China's airlines hit hard by weaker yuan
Leading carriers have issued profit warnings for the first half because of exchange losses from dollar-based debts caused by aircraft purchases
The weaker yuan is emerging as a major downside risk for mainland airlines already wrestling with a challenging business environment brought on by increased competition and higher taxes.
The unprecedented depreciation of the yuan this year has been blamed by the nation's biggest airlines warning their first-half profits could shrink significantly.
But foreign exchange distortion aside, business is not as bad as the balance sheet looks, analysts say.
Geoffrey Cheng, the head of transport at Bocom International, said there was little evidence the airlines were hedging against currency risks but there was also a lack of instruments for them to hedge against such losses incurred by currency fluctuations.
"Whether the airlines will be able to improve their income statement in the second half will depend on the outlook of the yuan," Cheng said. "If the yuan returns to its value at the beginning of this year, that would mean an exchange gain in the second half."
The yuan declined as much as 3.39 per cent against the US dollar in the first four months of the year and was down 2.48 per cent by the end of last month, the biggest fall for a six-month period since its peg to the dollar was broken in 2005.
The yuan has appreciated in the past decade, gaining almost 3 per cent last year.
Its decline this year is hitting Chinese airlines with large dollar-based debt hard, with most of the debt attributed to aircraft purchases and leases.
Analysts are expecting China Eastern Airlines Corp to join the other two major state airlines, Air China and China Southern Airlines, in issuing a profit warning for its interim results.
Air China, the country's flag carrier, said on Monday it expected net profit for the first half to drop 55 to 65 per cent from last year's 1.1 billion yuan (HK$1.37 billion).
China Southern, the nation's largest airline by fleet size, announced last Friday it could make a loss of 900 million to 1.1 billion yuan for the same period.
Both airlines cited exchange losses for the expected profit slump. China Southern also blamed the slower growth of the mainland economy.
Air China reported 111.6 billion yuan of interest-bearing debt last year, 70 per cent of which was in dollars.
China Southern and China Eastern, which did not break down their debts by currency, reported debts of 104.3 billion yuan and 111.5 billion yuan, respectively.
Given their liabilities are mostly in dollars, small changes in the exchange rate can result in different debt levels in yuan terms on the accounting book.
But the good news is the exchange distortions may be masking underlying trends of improved yields and profitability for the airlines, analysts say.
Jefferies said in a note it took Air China's profit warning "positively" as it indicated its core earnings, excluding currency losses, actually tripled in the first half.
Barclays estimated Air China had an exchange loss of 741 million yuan in the first half, compared to a gain of 1.11 billion yuan in the same period last year.
"If we exclude the forex gain/loss for both periods and adjust for tax, the core earnings of Air China should grow 177 to 214 per cent year on year in the first half, in line with our full-year core earnings estimates," Jefferies analyst Boyong Liu said.
Similarly, China Southern is estimated by Barclays to have had a currency loss of 1.59 billion yuan in the first half, compared to a gain of 1.51 billion yuan previously. Adjusting for the currency, the company's earnings per share should have improved to five to seven fen from a deficit of eight fen, largely driven by estimated higher yields.
The yuan-dollar rate has rebounded since falling to an 18-month low in April and is expected to stabilise.
Barclays dismissed the slower economy as a reason for China Southern's expected loss as the company's revenue passenger kilometres, an indicator of passenger demand, grew 10.2 per cent in the first half, unchanged from last year. Hence, there was no slowdown in passenger demand growth.
However, cargo demand actually saw significant improvement, growing 15.9 per cent in the same period, compared with 2.7 per cent previously.
Jefferies said it had a positive view of mainland airline stocks and expected stronger demand in the second half because of a higher portion of leisure travel and stability in the yuan exchange rate.