China's flagship carrier Air China began pre-marketing a $800 million to $1 billion IPO on Monday under the lead management of CICC and Merrill Lynch. Based on December 2005 profit forecasts of $305 million to $333 million, the deal is being pitched on a forward multiple of 8 to 10 times earnings.
At the mid point of this range, the deal is being marketed at a 4% premium to China Eastern, a 10% discount to China Southern, an 18% discount to Cathay Pacific and a 35% discount to its own 69% owned subsidiary, China National Aviation Corp (CNAC).
These discounts are based on the mid points of analysts' 2005 P/E estimates, which presently stand at 8.7 times and 10 times for China's other two national carriers, China Eastern and China Southern. Hong Kong's flagship carrier, Cathay Pacific, is currently trading around 11 times, while CNAC is at about 14 times.
Based on a 31% freefloat pre greenshoe, Air China will have a market capitalization of $2.6 billion to $3.22 billion. At the top end of the range, its market capitalization will almost completely encompass that of China Eastern, Southern and CNAC.
So too its 2005 profit forecasts are likely to top analysts' combined estimates for the other three - roughly $320 million. Hong Kong listed CNAC is forecast to contribute little of Air China's overall profit, with analysts estimating that 2005 profits will amount to about $45 million to $57 million.
CNAC's two major assets are a 52% stake in Air Macau and a 43% stake in Dragonair. It also holds 50% of Jardine Airport Services, the largest independent airport services operator at Hong Kong's Chek Lap Kok airport.
Lead managers are likely to argue that Air China's superior size and efficiencies of scale mean it should trade at a premium to its peers. Based on this argument the valuation looks conservative and particularly in the context of a recent spike in the share prices of both Eastern and Southern. The former has risen nearly 25% over the past month and the latter about 40%. Cathay is up a more modest 8% over the same time period.
Investors now need to ask themselves whether the recent share price recovery has overshot an easing in oil prices, which are currently down about 17% since their record high of $55.17 in late October. Yesterday (November 15), they were trading at $45.9 on the New York Mercantile Exchange.
Lead managers are also likely to point out that the transaction is supported by its structure, which will see far less shares allocated to institutional investors than is normally the case. This is because 33% of the IPO - equating to 9.9% of the overall company - is being placed at the eventual IPO price with Cathay Pacific. Analysts say Cathay's decision to take a strategic stake is being viewed as a huge vote of confidence in the deal.
A further 10% will be allocated to Hong Kong retail and 10% to a Japanese Public Offer Without Listing (POWL) being run by Daiwa SMBC. This will leave institutions with the remaining 47% pre-clawbacks.
Formal roadshows are scheduled to begin after two weeks of pre-marketing, with pricing likely to take place on December 9 and listing on December 16. Deutsche Bank and HSBC are co-leads.
Specialists say the company has not yet formalised its dividend policy. Of its most immediate comparables, Cathay is currently trading on a 5% dividend yield, China Eastern 2% and CNAC 1%. China Southern does not pay one.
Like so many China deals, the biggest selling point is the growth potential of the Mainland aviation sector and its insulation from hard landing fears. China is currently the world's fifth largest aviation market behind the US, Germany, UK and Japan. Within a decade it is expected to stand second only to the US.
According to CAAC (China Aviation Authority) figures, the Mainland registered 50% year-on-year growth in terms of airline passengers through to the end of September (90 million passengers). Air China is said to have a 35% market share, while the big three control 80% between them.
These growth figures are slightly distorted by the devastating impact of SARS during 2003, which pushed the whole industry into a loss making position during the first half of the year. Air China lost Rmb1.92 during 1H03, but went on to record a slight profit of Rmb112 million ($13.5 million) for the entire year.
CAAC estimates that China will continue to record 10% growth in traffic volume over the next decade, double the global average. This assumes a 7% GDP forecast as the base case figure. CAAC also says that domestic volume is expected to increase slightly faster than international volume and cargo slightly faster than domestic.
The Beijing Olympic games, Shanghai Expo and Guangzhou Asia Games should all further spur growth.
But one of the key concerns facing the industry is how they are going to pay for it. China's Aviation Industry Development Research Centre estimates the country will need a further 2,194 planes over the next 20 years. Air China currently has 139 and has budgeted to spend about Rmb19 billion ($2.3 billion) in capex before the end of 2006.
In the near term, investors' biggest concern is the direction of jet fuel prices. According to non-syndicate analysts, Air China has a higher ratio of fuel costs to operating costs than both China Eastern and Southern - 35% compared to 25% for the other two. They estimate that every $1 movement in oil prices will increase or reduce Air China's net profit by $13.3 million.
All three carriers have historically adopted extremely loose hedging policies and analysts say they typically hedge less than 10% of annual jet fuel costs versus a 50% global average. In part this is a function of the inadequate hedging mechanisms available to them and state-controlled China Aviation's monopolistic grip over jet fuel.
However, a fuel oil futures exchange was opened in Shanghai this September and CAAC has let the carriers impose a $14 surcharge on international flights since the summer. Domestic flights remain the same.
Given that Air China has the highest ratio of international flights of the three, it should benefit the most from the surcharge. Syndicate forecasts have also taken a conservative view and are assuming an average cost of $45 per barrel in their 2005 models.
On the plus side, the airline sector would be one of the greatest beneficiaries of a rumoured re-valuation of yuan against the US dollar.
The other big challenges facing the Chinese aviation sector have historically been cut throat competition and gross inefficiencies. Over the last few years, however, the Chinese government has gone a long way to tackling both.
Its forced merger of the country's many disparate airlines has created three domestic giants, which are hubbed in Beijing (Air China), Shanghai (China Eastern) and Guangzhou (China Southern). The government hopes a reduction in the number of airlines will lessen price cutting wars and create companies with enough scale to take on the international giants, which are increasingly being given more operating leeway on the Mainland.
Cathay, for example, will start to fly to Beijing daily from December and twice daily from March. It will, however, not be allowed to start flying to Shanghai until 2006.
Where the airlines' inefficiency is concerned, the government has taken a number of steps to try and improve standards. One of its latest measures has been to persuade the airlines to compensate passengers for delays. As of June about 22% of domestic flights failed to arrive on time, up 1% on the previous year.
