has been an important figure in the HSR network expansion, the program is far larger than one person. This forms the basis of our belief that the link between his downfall and any rally in airlines and expressways shares is tenuous at best. Liu’s replacement indicated as much in his first speeches to the MoR over the weekend, indicating the pace on the HSR program should be kept up. The central government’s People’s Daily Online has also reported the change will have no impact on high-speed rail expansion. While we would concede it is possible there could be closer scrutiny of contracts in the build-out going forward, which could slow the program down – especially if Liu’s removal is based on contract irregularities – we would not expect this to have a material impact on the overall rail goals as defined in the 12th Five-Year Plan. A more valid argument is that the powerful MoR stands the risk of being reformed, split up, or absorbed by another ministry, such as the Ministry of Transport, an effort Liu was opposed to. Still, legitimate economic concerns and critics of China’s HSR remain We have, however, written about the potential tailwind for PRC airline shares (and by extension, the expressways) in 2011 regarding a true deceleration of HSR expansion, but this is predicated on economics and not on personalities. The key is whether the central government would look to reappraise the entire HSR investment in light of high construction and maintenance costs with little or long-dated returns on investment based on actual HSR pricing and volumes, i.e. ridership. There are several mainland critics of the program who look upon it as a wasteful allocation of resources based on the assumption that it is better to invest in freight rail infrastructure to better serve the core migrant worker masses with regular train investment than to target high-income, white-collar workers who might well opt for air 2 China Transportation Update 15 February 2011 air travel for intercity journeys. China needs to upgrade its congested freight rail network, particularly for moving coal. Getting high-income passengers to “downgrade” from planes to HSR and migrant workers to “downgrade” from regular trains to long-distance busses (fleeing high HSR prices in the process) will not help nor is it the intent of the program. There is a danger HSR could be a rather large white elephant if it is not accepted by the masses. One point which may give some support to this idea is the Ministry of Transport’s forecast of a 12% increase in ridership on long-distance busses for the current Chunyun festival travel period, with airline traffic up only 6%. The increase would represent an additional 70,000 busses on the roads during the festival, further congesting highways which, again, is the opposite intent of HSR investment. We have not seen data for the HSR or overall rail system yet for the same period, but there is anecdotal evidence of a mode shift to busses by migrant workers this year as normal-speed train schedules have been reduced. Chinese airlines appear attractive again We consider four reasons to be re-examining the Chinese airlines: Individual share price corrections of 30-35% have brought 2011 valuations to attractive levels below regional averages. While not as strong as 2010, operational performance should be solid as long as China GDP growth remains above 8.0%, which we view as highly likely. Our own house view is for 9.5% growth in 2011. January’s results for the industry were a strong start to the year (see more below). The renminbi should continue to strengthen, improving gearing and balance sheets. A potential uplift from a real reappraisal or deceleration in the HSR program. We believe the key is the newsflow delta can only be positive for airlines: either HSR program slows down, which is good for airline shares, or it does not, in which case it is generally priced in. Separate from the change in leadership at the MoR, the Chinese airlines have begun to look more attractive following share price declines in the last three months. In the period from early November through last week, global airline market capitalization was down 12%, Asia-Pacific carriers were down 14%, and the Big-Three Chinese airlines fell 28%, all in US dollar terms (in local currency the PRC airlines were down even more). Clearly, the PRC carriers have underperformed the globe and region. Their share price peaks occurred right after the October end of the Shanghai Expo – which will not be repeated in 2011, and since mid-December global and domestic fuel prices have risen significantly. Also, PRC carrier profit alerts for 2010 failed to inspire as they implied only break-even results in 4Q 2010. The price declines have brought consensus P/E and P/B valuations for the Big Three into more attractive territory, with 2011F P/E ratios around 7.5x and 2011F P/B of 1-2x. EV/EBITDA ratios for 2011 are also low at 5-6x in the context of a 5-10x range over the cycle.