CFA Institute Research Challenge Hosted in Shanghai Shanghai Jiao Tong University Shanghai Jiao Tong University Student Research Industrial Sector, Transportation Industry Spring Airlines
Date: 28 October, 2016 USD/CNY: 6.79 Recommendation: BUY(60.74% in return) Ticker: 601021.SHA Current Price: CNY 43.99 Target Price: CNY 61.74 (USD 9.09) This report is published for educational Spring Airlines: Embracing its Spring purposes only by students competing in The CFA Institute Research Challenge. Highlights
Stock Price Movement Spring Airlines (SPA) is China’s first and dominating low-cost carrier (LCC). Based in Shanghai, it offers flights for passengers with fares typically 30% lower than other domestic 43.8 SPA SCI 3,160.0 airlines. We issue a Buy recommendation on SPA with a 12-month target price of CNY 61.74, 43.6 3,140.0 43.4 offering 60.74% upside from its closing price of CNY 43.99 on 28th Oct. 2016. Our 3,120.0 43.2 recommendation is primarily driven by: 3,100.0 43.0 3,080.0 42.8 A Highly Profitable Business Model 42.6 3,060.0 As a LCC, SPA has made relentless efforts to control cost and expand sources of revenue. 42.4 3,040.0 Oct.31 Nov.1 Nov.2 Nov.3 Reduce costs by resources integration: A uniform A320 fleet already saves huge amount of purchase and maintenance costs, while SPA’s operating efficiency (No.1 Source: Market Data load factor in 2015, 92.84%) further lowers fixed expenses. Together with online platform and streamlined staff, unit SG&A expense was cut to CNY 0.0179/ASK, only Market Profile half of industry average. 52 Week High/Low (CNY) 67.51/39.91 Expand profit through ancillary services: SPA attracts passengers with low ticket Avg. Daily Volume 2,762,839 price and earns more profit by offering various high-margin ancillary services. The Shares Outstanding 800.00M ancillary revenue achieved CNY 642 mn (+55.45% YoY) , accounted for a considerable Market Cap. (CNY) 33.64B part of gross profit (31.61%, 2015), and will be a crucial growth driver. Beta 0.91 Sustainable Future Growth P/E (LTM) 25.97 SPA’s visible growth is continually powered by P/S (LTM) 4.35 Potential in LCC industry: RPK of China’s civil aviation has a 13.50% CAGR in recent Company Data (2015 yearend) 3 years. At present, LCCs only account for 8% of local civil aviation market versus 28% Revenue Passenger 22.2bn for global average level, implying huge potential in China’s LCCs industry. Kilometers(RPK) Future success in tier 2/3 cities: SPA has cooperated successfully with Shijiazhuang Available Seat Kilometers(ASK) 23.9bn Hub. Tier 2/3 cities enjoy twice the demand growth (airport throughput, 12.40%) of Gross Margin 20.11% tier 1 cities (5.90%). We believe SPA can replicate its success in tier 2/3 cities. Net Margin 16.41% Capturing outbound travel trend: In line with 30% CAGR of short-routes outbound Load Factor 92.84% travel, SPA has promoted 22.70%(in 3Q16, YoY) in capacity on Thailand and boosted Debt-to-Asset Ratio 59.20% its Joint-Venture in Japan. We expect SPA to be a direct beneficiary of China’s outbound ROE 26.31% tourism. ROA 13.59% Source: Thomson Reuters, Team Analysis Entry Barrier and Unparalleled Advantage Due to slot resource, capital and technical barriers, monopoly is easy to form in China’s LCC Valuation Methodology industry. SPA’s unique advantages include Method Target Weight First mover advantage: As China’s earliest LCC, SPA has the largest market share st DCF 61.35 50% (43%) and outstanding profitability (16.4% net margin, rank 1 in the industry). With an operation model hard to replicate, SPA already formed scale of economy, and built PEG 66.59 20% a significant barrier for new entrants. P/B 61.14 15% Unique Tourism background: As part of the industry chain of SpringTour (SPA’s P/S 57.20 15% parent company), both load factor and precise capacity allocation can be ensured by Target 61.74 tourism resource sharing. Source: Team Analysis Investment Risks F1: SPA’s Price discrimination 1) Fluctuation of oil price; 2) Continuous Depreciation of CNY; 3) Deteriorating international political relationship; 4) Unsustainability of subsidies from government
Business Description
Founded by private capital in 2005, Spring Airlines (SPA) is China’s first and dominating low-cost carrier (LCC). Based in Shanghai, it offers scheduled domestic and international flights mainly for passengers with fares typically 30% lower than other Chinese airlines. As
Source: Team Analysis F2: Share and Growth of Ancillary Revenue of June 2016, SPA operates a fleet of 60 A320 aircraft, covering 66 domestic routes (-8.7% YoY) and 50 international routes (+66.1% YoY). SPA’s parent group, SpringTour, covers 3
industries including civil aviation, tourism and hotel. SpringTour’s integrated industrial chain offers more space for SPA’s business development.
Primary Business | Effective Cost Control System SPA strictly follows global LCC model to keep strong cost advantage over its domestic peers. The outstanding cost control system has three characteristics: Unitary aircraft type and booking class: SPA’s 60 aircraft are all in one type (A320), which reduces cost in purchasing or rental, repair, maintenance and pilot training, Source: Company Data, Team Analysis enhancing flexibility of capacity deployment. Meanwhile SPA’s aircraft has 15~20% F3: Daily IP Visits to Official Website more seats than its peers and all of them are in economic class. High passenger load factor and aircraft utilization rate: SPA keeps a 92.96% Air China, Hainan Airlines, 11.18% 3.26% passenger load factor in 1H16 versus ~80% for industry average level. Its high aircraft China Eastern utilization rate cut unit fixed costs to 0.0884/ASK. Airlines, Spring Low SG&A expense: 70% (2015) of SPA’s ticket sales were through online channel 13.02% Airlines, 36.68% (excl. charter business) which reduces its unit selling expense to CNY 0.0098/ASK versus CNY 0.0328/ASK (2015) for industry average level. SPA’s manning ratio was China Southern 86.7:1 in 1H16 versus ~200 for industry average level, which reduces unit admin. Airlines, expense to CNY 0.0081/ASK, half of the industry average. 35.87% Source: iResearch Ancillary Service | More Profitable Segment F4: Change in Tickets Purchasing Channel Besides relatively low price, another significant characteristic of LCC is to charge seat and ancillary service (excess luggage and meals on board etc.) separately. This special business Qunar.com 18.7% 26.2% model is actually a price discrimination(see F1) for minimizing customer surplus and helps Ctrip.com 17.6% 24.9% SPA keep differentiation to compete with FSCs (full-service carriers). In 2015, SPA’s 7.0% Official Sites 11.1% revenue from ancillary service achieved CNY 642 mn (+54.8% YoY), accounting for 39.00% 4.3% Alitrip 5.8% 2014 of gross profit; Revenue per capita from ancillary service achieved CNY 49 (+35.3% YoY). 2.6% 2015 Ly.com 3.0% other online 9.0% “Internet+” Strategy throughout Primary Business and Ancillary Service 5.7% 40.8% offline 23.3% SPA stays innovative by executing “Internet+” strategy. This innovation is conducted via its 0% 10% 20% 30% 40% own distribution system, which is independent from monopoly held by TravelSky (see Source: iResearch Appendix D). In 2016 SPA’s e-commerce department had 130 staffs. Online platforms (website & mobile APP) accounted for a significant 74.4% of SPA’s ticket sales. Daily IP F5: Shareholding Structure visits to SPA’s official website is the highest among China’s carriers. In 2014 SPA cooperated with DiDi to embed DiDi module into SPA’s APP. In July 2016 SPA began to allow online tickets instalment payment. All of these “Internet+” innovations help SPA to monetize its
traffic.
Corporate Governance
As one of the earliest privately owned airlines, SPA has well established corporate governance. It full discloses financial and operating data in time. Points worth further attention are listed below: Source: Company Data Concentrated Ownership Structure Shareholders’ decisions can be implemented effectively under sufficient F6: Related Party Transactions monitoring: SPA’s biggest shareholder SpringTour holds 63% equity, and the 5 Related Party Transactions with SpringTour (mn) biggest shareholders hold 77.38%. Although the general manager being the son of the 2,000 Propotion of Revenue 21.5% 25% chairman of the board can bring some problems when the management and the board 17.8% 20% 1,500 15.9% require mutual constraints, the decisions of the board can be implemented effectively. 13.3% 14.3% 15% Principle-agent problems are thus reduced. Special committees and the board of 1,000 supervisors are also well-organized (see Appendix G). 1737 10% 1308 Transparent related party transaction being a strong revenue support: SPA gains 500 1045 805 5% 594 a significant feeding from its parent company mainly through charter business (1,730 0 0% mn, 21% of the total revenue, 2015). This related party transaction is one of SPA’s 2011 2012 2013 2014 2015 important sales guarantees, and reflects a unique advantage over other carriers. SPA Source: Company Data reveals the pricing rule for the charter business, which is transparent and F7: Salary of SPA’s Executives appropriate.
825 800 Effective Management & Employee Incentive Plan 608 647 516 Distinctive Plans motivate management and employees: The main management 600 433 400 281 and core staff own 6.75% of SPA through Chunxiang(4.5%) and Chunyi 200 Investment(2.25%). According to a recent equity incentive plan, 30 core technique 0 staff who contribute distinctive value to SPA will get 0.0725% share of the company. Air China Eastern Southern Hainan Juneyao Spring Airlines Airlines Airlines Airlines Airlines Also, the average salary of executives is CNY 825k, much higher than its FSC peers (see F7). Employees have incentives to strive and agency problem is further attenuated. Source: Company Data F8: China’s Disposable Income Per Capital Industry Overview & Competitive Positioning
Disposable Income Per Capita/CNY YoY Industry Overview 25000 21966 30.0% 20167 20000 18311 25.0% Demand Side 16510 14551 20.0% Disposable Income Per Capita Promotes Consumption Upgrading: China’s disposable 15000 income per capita steadily increases in recent years and achieved CNY 21,966 in 2015, 15.0% 10000 10.3% 10.6% +8.9% YoY. Due to increase of disposable income per capita, China’s consumption is 8.1% 10.0% 8.0% 7.4% naturally upgrading from survival-oriented to enjoyment-oriented in three dimensions: 5000 5.0% Consumption structure: In leisure travel, entertainment plays increasingly 0 0.0% significant roles. In particular, outbound travel has enjoyed a 20% CAGR in 5 years. 2011 2012 2013 2014 2015 Distribution of channel: Online becomes more prevalent than offline, standard Source: National Bureau of Statistics products like air tickets and hotel become cheaper.
Consumption concept: As budget tour becomes more predominant, consumers F9: Consumption Structure of Leisure Travel prefer to spend more money on experience rather than standard products. For leisure outbound travel, spending on transportation & hotel decreases while those on 2015 5% 4% shopping increased in 2015. Since price sensitivity remains a major concern in leisure
9% travel, travelers may prefer to LCCs for transportation. 5%4% 9% 37% Leisure Outbound Travel and Tier 2/3 Cities Bring Future Opportunity for Civil 40% 16 2014 Aviation: Tourism, which accounts for over 10.8% of China’s GDP and contributed 10.2% 15% % of total job opportunities in 2015, has strong correlation with macroeconomics. Notably, leisure travel accounted for 60% of China’s total air passenger throughput in 2015, and 26% number of China’s leisure outbound tourists increased 18% YoY to 93.1 mn in 2015. 30% -3% Naturally, prosperity of leisure outbound travel will directly stimulate the growth of civil Transportation Shopping Hotel aviation. Geographically, compared with tier 1 cities, tier 2/3 cities have far more potential Diet Others Entrance Ticket for supply and demand growth given flight schedule and airspace resource. In recent 5 Source: iResearch years passenger volume of non-tier 1 airports has seen a 12.4% CAGR versus 5.9% for tier
1 airports. Specifically, passenger volume transported in international routes from tier 1 F10: Leisure Outbound Tourists Volume and tier 2/3 cities increased 23% and 41% YoY respectively in 2015. The spending power 100 93.1 of tier 2/3 citizens becomes stronger, leading to ample room for civil aviation growth. 77.6 80 64.6 54.5 60 50.0 Supply Side 40.8 Critical Slot Resources and China’s Strategy of Civil Aviation Popularization: As flight 40 schedule and airspace are almost saturated right now, CAAC is considering about releasing 20 more airspace for airlines growth, the implementation of which is highly uncertain. 0 2010 2011 2012 2013 2014 2015 According to official document on Strategy of Civil Aviation Popularization, China’s government expects an 8.5% CAGR for passenger volume growth to 1.5 bn by 2030. Source: National Tourism Administration Furthermore, no matter in ground or air transportation, an obvious gap lies between China
and developed countries, so that there is a promising growth space for civil aviation development. F11: Global Oil Price Movement Less Impact from Oil Price Fluctuation on LCC: As global oil price remains low since 85 2015, SPA’s fuel expense per ASK decrease 27.1% to CNY 0.063 in 1H16, and fuel expense 70 accounts for 24.3% of total cost. Recently oil price has rebounded to $50/barrel since OPEC 55 is trying to reach a limited production agreement. Although it’s hard to predict oil price
40 trend, we believe LCCs are faced with less risk if oil price rises. Compared with FSCs, LCCs’ advantage on cost control makes them less vulnerable to upside oil price. 25 2015/1/5 2015/2/5 2015/3/5 2015/4/5 2015/5/5 2015/6/5 2015/7/5 2015/8/5 2015/9/5 2016/1/5 2016/2/5 2016/3/5 2016/4/5 2016/5/5 2016/6/5 2016/7/5 2016/8/5 2016/9/5
2014/10/5 2014/11/5 2014/12/5 2015/10/5 2015/11/5 2015/12/5 Trend Source: Thomson Reuters Demand Growth Surpasses Supply Growth in Civil Aviation Sector: In supply side, from 2013 to 2015, ASK of China’s civil aviation increases from 695.7 to 884.5 bn*km (+12.8% F12: RPK Growth Surpasses ASK Growth CAGR); Number of routes rises from 2,290 to 3326 (+9.8% CAGR). In demand side, RPK of RPK/bn*km ASK/bn*km China’s civil aviation grows from 564.2 to 727.1 bn*km from 2013 to 2015 (+13.5% CAGR). RPK YoY ASK YoY 1000 15% Higher demand growth implies a promising outlook for civil aviation sector.
800 China’s LCC Market Size Expected to surge in 2030: We estimate China’s civil aviation 11% 600 passenger volume based on Civil Aviation Popularization Strategy (see Appendix H). Given
884.5 that global average LCC market share increased from 8% to 28% during 14 years, and 400 778.0 695.7 727.1 7% China’s LCCs accounted for ~8% of whole civil aviation sector in 2015, we estimate that 564.2 633.3 200 China’s LCCs market share will increase to 25% in 2030. Lastly as SPA’s average ticket price
0 3% and revenue per capita from ancillary services are CNY 600 and 49 respectively, we expect 2013 2014 2015 market size of China’s LCCs to be ~CNY 240 bn in 2030. Source: CAAC
F13: China’s LCC Market Size Forecasting China’s LCC market size forecasting 2015 2020E 2030E Civil Aviation Passenger Volume / million 440 700 1500 China’s LCC Passenger Volume / million China’s LCC Market Share 25% Times of Taking Airplane Per Capita 0.3 0.5 1.0 6 25% CAGR of Civil Aviation Passenger Volume 8.5% 5 20% LCC Market Share 8% 11% 25% 4 3.75 15% LCC Passenger Volume / million 0.35 0.77 3.75 3 11% 8% 10% CAGR of LCC Passenger Volume 17% 2 Market Size of LCC / CNY billion 22.9 50.1 243.8 1 0.77 5% 0.35 0 0% 2015 2020E 2030E Competitive Positioning Source: Team Analysis Benchmark | Catch up with Global LCC Peers
We predict SPA to have a further increase in market share based on the promising industry F14: LCCs’ Market Share in Various Region background described above along with internal and external causes. 2001 2015 70% SPA has comparable efficiency with global LCCs in its growing stage: Following 57.8% 60% its global LCC peers, SPA adopts standard low-cost model with a single-type aircraft 50% 36% fleet, no free dinner, many options of value-added services, etc. SPA’s cost per ASK was 40% 28% 31% RMB 0.27 in 2015, lower than Southwest Airlines, JetBlue and Spirit Airlines. SPA had 30% 25% 18% 20% 12.5% a high net profit margin of 16.41% compared with Southwest and JetBlue. The load 8% 5% 8.0% 10% 1.1% 0.0% factor of SPA was highest among the 5 LCCs, achieving 92.84% in 2015. 0% China’s LCC market has an enormous growth space, in which SPA is the World North Europe Asia Southeast China America Pacific Asia dominator: The market share of LCC remains low in China (8% in 2015) compared to the Asia Pacific average of 25.10%(2015). As an analogy, being the dominator of Source: iResearch LCC market in U.S, Southwest owned a market share of 18.20% in 2015. We are confident that given more time, SPA can expect a larger market share. F15: Porter’s Five Forces of LCC Sector Competitors | Global or Domestic FSCs and LCCs SPA’s direct competitors include Juneyao Airline (JYA, Private FSC), Eastern Airline (State-
owned LCC), China United (State-owned LCC) and AirAsia (Foreign LCC), are based or operating in Shanghai. We believe SPA’s strong competitiveness comes from: LCC=Low-Cost Carrier Spring China China JYA AirAsia FSC=Full-Service Carrier Airlines Eastern United Domestic Domestic Domestic Foreign Domestic Type LCC FSC Top 4 FSC LCC LCC Sales Revenue(CNY mn) 8,093 8,158 93,844 10,185 3,949 ASK(CNY bn) 23,885 20,951 181,793 37,408 - Net Income per Aircraft(CNY mn) 25.5 18.7 9.6 10.9 8.0
Aircraft Utilization(h/day) 11.47 11.98 10.03 12.44 - Avg Load Factor 92.84% 85.17% 80.50% 81.00% - Domestic Routes 94.83% 87.84% 81.23% - - Source: Team Analysis International Routes 88.12% 76.06% 60.91% - - Regional Routes 92.49% 73.16% 44.82% - - Fleet Size 52 55 526 80 33 T1: Operation Efficiency Comparison Avg. Age of Aircraft 3.48 3.68 5.45 5.00 -
Southwest Spirit Ryan Spring Ability to maintain high load factor and low cost during expansion: In 2015, SPA Operating Model LCC kept an industry No.1 load factor of 92.84% due to: 1) surge in individual travelers Single type aircraft fleet attracted by low price. 2) SPA’s strategy of intensified routes and single-aisle aircraft. Choose secondary airport Meanwhile, a young fleet (avg. 3.48y, industry lowest) saves huge amount of Different class tickets depreciation and maintenance costs. No free dinner Advantage from economies of scale: Until 2015, SPA achieved CNY 8 bn sales Many options of value-added services revenue with a fleet of 52 aircraft, far surpassing its domestic LCC peers (see table Few free package amount above). As with AirAsia, because of limited traffic rights, foreign airlines have found it Encourage online check-in hard to compete for slots resources in local market. Frequent flyer plan Co-brand credit card New Entrants | Barriers Hard to Overstep Sell souvenirs on the plane Three main barriers cause difficulties for new LCC Airlines to enter the market: Financial Data (2015 yearend) Slot Resources barrier: SPA explores a differentiated market by owning multiple slot Operating margin / % 24.0 24.1 22.3 20.1 resources in tier 2/3 cities, making it hard for new LCC airlines to enter if CAAC Net profit magin / % 12.1 18.8 23.9 16.4 doesn’t declare to release more airspace. If CAAC do so, SPA’s rigorous cost control Plane usage per day / h N/A 12.7 N/A 11.5 and unique tourism background can still earn it a head start in the competition. Load Factor / % 83.6 84.7 88.0 92.8 ASK / bn people*km 226.1 34.2 140.7 17.4 Capital barrier: Aviation industry is a capital-intensive industry, which requires a Cost per ASK/ CNY 0.50 0.31 0.26 0.27 substantial quantity of capital expenditure for airline companies to buy or lease
aircraft. Additional funding is also needed to maintain daily operation, such as aircraft Source: Company Data, Team Analysis fuel, maintenance and overhaul expenses. T2: Punctuality Comparison Technical and talent barrier: High technique requirements for pilots, lack of
experienced pilots and strict regulation over transferring pilots between companies Avg. Delay build an entry barrier. Ranking Company Punctuality / min 1 SPA 86.6% 14.69 Suppliers & Buyers | Fellowship with Suppliers & Price-Sensitive Buyers 2 JYA 86.3% 13.41 Reliable relationship with suppliers: SPA has long built a good relationship with 3 Shandong 86.1% 13.90 Airbus since all its aircraft are Airbus A320. MOU (memorandum of understanding) 4 Southern 85.8% 15.05 was signed with Airbus in 2015 on developing a new pilot training course. 5 Tianjin 85.8% 14.66 Attractive price to customers: In aviation industry, customers can easily transit to 6 Hainan 84.2% 16.72 other means of traveling, thus having high bargaining power. SPA has already built up 7 Capital 83.8% 17.84 reputation by offering appealing price. Charter business can also guarantee a solid 8 AirChina 82.7% 19.42 source of clients. 9 Shenzhen 82.4% 17.72 10 Eastern 82.0% 18.41 Substitute | Limited conflict with High-speed Railway Source: Company Data, Team Analysis Less exposure to substitute competition: Although taking High-speed Railway may be more comfortable and convenient than flights, SPA faces less conflict with it. F16: 6-Dimension Comparison of SPA and HSR According to the research of the CAAC, high-speed railway brings 50% impact (in Time RPK) to flights when stage length is less than 500km; 30% when stage length is less 4 than 800km, where SPA’s RPK accounts for only 3.7% (2015). The conflict decreases Non-stop Price 4 3 sharply when a stage is longer than 1500km, where SPA’s RPK accounts for 54.2% 3 4 3 (2015). Also, only 22.7% of SPA’s flight faces direct competition with high speed railway, where SPA initiate sales promotion.
3 Advantage of shorter time and lower price: The time to take a SPA flight (including 3 4 3 4 Convenience Comfort 2 hours of waiting and checking-in) is only 1/2 of taking high-speed railway, and the
4 price of SPA’s economy class ticket is only 2/3 of that on high-speed railway. Even less competition in the future: SPA indicates that it will focus more on Stability outbound routes to Southeast Asia, where there’s no threat of high-speed railway. Source: Team Analysis
1200 Ticket Price and Ride Time Comparison 14 1000 12 10 800 8 600 6
400 Ride Time(h) 4 Ticket Ticket Price(CNY) 200 2
0 0
Stage Length(km) Ride time of Spring Airlines Ride time of high-speed railway Total ticket price of High-speed Railway Total ticket price of Spring Airlines
Source: Company Data, Team Analysis Investment Summary
F17: Tourism’s Contribution to GDP Investment Drivers Revenue from Tourism/tn Tourism's Contribution to GDP 5 11.0% 4.13 1.Promising Outlook of Civil Aviation Sector: Tourism is gaining popularity with 3.73 4 Chinese, devoting 10.10% of GDP in 2015. Civil aviation transports tremendous number of 10.8% 2.95 3 2.59 10.80% passengers (436 mn, YoY +11.30%, 2015) and gains support from the government. Low- 1.93 10.6% cost airlines, as a unique part of the industry, is attracting more and more travelers because 2 of convenience and low ticket price. 10.4% 1 10.39% 2.Dominator of LCC industry in China with first mover advantage: As the first 0 10.2% 2011 2012 2013 2014 2015 and only listed company in China’s LCC industry, SPA is now the dominator with a market Source: National Tourism Administration share of 43%. By 1H16, SPA operates 122 routes, including 66 domestic routes, 50 international routes and 6 regional routes. SPA has the highest RPK and passenger volume F18: Coordination of SPA’s Cost Control System carried among private airlines. It is also one of the leading LCCs in Northeast Asia. SPA develops non-stop international routes from tier 2/3 cities, including routes to Japan from 11 tier 2/3 cities. It also established Shenyang hub in Northeast China, Shijiazhuang hub in North China, both earns SPA a head start.
3.Successful Low Cost Strategy Due to Effective Coordination: Over the past 12 years, SPA has developed a highly efficient operation mode, which requires well-organized coordination of IT system, staff, aircraft and scheduling. SPA is the first domestic airline Source: Team Analysis company who does not rely on the info system of TravelSky. Thanks to its own ticket system
(website & APP), CNY 280mn was saved from selling expenses in 2013. Further, quick transfer and excellent punctuation (No.1, September 2016) help Spring’s daily aircraft F19: SPA’s Future Capacity Layout hours increase to 11.47h, one of the highest among counterparts. Cost-saving measures also include mid-night flights (24% of total flights) and minimum staff (1/5 staff members
involved in more than one job, 2015).
4.Repeatable Success in Other Tier 2/3 Cities: Geographically, flight schedule and
airspace resource are almost saturated in tier 1 cities, while tier 2/3 cities have vast space for supply and demand growth. On supply side, according to “2Q16 License Agreement for International Routes” announced by CAAC, 63% of new approved routes lie in tier 2/3 cities. On demand side, in recent 5 years, CAGR of passenger throughput in tier 2/3 airports
(12.4%) is ~2 times of that in tier 1 airports (5.9%). Case study on Shijiazhuang: In 2009 passenger throughput of Shijiazhuang Airport was 1.32mn, the second lowest nationwide. After SPA selected Shijiazhuang as its North China Hub in 2011, passenger throughput of Shijiazhuang Airport increased 47.6% YoY, which was the highest in China. In 2015, passenger throughput of Source: Team Analysis Shijiazhuang Airport was 5.98 mn of which SPA covers 33%. SPA brings more tourists
to Shijiazhuang, helps booming its economy and thus is warmly welcomed by local F20: New International Routes Approved government and people. Recently SPA has been actively negotiating with other tier
tier 3 others 5% 2/3 cities for cooperation. We believe there is a high possibility for SPA to replicate
tier 1 Shijiazhuang’s success in other tier 2/3 cities. 34% 5.Capacity Allocation in Line with China’ s Outbound Tourism Growth: Due to tier 2 steadily increase of income level, leisure travel accounts for 60% of China’s total air 55% passenger throughput in 2015. As price sensitivity remains to be a major characteristic for leisure segment, low-cost airlines will benefit the most from flourishing leisure travel Source: CAAC market. Asia countries account for 74% of destinations (HK and Macau excluded) chosen by Chinese outbound tourists and have a 30% CAGR during 2010~2015. Given that SPA’s F21: Higher Throughput CAGR in Tier 2 Cities capacity allocation in Southeast Asia and capital operating in Japan are in line with demand
100000 passenger volume in non-tier 1 airports 20% trend of tourism, we expect SPA to be a direct beneficiary of China’s outbound leisure travel. passenger volume in tier 1 airports tier 1 YoY Case Study on Capacity Allocation in Thailand: SPA focused its capacity allocation 80000 non-tier 1 YoY 15% on international routes (172% international ASK growth versus 0.4% domestic, 60000 2015). SPA currently operates 15 China-Thailand routes. Between Jul. and Oct. 2016, 10% SPA raised seat capacity mainly on China-Bangkok routes (+22.7% YoY). Meanwhile, 40000 airports in Thailand react positively, planning for new runways by 2020. 5% 20000 Case Study on Joint-Venture in Japan: SPA gains first mover advantage in Japan as
0 0% it operates its first maiden flight to Ibaraki in Jul. 2010. SPA aims to further expand its 2011 2012 2013 2014 2015 business in Japan through Spring Japan, a joint-venture based in Tokyo and operated Source: CAAC, Team Analysis by SPA with a 37.75% stake. It plans to add more services to other Chinese cities besides Chongqing and Wuhan. F22: Destination Distribution of Outbound Tour 6.Unique Air+Tourism Model Supported by Parent Company: Seamless Asia Europe America Oceania Other 100% integration of air and tourism creates a powerful platform for LCCs to take full advantage 3% 90% 5% 4% 4% 4% of the more price-sensitive leisure market, while successful partnerships are quite rare due 17% 19% 18% 80% 20% 21% to potential conflicts of interest between travel agents and airlines. Different from other 70% 60% airlines, SPA has an unparalleled advantage to develop Air+Tourism model attributable to 50% direct shareholdings by its parent company-SpringTour, which was a leading tourism group 40% 74% 68% 73% 72% in China. SPA benefits from Air+Tourism model in following aspects: 30% 64% 20% Load factor: Supported by charter business of SpringTour, uncertainty is reduced 10% when exploring new markets. SPA earned 1,737 mn (21% of total revenue) through 0% 2011 2012 2013 2014 2015 charter business in 2015. Capacity allocation: SPA enjoys a superiority over other airlines in accuracy of Source: iResearch capacity allocation from unique information sharing with SpringTour.
Integrated industry chain: With prevalence of one-stop service, more travelers F23: SPA’s Historical Profitability Data prefer airlines who offer extensive products such as tour packages, hotels, cars and insurance. SPA will benefit a lot being part of SpringTour’s integrated industry chain.
7.Integration with Internet brings potential E-commerce opportunity: SPA expands its marketing channel through official site and mobile APPs (downloads amount to 20mn, +328% YoY). Daily visits to SPA official website is the highest among China’s carriers. Promised inflight Wi-Fi will also help promote inflight sales.
Investment Risks Economic risks, mainly from slowdown of China’s economy. Political risks, from deteriorating political relationship with other countries. Source: Company Data, Team Analysis Market risks, including (1) fluctuation of oil price; (2) continuous depreciation of CNY.
Operational risks, including (1) increasing competition with other airlines and substitute;
(2) lack of experienced pilots; (3) potential unsustainability of subsidies from local F24: SPA’s Historical Operating Data governments; (4) liquidity risk as corporate bonds mature.
120 Passenger Number(mn) 15,000 Routes Number 100 Fleet Size Financial Analysis 80 10,000 Domestic Competitors Company SPA 60 (2015 data) 40 5,000 Financial Condition 2011 2012 2013 2014 2015 JYA Eastern Profitability 20 Gross Profit Margin 12.61% 12.68% 13.00% 14.80% 20.10% 25.98% 17.79% 0 0 Net Profit Margin 10.83% 11.09% 11.20% 12.10% 16.40% 12.60% 5.38% 2011 2012 2013 2014 2015 EBITDA Margin 22.00% 23.77% 20.70% 22.80% 30.20% 22.78% 19.87% Source: Market Data EBIT Margin 18.90% 19.43% 16.10% 18.20% 25.00% 17.17% 7.90% Sales Growth -- 26.19% 16.54% 11.60% 10.50% 12.27% 10.46% Activity F25: Historical Net Income Comparison Accounts Receivable Turnover 150.7x 172.82x 142.92x 106.1x 91.5x 46.59x 27.89x Inventory Turnover 137.85x 142.36x 142.92x 147.9x 132.2x 149.48x 35.76x Sales & Management Expenses/ Sales 4.70% 4.60% 4.60% 4.75% 5.28% 8.65% 9.64% Total asset turnover 0.12x 0.10x 0.11x 0.10x 0.10x 19.87% 9.18% Fixed asset turnover 0.19x 0.20x 0.22x 0.25x 0.28x 39.31% 12.70% Net operating cash flow 697.86 884.01 1,536.38 1,076.38 1,610.30 1,975.63 24,325.00 Liquidity Current Ratio 0.61x 1.15x 0.86x 0.69x 0.86x 0.44x 0.31x Quick Ratio 0.59x 1.13x 0.84x 0.68x 0.85x 0.44x 0.28x Cash Ratio 0.42x 0.92x 0.66x 0.57x 0.62x 0.21x 0.12x Solvency Debt to Total Assets 70.08% 70.39% 64.20% 68.50% 59.20% 74.16% 80.76% Non-current Liability to Liability 48.92% 64.00% 54.60% 45.30% 47.50% 36.87% 52.94% Source: Company Data, Team Analysis Non-current Liability to Asset 34.28% 45.05% 35.00% 31.00% 28.10% 27.34% 42.26% Interest Coverage Ratio 6.35x 5.81x 8.05x 10.39x 16.46x 10.81x 1.79x F26: Comparison of SG&A Expense per ASK Investor Ratios EPS 1.61 2.08 2.44 2.95 1.66 0.97 0.35 ROE 33.35% 35.47% 30.41% 28.09% 26.31% 39.00% 14.45% ROA 14.86% 15.89% 15.02% 13.78% 13.59% 14.30% 4.34%
1.Net operating cash flow steadily driven by revenue growth SPA maintains a healthy operating cash flow over the last 5 years with a CAGR of 23.25%, driven by a steady growing revenue (see F25). In 1H16, SPA’s sales revenue amounted to CNY 3,953 mn. It saw steady growth in total revenue with a 4-year CAGR of 16.05%, mainly due to expansion of routes while keeping a high load factor above 90%. In 1H16, SPA operated 122 routes with a fleet size of 60, transporting 6,570 mn people. Source: Company Data, Team Analysis 2.Leading net profit margin due to rigorous cost control and rising F27: Expense per ASK Breakdown ancillary revenue SPA’s net profit margin was 16.41% in 2015, which was 30% higher than its peers. It outperforms other carriers in net profit per aircraft. In 2015, SPA’s unit SG&A expense was CNY 0.0098/ASK and 0.0081/ASK accordingly, while the industry average was CNY 0.0328/ASK and 0.0162/ASK.
Cost Side: Within SG&A expenses, SPA has a powerful control over the engine depreciation, salaries and fuel fees. SPA promotes online tickets sales through its official site and mobile apps, and the proportion of direct online sales in total sales Source: Company Data, Team Analysis has been increasing year by year.
2011 2012 2013 2014 2015 F28: SPA’s Historical Ancillary Revenue Proportion of direct online sales 84.32% 84.22% 84.51% 87.43 70%
Revenue Side: Ancillary revenue grows at a faster pace, whose gross profit also keeps increasing. Ancillary revenue per capita amounted to CNY 49 per person in 2015, +36% YoY. The gross margin of ancillary revenue reached 80%, far higher than the 20% comprehensive gross margin. In particular, online ancillary revenue reached CNY 320mn in 2015, +96% YoY. SPA installs more inflight POS terminals and plans to launch more inflight Wi-Fi, which will further promote ancillary revenue.
Source: Company Data, Team Analysis 3.Decent solvency due to proper leverage SPA had a current ratio of 1.31, quick ratio of 1.30 and cash ratio of 1.63 in 3Q16, F29: Liquidity & Solvency Ratios outperforming the industry average. SPA’s interest coverage ratio also increases year by year, displaying strong ability to repay debt. All of them should be attributed to a proper leverage structure, reflected in a declining debt to total asset ratio. Also, SPA still owns a bank line of CNY 23.08 bn by 1H16, of which CNY 14,770 mn is available. We believe this ample financing room ensures SPA’s future growth.
4.Short operating cycle indicating efficient operation SPA’s unitary aircraft type leads to uniform air equipment, which can be intensively stored. Source: Company Data, Team Analysis Inventory cost is thus saved and inventory turnover stays at a high level. Meanwhile, the F30: Operating Cycle Comparison incremental direct online tickets sales cut down the accounts receivable, leading to a high accounts receivable turnover. SPA’s high inventory turnover and accounts receivable
turnover contribute to a short operating cycle of 6.07 days, lower than other FSCs and world famous LCC, AirAsia. The short operating cycle indicates a quick capital turnover and efficient operation.
Valuation
Our choice of valuation methods is based on the following observations: 1) SPA’s capability Source: Company Data, Team Analysis to bring in positive cash flows is determined by economic climate, capital expenditure and T3: DCF Summary operating efficiency; 2) Few comparable company exists, since SPA is the dominator and Sum of FCFF PV 17,420 only listed LCC in A-share market; 3) SPA enjoys both high P/E and high growth among Terminal growth rate 2.55% airline companies. Therefore, we apply 1) A FCFF (Free Cash Flow to Firms) to find out Terminal value 76,300 intrinsic value’s sensitivity to factors; 2) PEG method to reflect SPA’s high growth; 3) Relative multiples method to analyze stock performance. PV of Terminal Value 36,070 Enterprise Value 53,490 Method Target Weight Advantages Limits + Cash and cash equivalents 5,890 Precise, easy for scenario Highly sensitive to certain + Non-coral Assets 1,877 DCF 61.35 50% analysis factors (oil price and WACC) - Total liabilities 12,178 Emphasizes SPA’s high Growth of core net income is - Minority shareholder’s equity 0.00 PEG 66.59 20% growth potential also sensitive to certain factors Value of Equity 49,079 Reflects aviation’s capital- Not enough reflection on Common shares outstanding 800 P/B 61.14 15% intensive nature profitability Intrinsic Value 61.35 Sales are relatively stable; No Reflection of SPA’s ability to Source: Team Analysis P/S 57.20 15% Free from manipulation control costs T4: Assumption – Sales Target CNY 61.74 Market Share Expected Airlines Type Assumptions 2016-20 CAGR DCF Model Domestic Stable 9.46% We first derive a detailed and fair 5-year projection of Income Statements, Balance Sheet Increased due to International expansion to Southeast 24.4% and Cash Flows Statement. Assumptions are based on historical macroeconomic condition, Asia aviation industry’s promising outlook and the company’s competitive position. Then a Regional Stable 9.13% WACC analysis and a FCFF Derivation are presented. (See Appendix Q for details)
Source: Team Analysis Sales Revenue F31: Sales and Cash Flow Projection Primary business - We divide SPA’s business into 3 parts according to route types: Sales Non-leveraged Cash Flow domestic, international and regional. First, we use historical disposal income and China’s 200 20 population growth to predict the number of total airline passengers through regressions. 150 10 Since: 1) The portion of international travelers will continue to increase 2016-20,estimated 100 0 by CAAC; 2) SPA is grasping the opportunity to capture the market in Southeast Asia,
50 -10 increasing direct flights from tier 2/3 cities to popular destinations such as Thailand; 3) The market share of domestic and regional routes remains stable. We obtain the expected 0 -20 2013A2014A2015A 2016E 2017E 2018E 2019E 2020E CAGR of sales from each part to be 9.46%, 24.40% and 9.13%. As a whole, SPA is going to Source: Team Analysis enjoy a CAGR of 15.00% in its primary business 2016-2020. T5: Assumption – Fleet Size Ancillary business - As indicated, SPA is committed to upgrade its ancillary services to meet customers’ need while performing perfect price discrimination, with a CAGR of Fleet Size 2013 14 15 16E 17E 18E 36.80% 2013-15. Out of prudence, we estimate this portion to increase gradually from Operating 25 30 30 37 44 51 Lease 5.53% to 7.00% 2016-20. Therefore, ancillary sales are promised to increase with a CAGR Finance 2 4 3 3 3 3 Lease of 20.55% for the next 5 years. Purchase 12 12 19 25 31 37 Total 39 46 52 65 78 91 Expenses As a LCC, SPA controls the operating cost and SG&A expenses through various ways, much Source: Team Analysis more effective compared to industry average. We decompose those costs into micro-parts, T6: WACC Analysis and find that the primary item is fuel cost (24.30% of the total cost). Over the past 3 years, Variable Value Fuel Cost/Revenue(F/R) decreased all the way from 37.59% to 23.98%, mainly due to the Risk Free Rate 2.87% downturn of oil price. In our model, we expect the ratio to be 25% for the next 5 years. For Market Premium 5.54% other costs, we assume SPA is capable of maintaining its present level of cost control. Beta 0.91 Cost of equity 6.91% Capital Expenditure Marginal Tax Rate 26.00% During the expansion of SPA, large amount of capital expense is inevitable. This kind of Pre-tax Cost of Debt 3.40% expense usually takes the form of new fixed asset purchase and construction in process Post-tax Cost of Debt 2.52% (prepaid fee of buying aircraft). Company’s plan states that 1) SPA will introduce 10 to 15 Equity to Debt 73:27 new planes each year; 2) The portion of self-purchasing planes is 40% to 50%, the rest are WACC 5.84% mainly under operating lease. Given the price of each new plane to be CNY 400 million Source: Team Analysis, Wind (estimated through company’s historical orders), we assume the total required pay for
buying (i.e. not operating leases) new planes to be CNY 2.4 bn each year 2016-20.
T7: PEG WACC We use a CAPM model to determine the cost of equity. When calculating Beta, it should be Scenario Oil Price IMS(2020E) Target Weight noted that since SPA is listed for less than 2 years, we apply the daily data of stock price and Bull $45/bbl 11% 91.46 10% SCI to avoid possible bias caused by insufficient samples.
Base $52/bbl 10% 66.36 80% 10-Year & Terminal Growth Bear $59/bbl 9% 43.59 10% We divide the timeline after 2020 into 2 phases: 2020 to 2030 and ahead, applying different growth rate to each phase. (See Appendix R for traditional one-phase DCF results.) Our logic Average 66.59 is that it will take more than 5 years for SPA to enter its mature stage, because according to Source: Team Analysis CAAC’s work plan, the CAGR of aviation is targeted at 7.71% 2020-30. For the first phase, T8: Comparative Analysis we conservatively apply the growth rate of 5%.
P/B P/S To determine the terminal growth rate, we consider 1) target inflation rate of 2.00%, 2) our Company expectation of population growth of China, 0.55%. After adjusting, the terminal growth rate 2016.10.27 2016.10.27 is 2.55%. SPA 5.03 x 4.42 x PEG JYA 4.59 x 3.59 x In order to reflect the high growth nature of SPA (which traditional P/E method ignores), Mean 4.81 x 4.00 x we apply PEG multiples. Although SPA’s P/E is relatively high among counterparts, its PEG
NAPS or SPS 12.71 14.3 is low due to high CAGR of core net income (Appendix T). 1x PEG is applied for 3 scenarios, each assuming different oil price and International Market Share (IMS, 2020E). A 12-month Target Price 61.14 57.2
target price of CNY 66.59 is obtained for SPA.
Source: Team Analysis, Wind Relative Multiples Valuation T9: Sensitivity Analysis – WACC & g Due to absence of domestic listed LCC peers, we determine JYA as SPA’s only comparable Buy Hold company based on historical data (profitability, leverage, market status) and our Accumulate Sold understanding of airlines’ life cycle (See Appendix U). Therefore, our P/B and P/S analyses
are based on the comparison between SPA and JYA. By taking average of market expectation
on both, we are able to predict SPA’s 12-month target price with latest P/B and P/S.
Sensitivity Analysis In previous discussions, we are curious about how external factors would affect the intrinsic value of SPA, e.g. income growth, oil price, WACC and terminal growth. For internal Source: Team Analysis factors, we emphasize cost control and future international market share. We observe that the target price is far more sensitive to F/R and WACC. If converted to oil T10: Sensitivity Analysis – Fuel, Other price changes, a 1% increase in F/R represents about a $2/barrel increase in oil price. Our Cost/Reveue recommendation will be affected if oil price jumps above $50/barrel. An increase of Other Intrinsic F/R ΔRate Change Operating Cost/Revenue(OOC/R) to 49.02% will have the same impact. Value 23.00% -2.00% 71.91 17.21% Monte Carlo Simulation 24.00% -1.00% 66.63 8.61% In order to summarize the continuous effect from the 6 key factors, we perform 10,000 25.00% 0.00% 61.35 0.00% simulations, assuming normal distribution of WACC, terminal growth, 10-year growth rate, 26.00% 1.00% 56.07 -8.61% Per Capita Disposal Income and F/R (Appendix xx). We obtain a 62.37% confidence level in 27.00% 2.00% 50.79 -17.21% our Buy recommendation, and a 90% confidence interval of [42, 140]. Intrinsic OOC/R ΔRate Change Value
45.02% -2.00% 71.91 17.21%
46.02% -1.00% 66.63 8.61%
47.02% 0.00% 61.35 0.00%
48.02% 1.00% 56.07 -8.61% 49.02% 2.00% 50.79 -17.21%
Source: Team Analysis
T11: Monte Carlo Statistics
Key features Value
Mean 64.76 Standard error 21.57 Valuation Conclusion After taking weighted average of different valuation methods, we obtain a 12-month target 5% percentile 38.19 price to be CNY 61.74 (60.74% upside). The support of SPA’s present stock price and future Median 61.04 growth mainly relies on: 95% percentile 101.53 • The macroeconomic condition; • SPA’s ability to quickly expand its international market, while keeping a portion Skewedness 2.14 domestically, to offset the effect of capital expenditure on free cash flow; Kurtosis 11.95 • SPA’s ability to finance continuously for new aircraft under low costs;
• SPA’s ability to control cost and maintain high gross margin. Source: Team Analysis Investment Risks
Risk Matrix Economic Risks Slowdown of China’s Economy (ER1) Aviation, as a cyclical business, depends heavily on GDP and disposal income growth. Unfavorable macroeconomic conditions will put stress on GDP growth. China’s 1Q16~2Q16 GDP growth slides to 6.7%, the worst since 1990. Nominal growth rate of Disposable Income Per Capita declines to 7.4% in 2015. Expected downward trend of overall economic growth in near future and obstacles in China’s economic transformation would constrain overall demand for aviation industry.
Political Risks Deteriorating political relationship with other countries (PR1) SPA emphases raising ASK on international routes (to Japan, Korea and Southeast Asia) compared to domestic ones. If China’s international political relationship deteriorates, corresponding outbound tourism will be depressed. For instance, SPA has been laying Source: Team Analysis more ASK on Japan routes since 2015, which accounted for 13% of total ASK in 1H16. Given T12: Risks Mitigation the history of the two countries, if China has some conflict with Japan, tourism to Japan may be threatened and SPA’s load factor and revenue will be negatively influenced. Risk Rating Mitigating Factors Economic Risks Market Risks Fluctuation of oil price (MR1)
Improving disposal Income; Jet fuel accounted for 24.3% of SPA’s total cost in 2015 and SPA does not have any hedge Strong growth of aviation positions. In 2016, oil price has rebounded to $50/barrel from sharp early declines since ER1 9 passengers; Rising proportion of OPEC is trying to reach a limited production agreement. If the future price of oil continues international passengers to recover from the corporation of OPEC members, the rising jet fuel cost will weaken SPA’ profitability. Political Risks SPA can adjust its ASK allocation Continuous Depreciation of CNY (MR2) in time compared with its peers; SPA purchases airplanes and other aircraft materials from overseas, which are priced in US PR1 6 China adores peace and try best to dollar. The foreign exchange market witnessed unprecedented volatility in 2015 and the avoid conflict. depreciation of USD/CNY has been up to 8%. The capital cost of SPA will increase Market Risks proportionally if CNY continues to depreciate. However, future uncertainty of foreign
Excessive supply of global oil; exchange market would only cast limited risk on SPA’s balance sheet considering its Prisoner's dilemma among OPEC liabilities in JPY and USD have been hedged by its dollar assets and yen assets.
MR1 8 members; Expanding production of U.S. shale oil when oil price Operational Risks continues to rebound Competition with Other Airlines and Substitute (OR1) As most of China’s major FSCs are state-owned enterprises controlled by the government,
Hoarding US dollars from HK they have been enjoying more favorable allocations and occupying 85% market share. MR2 3 market；Using forwards and Additionally, SPA encounters fairly direct competition when many LCCs crowded in since swaps；Issuing domestic bonds 2013. Intense price wars, as a main approach to expand market share, would break out and squeeze SPA’ profit margin. Furthermore, high-speed railway as a burgeoning means of Operational Risks transportation, has attractive punctuality and convenience, and may place substantial pressure on the demand of whole aviation industry. Higher entry barrier due to more strict regulation; First-mover A lack of Experienced Pilots (OR2) OR1 12 advantage and economics of In recent years, with the expansion of fleet capacity and establishment of new airlines, scale; Differentiated competitive many private airlines get into trouble from a lack of pilot resources, particularly the strategy experienced captains. According to industry practice, it takes 8 to 10 years for a junior pilot Sufficient pilot resources from to become an excellent captain. If SPA cannot train or introduce enough qualified pilots to self-own training center; achieve its fleet expansion plan, its development strategy might not be effectively OR2 2 Implementation of international implemented and thus restricts its future revenue growth. captains introduction program Unsustainability of subsidies from local governments (OR3) Subsidies as a convention in Government subsidies contributed 849 million (nearly 10%) to SPA’s total revenue in 2015. China's aviation industry, OR3 4 especially from governments in Due to the time limit of its cooperation agreements with local governments, SPA might not middle-sized cities aiming to obtain sustainable subsidies if it’s unable to renew these contracts. In addition, the promote local economy standard of subsidies for new routes developed by SPA will also remain uncertain, thus affecting its future income.
Adequate line of credit from Liquidity Risk as Corporate Bonds Mature (OR 4) OR4 3 commercial bank; Enough cash; SPA has a fixed rate bond outstanding, of which CNY 2.3 billion matures in 2020. If SPA Issuances of new bonds wants to maintain the capital structure but fails to issue new bonds or obtain sufficient bank loans, it may face liquidity risk at maturity.
Source: Team Analysis Appendix: Table of Contents Section Appendix Content Page All A Glossary of Terms 1 B Unitary Aircraft Type and Booking Class 2 C Spring Airlines Official Website & Mobile APP 2 Business Description D Introduction of TravelSky 3 E SPA’s Primary Revenue Breakdown 3 F SPA’s Ancillary Revenue Breakdown 3 Corporate Governance G Shareholding & Board Structure 4 H China’s Strategy of Civil Aviation Popularization 4 Industry Overview I Comparison of Transportation Facilities Density 5 and Competitive Positioning J Trend of China’s Outbound Tourism 5 K Details of Comparison between SPA and High-Speed Railways 6 Investment Summary L Air + Tourism Business Model 7 M Balance Sheet 7 N Income Statement 8 Financial Analysis O Cash Flow Statement 9 P DuPont Analysis 10 Q DCF Details 11 R Traditional 1-Phase Results 14 S WACC Analysis 14 Valuation T Grounds for PEG 15 U Comparative Analysis 15 V Sensitivity Analysis and Monte Carlo Simulation 17 W Rating Criteria 18 X Rating and Mitigating Factors of Investment Risks 19 Investment Risks Y Moderator Effect of US Shale Oil 20 All Z Reference 20
Appendix A: Glossary of Terms Aircraft utilization Average number of block hours per day per aircraft operated ASK Available Seat Kilometers, total seats flown multiplied by the number of kilometers flown A method used to project the ending value of an account by adding and subtracting specific BASE columns from the beginning value in a period of time CAAC Civil Aviation Administration of China Capacity The number of seats flown Air charter is the business of renting an entire aircraft as opposed to individual aircraft seats Charter Business (i.e., purchasing a ticket through a traditional airline). Chunxiang Chunxiang Investment Ltd, one of SPA's share holders Chunyi Chunyi Investment Ltd, one of SPA's share holders Eastern China Eastern Airlines Co. Fleet Size Number of aircrafts FSC Full Service Carriers, those who provide ancillary services for free Hainan Hainan Airlines Co. JV Joint-Venture JYA Juneyao Airlines Co. LCC Low Cost Carriers, those who charge seats and ancillary services separately Load Factor Number of passengers as a percentage of capacity Manning Ratio Number of staff to Number of Aircrafts MOU Memorandum Of Understanding Revenue Passenger Kilometers, number of passengers multipled by the number of kilometers RPK those passengers have flown SCI Shanghai Composed Index Southern China Southern Airlines Co. SPA Spring Airlines Co. SpringTour Spring International Travel Services Ltd., SPA's controlling shareholders Stage A one-way revenue flight Tier 2/3 Cities Less developed cities compared to Beijing and Shanghai, such as Nanjing, Hangzhou and Lasa TravelSky The leading supplier of China's aviation tourism information system
Appendix B: Unitary Aircraft Type and Booking Class
Source: Company Data
Appendix C: Spring Airlines Official Website & Mobile APP Official Website Mobile APP
Source: Company Data
Appendix D: Introduction of TravelSky TravelSky is the leading supplier of China’s aviation tourism information system. The company's core business focuses on electronic travel distribution (ETD), airport passenger processing (APP), air cargo system(ACS) and Internet-based tourism platform. TravelSky’s domestic service network has covered about 300 cities in China and extended to more than 50 cities overseas through Societe International De Telecommunications (SITA ). TravelSky’s customers include China’s most airlines, more than 120 airports and over 5000 travel agencies.
The departure system of TravelSky mainly includes Check-in System and Flight-Control System, which are directly related to passengers’ check-in process and seat selection. At present, most of the airline companies in China are dependent on the departure system of TravelSky, spending over one hundred million (in CNY) in sales expenses. This estimate has not counted in huge amounts of system maintenance fee every year. The major difficulty in developing independent departure system is the absence of company’s own sales system. For SPA, the sales system has been self- developed at the very beginning, based on Spring Tour’s marketing network. This provides necessary condition for company’s own departure system. For SPA customers, it takes only a few seconds to book tickets in www.CH.com and print boarding pass. In addition, special offers (cost only CNY 199/299/399) are available only through company’s website.
Appendix E: SPA’s Primary Revenue Breakdown
Source: Company Data, Team Analysis
Appendix F: SPA’s Ancillary Revenue Breakdown
Source: Company Data, Team Analysis
Appendix G: Shareholding & Board Structure
Shareholding Structure:
Board Structure:
Source: Company Disclosure
Appendix H: China’s Strategy of Civil Aviation Popularization Summary of CAAC’s Targets, Nov. 2016 Date CAAC Targets Implications Promote airports in tier 2/3 cities, covering SPA will benefit from cooperating with tier up to 50% 5A tourist attractions; 2020’s target 2/3 airports; To encourage combinations of Air + Internet Air + Tourism + Internet strategy prevails + Innovative economics To construct 500+ general airports; 5000+ general aviation aircrafts, servicing for 2+ million hours per year; Large potential capacity and market for LCCs To achieve economic scale of more than 1 trillion (CNY) To encourage pilot training, increasing Increased supply of pilots will lower down number of holders with driving licenses SPA’s operating cost To promote fund, expand routes in remote Subsidies from government is sustainable districts and enhance subsidiaries to airline with high possibility companies To construct 2058+ general airports; Market growth is approximate 7.71% 2030’s target 100 million people travelling by air annually (CAGR), 2020-30 Source: CAAC Appendix I: Comparison of Transportation Facilities Density
China USA Japan 30 25 20 15 10 5 0 Highway Density Railway Density Airport Density
Source: Company Disclosure
Appendix J: Trend of China’s Outbound Travel 10 Most Popular Destinations for China’s Mainland Top 10 Departure Cities for China’s Outbound Travel Outbound Travelers in 2015 in 1H16 Largest Number of Tourists Highest Growth Rate Number of Tourists / thousand 1 Shanghai 1 Changsha 7000 6110 2 Beijing 2 Shenzhen 6000 4900 5000 3 Guangzhou 3 Chongqing 3490 4000 4 Shenzhen 4 Chengdu 3000 2090 1930 1790 2000 1430 1350 5 Hangzhou 5 Wuhan 690 1000 260 6 Chengdu 6 Kunming 0 7 Nanjing 7 Fuzhou
Japan 8 Tianjin 8 Xi’an Vietnam Thailand Malaysia Indonesia Myanmar Mongolia Singapore Cambodia 9 Wuhan 9 Nanjing SouthKorea 10 Chongqing 10 Hangzhou
Source: China Tourism Research Institute, "Consumption Upgrading: 1H16 China Outbound Tourism Report"
Appendix K: Comparison between SPA and High-Speed Railways
Time Time: considering the time to check in and go through security, 4 we add 2 hours to the fly time. The ride time of SPA’s flight is
Non-stop Price still 1/2 of the ride time of high-speed railway. Thus passengers 4 3 3 4 can save more time if they choose SPA against high-speed 3 railway. Price: SPA initiate sales promotion in the flights that face 3 3 competition with high-speed railway. The price of SPA 4 3 4 Convenience Comfort economy class tickets is 2/3 of that on high-speed railway. As 4 the ticket price booked 3 days before traveling represents the
Stability high level of air ticket price, it is convincing that SPA’s ticket price is more attractive. Source: Team Analysis
Comfort: passengers may feel sick when the plane is taking off or landing, while taking a high-speed railway can avoid this problem. Plus, it is typical for LCCs as SPA to add more seats on the plane, the leg room between seats maybe smaller, thus brings less comfort. Stability: flights can delay because of bad weather and aviation control, while high-speed railway runs more regularly. Convenience: passengers need to go through the security, check baggage and take boarding pass before board the plane, while the check-in process is much shorter with high-speed railway. Also, high-speed railway may provide more rides than flights. Non-stop: high-speed railway typically has many stops on the route, while planes fly directly spot-to-spot.
Ticket Price and Ride Time Comparison
1200 14
1000 12
800 10 8 600 6 400
4 Time(h) Ride
Ticket Price(CNY) Ticket 200 2
0 0
425 551 694 755 819 860 870 881 958 959 987 1047 1084 1099 1157 1177 1207 1216 1251 1270 1319 1402 1410 1442 1473 1489 1514 1522 1596 1668 1685 1727 Stage Length(km)
Ride time of Spring Airlines Ride time of high-speed railway Total ticket price of High-speed Railway Total ticket price of Spring Airlines
Source: Company Data, Team Analysis
Total ticket price of high-speed railway: High-speed railway has 3 types of classes: business, first class and second class. Second class seats, where ticket price is the cheapest, account for 80% of total seats. Here we use the ticket price of second class seats. Total ticket price of Spring Airlines: SPA also has 3 types of seats and we use ticket price of the economy class. Unlike ticket price of high-speed railway, ticket price of SPA can change over time. We use the ticket price booked 3 days before ride because it represents a high level of ticket price. Total ticket price also include RMB 50 of airport construction fee and RMB 30 of insurance fee, in addition to the base ticket price. Ride time of high-speed railway: just the running time. Ride time of SPA: considering the time of checking-in, we use the flying time plus 2 hours of waiting time.
As is shown in the graph, the time to take a SPA flight (including 2 hours of waiting and checking-in) is only 1/2 of taking high-speed railway, and the total ticket price of SPAis only 1/2 of that on high-speed railway, regardless of the stage length. It is convincing that the short ride time and low ticket price is very attractive against high-speed railway.
Appendix L: Air + Tourism Business Model
Source: Team Analysis
Appendix M: Balance Sheet
Unit: million CNY 2015A 2016E 2017E 2018E Assets Percentage Percentage Percentage Percentage Cash and cash equivalents 3,074 19.2% 4,624 23.7% 5,581 25.4% 6,847 27.7% Other monetary assets 20 0.1% - 0.0% - 0.0% - 0.0% Notes and accounts receivables 102 0.6% 101 0.5% 116 0.5% 131 0.5% Other receivables 721 4.5% 721 3.7% 721 3.3% 721 2.9% Prepaid expenses 261 1.6% 240 1.2% 280 1.3% 318 1.3% Inventory 55 0.3% 54 0.3% 63 0.3% 71 0.3% Other current assets 31 0.2% 48 0.2% 56 0.3% 63 0.3% Total current assets 4,264 26.6% 5,786 29.7% 6,817 31.0% 8,151 32.9% Long-term equity investments 95 0.6% 95 0.5% 95 0.4% 95 0.4% Fixed assets 5,858 36.5% 7,839 40.2% 9,971 45.3% 12,232 49.4% Construction in progress 4,288 26.7% 4,271 21.9% 3,638 16.5% 2,805 11.3% Intangible assets 63 0.4% 69 0.4% 67 0.3% 64 0.3% Long-term deferred expenses 442 2.8% 403 2.1% 365 1.7% 327 1.3% Deferred tax asset 128 0.8% 145 0.7% 168 0.8% 189 0.8% Other non-current assets 891 5.6% 891 4.6% 891 4.0% 891 3.6% Total non-current assets 11,765 73.4% 13,715 70.3% 15,195 69.0% 16,602 67.1% Total assets 16,029 100% 19,501 100% 22,012 100% 24,753 100% Liabilities & Owners' Equity
Short-term borrowings 1,561 9.7% 1,561 8.0% 1,561 7.1% 1,561 6.3%
Accounts payable 340 2.1% 352 1.8% 411 1.9% 467 1.9% Accrued payroll 200 1.2% 181 0.9% 212 1.0% 241 1.0% Advance receipts 1,355 8.5% 791 4.1% 925 4.2% 1,050 4.2% Accrued tax 317 2.0% 358 1.8% 419 1.9% 476 1.9% Accrued interest payable 33 0.2% 39 0.2% 37 0.2% 40 0.2% Other payables 150 0.9% 145 0.7% 170 0.8% 193 0.8% Current liabilities falling due 1,023 6.4% 925 4.7% 986 4.5% 1,059 4.3% within one year Total current liabilities 4,979 31.1% 4,353 22.3% 4,721 21.4% 5,086 20.5% Long-term debt 3,354 20.9% 3,702 19.0% 4,110 18.7% 4,572 18.5% Bonds payable - 0.0% 2,288 11.7% 2,291 10.4% 2,294 9.3% Long-term accounts payable 1,006 6.3% 851 4.4% 745 3.4% 643 2.6% Deferred income 17 0.1% 13 0.1% 15 0.1% 17 0.1% Other non-current liabilities 133 0.8% 133 0.7% 133 0.6% 133 0.5% Total liabilities 9,489 59.2% 11,339 58.1% 12,015 54.6% 12,746 51.5% Owners' Equity Share capital 800 5.0% 800 4.1% 800 3.6% 800 3.2% Capital reserve 1,534 9.6% 1,534 7.9% 1,534 7.0% 1,534 6.2% Earnings reserve 280 1.7% 400 2.1% 400 1.8% 400 1.6% Retained earnings 3,926 24.5% 5,427 27.8% 7,262 33.0% 9,273 37.5% Owners' equity attributable 6,540 40.8% 8,161 41.9% 9,996 45.4% 12,007 48.5% to the parent company Non-controlling interests - 0.0% - 0.0% - 0.0% - 0.0% Total equity 6,540 40.8% 8,161 41.9% 10,240 46.5% 12,007 48.5% Total liabilities 16,029 100.0% 19,501 100.0% 22,012 100.0% 24,753 100.0% and owners' equity Source: Company Data
Appendix N: Income Statement
Unit: million CNY 2015A 2016E 2017E 2018E (except for specific notification) Revenue Percentage Percentage Percentage Percentage Operating revenue 8,094 90.5% 9,303 91.6% 10,883 92.8% 12,352 93.6% Subsidy revenue 849 9.5% 849 8.4% 849 7.2% 849 6.4% Total revenue 8,943 100.0% 10,153 100.0% 11,732 100.0% 13,202 100.0% Operating expenses 6,063 67.8% 6,969 68.6% 8,152 69.5% 9,253 70.1% Aircraft fuel 1,941 21.7% 2,326 22.9% 2,721 23.2% 3,088 23.4% Other operating expenses 4,123 46.1% 4,374 43.1% 5,117 43.6% 5,808 44.0% Sales and marketing 232 2.6% 233 2.3% 272 2.3% 309 2.3% Administrative expenses 183 2.0% 206 2.0% 240 2.0% 273 2.1% Business tax and extra 24 0.3% 28 0.3% 32 0.3% 37 0.3% EBITDA 2,441 27.3% 2,987 31.4% 3,350 28.6% 3,687 27.9% Depreciation 375 4.2% 435 4.3% 501 4.3% 572 4.3% Amortization of intangible assets 2 0.0% 3 0.0% 3 0.0% 3 0.0% Amortization of long term 38 0.4% 38 0.4% 38 0.3% 38 0.3% deferred expenses Depreciation & amortization 416 4.6% 477 4.7% 542 4.6% 613 4.6% EBIT 2,025 22.6% 2,510 22.0% 2,807 23.9% 3,074 23.3% Financial expenses 154 1.7% 138 1.4% 128 1.1% 139 1.1% Non-operating income 53 0.6% - 0.0% - 0.0% - 0.0% Non-operating expenses 2 0.0% - 0.0% - 0.0% - 0.0% Loss on investments 117 1.3% - 0.0% - 0.0% - 0.0% Non-recurring gain 51 0.6% - 0.0% - 0.0% - 0.0% Income before income taxes 1,804 20.2% 2,372 20.6% 2,679 22.8% 2,935 22.2% Income taxes 476 5.3% 628 6.2% 710 6.0% 778 5.9% Net income 1,328 14.8% 1,744 17.2% 1,969 16.8% 2,157 16.3% Minority interests - 0.0% - 0.0% - 0.0% - 0.0% Net profit attributable 1,328 14.8% 1,744 17.2% 1,969 16.7% 2,157 16.3% to the parent company EPS 1.66 2.18 2.46 2.70 Source: Company Data
Appendix O: Cash Flow Statement
Unit: million CNY 2014A 2015A 2016E 2017E 2018E 2019E 2020E Operating activities Net income 884 1,328 1,744 1,969 2,157 2,411 2,685 + Depreciation 304 375 435 501 572 620 674 + Amortization of intangible assets 2 2 3 3 3 3 3 Amortization of long term deferred + 32 38 38 38 38 38 38 expenses - Disposal gains from non-current assets -10 -25 - - - - - + Loss on investments 81 117 - - - - - + Financial expenses 98 154 138 128 139 127 112 - Increase in OWC -197 323 -526 237 220 249 269 + Increase in long-term accounts payable 391 -61 -155 -106 -102 -94 -70 + Increase in deferred income 6 8 -5 2 2 2 2 - Increase in deferred tax asset -10 -15 -17 -23 -21 -24 -14 Net cash flows from operating activities 1,581 2,246 1,655 2,750 3,009 3,332 3,701 Investing activities - Construction of fixed assets -655 -1,649 -1,273 -1,489 -1,690 -1,917 -2,163 - Construction of intangible assets -5 -11 -9 - - - - + Disposal of fixed assets 0 105 - - - - - + Disposal gain from non-current assets 10 25 ------Loss on investment -81 -117 - - - - - Construction of fixed assets - net increase of - -2,184 -2,093 -1,127 -511 -310 -83 - construction in progress - Increase in long-term deferred expenses -97 -119 - - - - - + Decrease in long-term deferred expenses 3 2 ------Increase in long-term equity investments -13 15 ------Increase in other non-current assets 19 -75 - - - - - Net cash flows from investing activities -3,002 -3,918 -2,409 -2,000 -2,000 -2,000 -2,163 -1,421 -1,672 -755 750 1,009 1,332 1,538 Financing activities - Financing expenses -98 -154 -138 -128 -139 -127 -112 + Increase in short-term borrowings 1,755 -484 - - - - - + Increase in long-term borrowings 368 1,024 349 408 463 525 592 + Increase in bonds payable - - 2,288 3 3 3 4 + Increase in interests payable 17 -5 7 -3 3 -3 -4 Increase in non-current liabilities due + 334 280 -99 61 73 87 106 within one year + Increase in other non-current liabilities 45 48 - - - - - + Increase in share capital and capital reserve - 1,755 ------Dividends payable -74 -96 -122 -134 -147 -162 -180 Net cash flows from financing activities 2,347 2,367 2,284 207 257 324 405 Adjustments of exchange rate and others -7 52 - - - - - on cash and cash equivalents Net cash flow 925 695 20 0 - 0 -0 Beginning cash and cash equivalents 1,410 2,328 1,530 957 1,265 1,656 1,944 Ending cash and cash equivalents 2,328 3,074 3,074 4,624 5,581 6,847 8,502 Ending cash and cash equivalents 2,328 3,074 4,624 5,581 6,847 8,502 10,446 before financial gap Cash distribution Cash needed 2,328 3,074 2,031 2,346 2,640 2,972 3,331 Cash surplus 0 0 2,593 3,235 4,206 5,530 7,115 Financial gap ------Ending cash and cash equivalents 2,328 3,074 4,624 5,581 6,847 8,502 10,446 Source: Company Data
Appendix P: DuPont Analysis We use DuPont analysis to evaluate SPA’s profitability and return on shareholders. In 2015, SPA exhibited high return on equity (23.01%). The main driver of profitability was total assets turnover, as well as equity multiplier and net income margin. This indicated that the company had a healthy earning and efficient performance. In 2020, we forecast ROE will be lower (16.02%) mainly due to the quicker increase in equity than revenue.
DuPont analysis suggests the most important driver for sustaining future level of ROE to be financial leverage, calculated as ratio of asset divided by equity. Hence, we forecast decrease of the company’s leverage to have positive influence on profitability. Second driver appears to be revenue increase, which leads to a higher operating margin.
Source: Company Data
Appendix Q: DCF Details Valuation methodology: We evaluated Spring Airlines’ intrinsic value mainly through a discounted cash flow analysis and a relative multiples valuation, indicating CNY 61.74 per share. This target price is supported by Spring Airlines’ capability to conduct expansion while carrying on its low cost strategy.
Sales Revenue Below are the key assumptions and the process showing how we project the sales growth step by step. It should be noted that our assumptions are conservative to some extent, since a) International Passengers/Total increased from 7.5% to 9.65% 2013-16 with no trend of slowing down, but we only predict a 11.00% for the next 5 years, so do we predict a 6%~7% for other sales; b) It is predicted by CACC that in 2020, total number of airline passengers will be at least 7 billion, more than our estimate of 6.5 billion; c) The sudden decrease of Per Capita Revenue - Domestic in 2015 is due to a cancellation of fuel surcharge(CNY), therefore in the future there is actually little room for per capita revenue to decrease. Yet we still estimate a CNY 480, 4% lower than previous year.
CNY 10 thousand 2013A 2014A 2015A 2016E 2017E 2018E 2019E 2020E (except for Per Capita Revenue) Assumptions Population Growth -- -- 0.55% 0.55% 0.55% 0.55% 0.55% 0.55% Per Capita Income Growth 9.73% 7.01% 8.15% 6.00% 6.00% 6.00% 6.00% 6.00% International Passengers/Total 7.50% 8.05% 9.65% 11.00% 11.00% 11.00% 11.00% 11.00% Domestic Passengers/Total 92.50% 91.95% 90.35% 86.60% 86.60% 86.60% 86.60% 86.60% Regional Passengers/Total 2.55% 2.56% 2.34% 2.40% 2.40% 2.40% 2.40% 2.40% Market Share - International 2.79% 3.14% 6.20% 7.00% 8.00% 10.00% 10.50% 11.00% Market Share - Domestic 2.83% 2.72% 2.80% 2.80% 2.80% 2.80% 2.80% 2.80% Market Share - Regional 5.87% 6.53% 6.12% 6.12% 6.12% 6.12% 6.12% 6.12% Per Capita Revenue -International 783 958 921 900 900 900 900 900 Per Capita Revenue - Domestic 574 577 499 480 480 480 480 480 Per Capita Revenue - Regional 809 669 649 650 650 650 650 650 Other Sales 3.58% 4.07% 5.53% 6.00% 6.30% 6.60% 7.00% 7.00% Regression Population 136,072 136,782 137,462 138,218 138,978 139,743 140,511 141,284 Per Capita Income 26,955 28,844 31,195 33,067 35,051 37,154 39,383 41,746 Airline Passengers 35,397 39,195 43,618 47,901 53,199 57,232 61,389 65,675 Key Sales International International Passenger 2,655 3,155 4,207 4,138 4,910 5,620 6,391 7,224 Spring - International Passenger 74 99 261 288 379 477 590 722 Revenue - International 58,093 94,778 240,098 259,200 341,128 428,905 531,423 650,184 Domestic Domestic Passenger 32,742 36,040 39,411 42,613 47,012 50,239 53,525 56,875 Spring - Domestic Passenger 928 980 976 1,193 1,316 1,407 1,499 1,592 Revenue - Domestic 532,654 565,431 486,351 572,715 631,845 675,208 719,375 764,396 Regional Regional Passenger 904 1,005 1,020 1,150 1,277 1,374 1,473 1,576 Spring - Regional Passenger 53 66 62 70 78 84 90 96 Revenue - Regional 42,937 43,865 40,513 45,744 50,803 54,655 58,624 62,717 Sum-up Revenue - Primary 633,683 704,074 766,962 877,659 1,023,776 1,158,768 1,309,422 1,477,298 Revenue - Other 22,661 28,688 42,405 52,660 64,498 76,479 91,660 103,411 Total Revenue 656,344 732,761 809,367 930,318 1,088,274 1,235,246 1,401,082 1,580,709 Source: Team Analysis
Also, the statistics for the regression are: (data from 2004 to 2016) Y X R-square F-statistics P-value Number of Total Passenger Population, Per Capita Income 0.9982 540.4 0.001847 Source: Team Analysis
Operating Expenses, Business Tax and Extra Here, operating expenses, sales expenses and management expenses have excluded depreciation and amortization. When we forecast the changes in these items, we first examine whether the past trend is in accordance with macroeconomics and company’s strategy. Then, in regard to different composites, we make the following assumptions:
Account Items Facts (2013-15) Assumptions (2016~2020) Business Tax and Extra Percentage of revenue stays near 0.30% 0.30% of revenue Percentage of revenue decreased from Operating Expenses - Fuel Cost 37.59% to 23.98% due to downward oil 25.00% of revenue price Operating Expenses – Other Salary and Welfare Percentage of revenue stays near 14.70% 14.70% of revenue Percentage of revenue increased from Landing Fee 10.10% to 14.16% due to international 16.00% of revenue expansion Percentage of revenue increased only a bit Aircraft and Engine Rental Fee 8.59% of revenue from 8.15% to 8.59% Aircraft and Engine Repair Fee Percentage of revenue stays near 3.84% 3.84% of revenue Civil Aviation Development Fund Percentage of revenue stays near 2.70% 2.70% of revenue Amount decreases because of synergy Pilot Training Cost The same with 2015 effect Other Percentage of revenue stays near 8.80% 8.80% of revenue Source: Team Analysis
Fixed Asset or Intangible Asset & Related Items
Unit: CNY million 2013A 2014A 2015A 2016E 2017E 2018E 2019E 2020E
Fixed Assets Balance at beginning of year 3393.6 3799.5 4371.8 5858.4 7920.8 10145.9 12585.9 14019.4 Addition-from purchase 375.7 654.8 1649.1 1356.6 1587.6 1878.1 2066.5 2258.4 Addition-from construction in process 301.0 221.6 317.6 1143.4 1143.4 1143.4 0.0 0.0 Subtraction-Impaired or Disposed 0.0 2.8 113.6 0.0 0.0 0.0 0.0 0.0 Subtraction-Depreciation 271.1 303.6 375.1 437.6 505.8 581.4 633.0 689.5 Addition-Depreciation Decrease 0.0 2.4 8.4 0.0 0.0 0.0 0.0 0.0 Ending Balance 3799.5 4371.8 5858.4 7920.8 10145.9 12585.9 14019.4 15588.3 Construction in Process 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Balance at beginning of year 455.6 549.4 2512.1 4287.6 4187.6 3456.7 2435.2 2435.2 Addition-New prepayments 394.8 2184.3 2093.1 1043.4 412.4 121.9 0.0 0.0 Subtraction-Into Fixed Assets 301.0 221.6 317.6 1143.4 1143.4 1143.4 0.0 0.0 Ending Balance 549.4 2512.1 4287.6 4187.6 3456.7 2435.2 2435.2 2435.2 Intangible Assets 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Land: 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Balance at beginning of year 49.3 48.3 47.3 46.3 45.3 44.3 43.3 42.3 Addition-Purchase 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Subtraction-Amortization 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 Ending Balance 48.3 47.3 46.3 45.3 44.3 43.3 42.3 41.4 Software: 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Balance at beginning of year -- 3.0 7.0 16.6 24.7 22.7 20.8 18.9 Addition -- 4.7 11.1 9.9 0.0 0.0 0.0 0.0 Subtraction-Amortization -- 0.7 1.4 1.9 1.9 1.9 1.9 1.9 Ending Balance 3.0 7.0 16.6 24.7 22.7 20.8 18.9 16.9 Sum of Land and Software 51.3 54.3 63.0 70.0 67.1 64.1 61.2 58.3 Source: Company Data, Team Analysis
In this part, we apply a BASE method to predict fixed asset, depreciation, intangible asset, amortization, etc. For the new fixed asset purchase, we compute its historical average portion to revenue to be 13.69%, and assume that in the future, the portion remains constant. For the new construction in process, the amount is the higher of 0 and required pay minus new fixed asset purchase. In this way, we make sure the capital expenditure each year is no smaller than a portion of revenue, meanwhile in accordance with the company’s goal of expansion.
Operating Working Capital About the projection of current assets and current liabilities, our assumptions are: Items Assumptions Accounts and notes receivable Percentage of total revenue Advanced to suppliers In proportion to operating costs Inventories Percentage of sales revenue Other operating current assets Percentage of total revenue Accounts and notes payable Increase in line with operating costs Payment received in advance In proportion to total revenue Other payables Percentage of total costs Source: Team Analysis
Debt Financing & Related Items Items Assumptions
Added short term borrowings Percentage of change in OWC
Added long term borrowings Percentage of added fixed assets
Debt securities issued Equal to former nominal amount Source: Team Analysis
Other Assets and Liabilities Items Assumptions Works as a balance item and is obtained after building overall Cash and cash equivalents linkages among Balance Sheet, Income Statement and Cash Flow Statements. Long-term receivables Percentage of total revenue Long-term equity investments Equal to 2015 nominal amount Deferred tax assets Percentage of total revenue
Deferred tax liabilities Percentage of operating costs
Other non-current assets Equal to 2015 nominal amount
Other current but non-operating liabilities Equal to 2015 nominal amount Source: Team Analysis
Appendix R: Traditional 1-Phase Results Unit: million, CNY(except for Intrinsic Value): Sum of FCFF PV 4,301 Terminal growth rate 2.55% Terminal value 46,842 PV of Terminal Value 39,062 Enterprise Value 43,363 + Cash and cash equivalents 5,890 + Non-coral Assets 1,877 - Total liabilities 12,178 - Minority shareholder’s equity 0.00 Value of Equity 38,952 Common shares outstanding 800 Intrinsic Value 48.69 Source: Team Analysis
Other things being equal, if we apply the traditional 1-phase DCF, while still assuming only 2.55% terminal growth rate, the intrinsic value will be decreased to CNY 48.69. This would by no means reflect the true growth of SPA, because a) As projected, the free cash flow will just turn positive in 2017, its rapid expansion will not slow down in 2020; b) China’s LCCs still have a long way to achieve a steady market share, because it took more than 14 years for global LCCs to capture 25% of the market.
Appendix S: WACC Analysis Since Spring Airlines was listed on Shanghai Stock Exchange, we choose Shanghai Stock Exchange Composite Index as the benchmark. We use the CAPM model to estimate the cost of equity, and the followings are the assumptions for the parameters: Variable Value Assumptions Risk Free Rate 2.87% 5-year average yield on 1-year China Government Bonds 5-year average annual return on Shanghai Stock Market Return 8.41% Exchange Composite Index CAPM, regress daily stock returns on benchmark returns Beta 0.91 (2015 to 2016) Cost of equity 6.91% -- 3-year averaged actual tax rate (Tax expenses/Taxable Marginal Tax Rate 26% income, 2013 to 2015) Pre-tax Cost of Debt 3.40% (See below) Post-tax Cost of Debt 2.52% -- At the end of 2015, the market value of equity is 35.8 Equity to Debt 73:27 billion, and total liability is 13.4 billion WACC 5.84% -- Source: Wind, Company Data and Team Analysis
As regards to the pre-tax cost of debt, we apply the weighted average debt cost of short-term debt and long-term debt, which are about 1:3 in size. Since the 3-year averaged interest rates are 2.2% and 3.8% respectively, the weighted average debt cost is calculated to be 3.4%.
Appendix T: Grounds for PEG If we calculate the growth rate of Net Income(core), we will see that SPA displays a very large CAGR 2013-15. This is in accordance with its high P/E. P/E Net Income(core) 2011/12/31 2012/12/31 2013/12/31 2014/12/31 2015/12/31 3-year CAGR (2016.10) SPA 14,625 31,898 45,464 62,121 102,097 47.32% 24.72 Eastern 418,208 54,816 (94,380) (53,100) 20,100 -28.40% 22.17 Hainan 213,264 138,580 177,851 193,702 189,165 10.92% 17.71 JYA 60,952 19,802 30,783 40,307 112,837 78.51% 26.21 Southern 555,300 225,300 155,200 19,400 215,000 -1.55% 20.20 AirChina 992,671 506,639 362,466 290,318 684,006 10.51% 15.47 Source: Wind, Company Data and Team Analysis
Appendix U: Comparative Analysis We notice 2 facts that make it difficult to find comparable companies for SPA. 1) From a global perspective, LCCs generally have a higher PE and PB/ROE, indicating higher market expectation of stock performance; 2) From a A-share market perspective, SPA is the first and the only listed company whose operation mode is totally different from other airline companies. Table: Market holds different expectations for LCCs and FSCs P/E P/B Market Cap Company Name Type (SmartEstimate, (SmartEstimate, ROE(TTM) PB/ROE (bn usd) NTM) NTM) Southwest Airlines Co 12.03 2.48 26.86 30.09% 39.98 JetBlue Airways Corp 9.85 1.47 6.22 22.38% 44.03 Spirit Airlines Inc 12.85 2.11 3.57 23.33% 55.10 LCC Allegiant Travel Co 13.22 4.45 2.53 60.22% 21.96 Virgin America Inc 20.95 2.40 2.90 38.06% 55.05 Ryanair Holdings PLC 13.94 -- 19.08 28.72% 48.53 LCC Average 13.81 2.58 10.19 33.80% 44.11 Delta Air Lines Inc 8.75 2.05 34.41 41.40% 21.13 United Continental Holdings Inc 9.51 1.82 19.02 32.68% 29.10 American Airlines Group Inc FSC 9.67 4.20 21.92 139.04% 6.95 Alaska Air Group Inc 11.17 2.65 9.24 34.08% 32.78 Hawaiian Holdings Inc 10.23 2.89 2.48 52.05% 19.66 FSC Average 10.52 2.72 17.41 59.85% 21.93 Source: Thompson Reuters
Table: Domestic Airlines Comparison Until 2015 yearend Company SPA JYA Eastern AirChina Hainan Southern Operation Data Founded Year 2004 2005 1988 1988 1993 1995 Headquarter Shanghai Shanghai Shanghai Beijing Haikou Guangzhou Ownership Private Private State-owned State-owned State-owned State-owned Load Factor 92.84% 85.17% 80.47% 79.90% 89.19% 80.45% Fleet Size 52 55 526 590 202 667 ASK/bn seat*km 23.9 21.0 181.8 214.8 75.1 235.6 Stock Data Market Cap / bn CNY 33.6 32.5 76.5 84.6 54.3 61.1 P/B 4.46 4.26 1.82 1.46 0.96 1.58 P/E 25.94 24.29 15.52 25.82 13.78 12.45 P/S 4.35 3.59 0.94 0.86 1.43 0.62 Financial Data Sales Growth 2013-15 11.05% 17.31% 3.18% 5.63% 2.81% 6.61% ROE 26.31% 39.00% 13.47% 12.42% 9.67% 9.99% Adjusted Total Liability/Asset 41.85% 42.50% 67.72% 54.55% 59.54% 55.10% Current / Total Liability 52.47% 63.13% 47.06% 34.13% 34.24% 47.95% Source: Company Disclosure, Thompson Reuters
Despite of these two concerns, we do find JYA as the only comparable company to SPA. They share very similar features such as operation, profitability and leverage (operating leases adjusted), although JYA is not LCC who targets at different customers. But why?
Based on the theory of life cycle, we think at present and for the near future, JYA and SPA are and will be in the same stage of Growth. Moreover, if we emphasize ownership (a historical problem in China), it can be observed that there has been stable and apparent discrepancy in P/E, P/B and P/S between state-owned and private airlines (see graph below), and multiples of JYA and SPA are extraordinarily homologous from 2014 to 2016. Therefore, it’s highly possible that A-share market will continue to hold very similar expectation on both firms for the next year. P/PE/ E P/PB/ B 70 12 60 10 50 Eastern 8 Eastern 40 AirChina 6 AirChina 30 Southern Southern 20 4 JYA JYA 10 2 SPA SPA 0 0 4/1/11 8/1/11 4/1/12 8/1/12 4/1/13 8/1/13 4/1/14 8/1/14 4/1/15 8/1/15 4/1/16 8/1/16 5/1/11 3/1/12 8/1/12 1/1/13 6/1/13 4/1/14 9/1/14 2/1/15 7/1/15 5/1/16 12/1/10 12/1/11 12/1/12 12/1/13 12/1/14 12/1/15 12/1/10 10/1/11 11/1/13 12/1/15 10/1/16 P/SP/ S 8 7 6 Eastern 5 4 AirChina 3 Southern 2 JYA 1 0 SPA
5/1/11 3/1/12 8/1/12 1/1/13 6/1/13 4/1/14 9/1/14 2/1/15 7/1/15 5/1/16 12/1/10 10/1/11 11/1/13 12/1/15 10/1/16 Source: Wind Appendix V: Sensitivity Analysis and Monte Carlo Simulation We conduct sensitivity analysis on both external and internal factors: Per Capita Dispensable Income, Fuel/Revenue, WACC, Terminal Growth Rate, 10-year Growth Rate, International Market Share(2016E), Other Operating Cost/Revenue. We find that the intrinsic value of SPA is highly sensitive to oil price, WACC and Other Operating Cost/Revenue.
Percentage Per capita DI Intrinsic Value Change Recommendation Return from stock Change
5.50% -0.50% 60.64 -1.16% Buy 37.85%
5.75% -0.25% 60.99 -0.59% Buy 38.65%
6.00% 0.00% 61.35 0.00% Buy 39.46%
6.25% 0.25% 61.71 0.59% Buy 40.28%
6.50% 0.50% 62.08 1.19% Buy 41.12%
Percentage Fuel/Revenue Intrinsic Value Change Recommendation Return from stock Change
23.00% -2.00% 71.91 17.21% Buy 63.47%
24.00% -1.00% 66.63 8.61% Buy 51.47%
25.00% 0.00% 61.35 0.00% Buy 39.46% 26.00% 1.00% 56.07 -8.61% Buy 27.46% 27.00% 2.00% 50.79 -17.21% Accumulate 15.46% Percentage WACC Intrinsic Value Change Recommendation Return from stock Change 5.34% -0.50% 73.38 19.61% Buy 66.81% 5.59% -0.25% 66.86 8.98% Buy 51.99%
5.84% 0.00% 61.35 0.00% Buy 39.46%
6.09% 0.25% 56.63 -7.69% Buy 28.73% 6.34% 0.50% 52.55 -14.34% Buy 19.46% Percentage Terminal growth Intrinsic Value Change Recommendation Return from stock Change 2.25% -0.30% 57.46 -6.34% Buy 30.62% 2.40% -0.15% 59.32 -3.31% Buy 34.85%
2.55% 0.00% 61.35 0.00% Buy 39.46% 2.70% 0.15% 63.57 3.62% Buy 44.51%
2.85% 0.30% 66.02 7.61% Buy 50.08%
Percentage 10-year growth Intrinsic Value Change Recommendation Return from stock Change
4.50% -0.50% 58.82 -4.12% Buy 33.71% 4.75% -0.25% 60.07 -2.09% Buy 36.55%
5.00% 0.00% 61.35 0.00% Buy 39.46% 5.25% 0.25% 62.65 2.12% Buy 42.42%
5.50% 0.50% 63.99 4.30% Buy 45.46% International Percentage Market Share Intrinsic Value Change Recommendation Return from stock Change (2020E) 8.00% -2.00% 55.51 -9.52% Buy 26.19% 9.00% -1.00% 59.01 -3.81% Buy 34.14%
10.00% 0.00% 61.35 0.00% Buy 39.46% 11.00% 1.00% 63.66 3.77% Buy 44.71%
12.00% 2.00% 65.93 7.47% Buy 49.87% Other Operating Percentage Intrinsic Value Change Recommendation Return from stock Cost/Revenue Change 45.02% -2.00% 71.91 17.21% Buy 63.47%
46.02% -1.00% 66.63 8.61% Buy 51.47% 47.02% 0.00% 61.35 0.00% Buy 39.46%
48.02% 1.00% 56.07 -8.61% Buy 27.46%
49.02% 2.00% 50.79 -17.21% Accumulate 15.46% Source: Team Analysis
Further, we perform 10,000 Monte Carlo simulations to test continuous effect from 6 external factors. The parameters of simulation are set as follows： 10-year Features Per capita DI Fuel/Revenue WACC Terminal Growth growth Mean 6.00% 25.00% 5.84% 2.55% 5.00% Standard 1.00% 2.00% 0.50% 0.50% 0.50% error Source: Team Analysis
From simulations, it’s shown that SPA still has an appreciating space of 50.57% to reach its target price. We then obtain a confidential level of 62.37% in our Buy Recommendation, and an 90% interval of [42 , 140].
Source: Team Analysis
Appendix W: Rating Criteria Benchmark: Shanghai Stock Exchange Composite Index (expected rate of annual return: 7.41%) Time Horizon: 12 months Rating Criteria Sell Stock expected to underperform benchmark by more than 5% Hold Expected stock relative performance ranges between -5% and 5% Accumulate Stock expected to outperform benchmark by more than 5% but not more than 10% Buy Stock expected to outperform benchmark by more than 10% Source: Team Estimation
Appendix X: Rating and Mitigating Factors of Investment Risks
Risk Explanation Rating Economic Risks Although GDP and other indicators reflect China's economy is slowing down, which may inevitably influence the demand of air transport. Other signs show mitigation. Per capita disposable income Slowdown of still goes up in recent years. In 2015 the number of air transport passengers reached 436 million, an ER1 9 China’s economy increase of 11.1% compared to 2014. International airline passengers show a strong growth rate of 33.3% particularly. In addition, as a low-cost airline, Spring Airlines is relatively less affected by the macroeconomic cycle. SPA emphases raising ASK on international routes compared to domestic ones. For instance, SPA has been laying more ASK on Japan routes since 2015, which accounted for 13% in 1H16. If China’s politic Deteriorating relationship with other countries deteriorates, corresponding outbound tourism will be depressed. political PR1 This situation may decrease SPA’s load factor and revenue. China’s political relationship with 6 relationship with neighbor countries can deteriorate, especially with Japan given the historic conflict. But since SPA has other countries unitary fleet, it can flexibly adjust its ASK allocation compared to its peers, thus a certain level of negative impact can be avoided. Market Risks The price of aviation fuel has a significant impact on profit of Spring Airlines for fuel expense accounts for 27% of its total cost. In 2016, oil price has rebounded to $50 / barrel from sharp early declines since OPEC is trying to reach a limited production agreement. However, the probability that fuel price continues to rise may be mitigated. On the one hand, although OPEC proposed a limited production agreement in 2016, a prisoner's dilemma exists among its members. Iraq even stated an Fluctuation of Oil MR1 increase of its production. On the other hand, the prospective ceiling of oil price will be determined 8 Price by U.S. shale oil supply since advanced drilling technology has reduced production cost of shale oil to about $40~50 per barrel. Even if OPEC’s agreement results in oil price rebounding above $55 per barrel, U.S. shale oil producers will increase their outputs due to higher profit margin, which consequently pulls global oil price down. Thus, we think there will not exist a significant rebound of oil price in foreseeable future. The foreign exchange market witnessed unprecedented volatility in 2015 and the cumulative depreciation of USD/CNY has been up to 8%. The probability of CNY depreciation is relatively high considering the Fed's interest rate lattice figure. Spring Airlines purchases airplanes and other Continuous aircraft materials from overseas, which means its capital cost will increase proportionally with USD MR2 Depreciation of 3 appreciation. In fact, SPA has implemented two methods to mitigate the risk. One is hoarding US CNY dollars from Hong Kong market. Another is signing forward contract and exchange rate swap with counterparties. In order to strictly control its exposure to foreign exchange risk, Spring Airlines plans to issue domestic bonds instead of contracting foreign loans for future financing. Operational Risks
Spring Airlines occupies largest share in China's low-cost aviation market. In recent years, many Competition with low-cost airlines crowded in the market since 2013. But new entrants pose limited threat to Spring OR1 Other Airlines and Airlines because of its first-mover advantage and superiority of scale. Furthermore, the Civil 12 Substitute Aviation Bureau issued a new policy in September 2016, which clearly pointed out more stringent market access conditions, including higher-standard requirement for the quality of new airlines’ aircraft materials and their operational efficiency. This will form a significant entry barrier. To mitigate competition with high-speed railway, Spring Airlines adopt differentiated competitive strategy, especially vigorously developing non-stop fights from China’s middle-sized or small cities to Southeast Asia. In recent years, with the expansion of fleet capacity and establishment of new airlines, many private airlines get into trouble from a lack of pilot resources, particularly the experienced captains. In order to ensure adequate pilots / aircraft ratio, SPA set up a pilot training center in 2006. By 2016, SPA’s A lack of earliest 30 self-training pilots have grown to be qualified captains. The number of captains from self- OR2 2 Experienced Pilots training program is expected to increase by 60 in 2017 and 80 in 2018. Besides, SPA also keeps introducing international captains as a supplementary means and plans to introduce 30 to 40 foreign captains in 2016. So far SPA has 830 pilots including 370 captains, which shows a quite low probability for SPA to be lack of sufficient pilots.
To stimulate local economies, it has been normal practice for the government to offer subsidies to airlines in China. Total subsidies received by four major FSCs were up to 8 billion in 2015. We think Unsustainability of this trend will continue in the foreseeable future, given the government is encouraging the OR3 subsidies from 4 development of LCCs. The CAAC document issued in March 2014 stated it would offer subsidies to local governments promote China’s LCC development, which shows a clear regulatory attitude. Consequently, we think government subsidies are probably sustainable.
SPA has a fixed rate bond outstanding, of which CNY 2.3 billion matures in 2020. SPA has established Liquidity Risk as good long-term cooperative relationships with many commercial banks and remaining line of credit OR4 Corporate Bonds for SPA is up to CNY11.2 billion. Moreover, SPA’s holding cash is abundant and its interest coverage 3 Mature ratio is high. Additionally, Since SPA keeps its credit rating of corporate bonds at AA+, it may be not difficult for SPA to issue new bonds to raise funds. Source: Team Analysis Appendix Y: Moderator Effect of US Shale Oil
million World Oil Production and Consumption barrels Company Production cost Depletion Total($/barrel) annual oil production annual oil consumption 4,400 BC 14.9 15.4 30.3 PE 13.7 24.1 37.8 4,200 BBG 18.4 24.6 43 CRZO 20.2 26.9 47.1 CXO 18.8 24.4 43.2 4,000 BCEI 26.3 25.6 51.9
OAS 26 24.5 50.5 3,800 WLL 22.2 26.6 48.8 2010 2011 2012 2013 2014 2015 Source: Wind, Team Analysis
Appendix Z: Reference [1] Qianhui Shang, Feng Tian, Xiangxin Liu, Shan Zhong, The Monitoring Report of the impact of High-speed Railway on Civil aviation, China Academy of Civil Aviation Science and Technology, 2012. (Competitive Positioning, Investment Risks) [2] CAAC, statistical bulletin of the development of civil aviation, 2015 (Industry Overview and Competitive Positioning, Valuation) [3] Research Team on Corporate Governance, Research on the Evaluation System of Corporate Governance for Listed Companies in China, Nankai University, 2003 (Corporate Governance)
Disclosures: Ownership and material conflicts of interest: The author(s), or a member of their household, of this report does not hold a financial interest in the securities of this company. The author(s), or a member of their household, of this report does not know of the existence of any conflicts of interest that might bias the content or publication of this report. Receipt of compensation: Compensation of the author(s) of this report is not based on investment banking revenue. Position as a officer or director: The author(s), or a member of their household, does not serve as an officer, director or advisory board member of the subject company. Market making: The author(s) does not act as a market maker in the subject company’s securities. Disclaimer: The information set forth herein has been obtained or derived from sources generally available to the public and believed by the author(s) to be reliable, but the author(s) does not make any representation or warranty, express or implied, as to its accuracy or completeness. The information is not intended to be used as the basis of any investment decisions by any person or entity. This information does not constitute investment advice, nor is it an offer or a solicitation of an offer to buy or sell any security. This report should not be considered to be a recommendation by any individual affiliated with CFA China, CFA Institute or the CFA Institute Research Challenge with regard to this company’s stock.
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