China Southern top pick among big 3 Chinese airlines - Merrill Lynch

In a research note, Merrill Lynch said China Southern's price to book value is at a 32 pct discount to Air China and a 43 pct discount to China Eastern, the nation's other two main airlines.

China Southern benefits from currency appreciation, with every one pct increase in the value of the yuan generating a currency gain of 400 mln yuan, while also lowering its US dollar-denominated operating costs by 180 mln yuan a year, Merrill Lynch said.

The brokerage added that it expects the yuan to appreciate by five pct this year.

China Southern will also benefit from an improving balance of supply and demand in the domestic market, as the carrier boosts transfer traffic through its Guangzhou hub and spurs growth out of the higher yield Beijing market, Merrill Lynch said.

The airline yesterday announced a strong turnaround in earnings last year, with net profit at 188 mln yuan, compared with 2005's hefty net loss of 1.85 bln yuan. The recovery was driven by higher fuel surcharges, moderating domestic market supply growth and currency gains, Merrill Lynch noted.

It added that although China Southern is highly geared, government support eliminates the risk of bankruptcy, while ongoing currency gains makes debt effectively cost free.

Leverage should make China Southern's share price highly sensitive to positive news flow, Merrill Lynch said.

The brokerage has a 4.75 hkd price target on the airline.

China Southern's shares were down 0.54 pct at 3.70 hkd this morning in Hong Kong.

Merrill Lynch added that it has a "neutral" rating on Air China, the country's most profitable airline thanks to its grip on the Beijing market, strong balance sheet and partnership with Cathay Pacific.

But the airline is the weakest play of the "big three" on currency appreciation because of its extensive international flight program and stronger balance sheet, Merrill Lynch said.

The brokerage said it expects the Chinese flag carrier's net income to rise 20 pct this year, driven by continued strength in the passenger segment, profit contribution from its 17.5 pct stake in Cathay Pacific and 14 pct capacity expansion.

The expansion of Beijing Airport will give Air China the capacity needed to further expand its operations and transform the airport into one of the region's "mega-hubs", Merrill Lynch said.

But it added that pricing will come under pressure as extra capacity at the airport will allow rival airlines to increase their presence there.

Air China's shares were up 0.18 pct at 5.46 hkd this morning in Hong Kong.

Merrill Lynch does not have a price target on the company.

China Eastern is the weakest of the three, with 2006 losses expected to reach a record 1.35 bln yuan, on the back of weak revenues and surging fuel, staff and aircraft ownership costs, the note said.

Break-even is not forecast until 2008 despite large currency gains, Merrill Lynch said.

China Eastern continues to face intense competition at its Shanghai hub as Air China and Shanghai Airlines raise their presence in the passenger market there. China Eastern's cargo business is also under pressure from new startup carriers and Cathay Pacific, Merrill Lynch noted.

The company will remain "firmly cash flow negative" over the next three years with committed aircraft orders of around 10 bln yuan per year over the period, the brokerage said.

Meanwhile, talks with Singapore Airlines to take a 25 pct stake are no longer expected.

"It remains unclear whether Singapore Airlines would be prepared to inject new capital at current valuations or will instead seek a new cooperation agreement," the note said.

"We see significant downside risk to the stock should Singapore Airlines decline to inject new equity," it added.

Merrill Lynch has a "sell" rating on China Eastern. The brokerage did not provide a target price for the stock.

China Eastern's shares were unchanged at 1.8 hkd this morning in Hong Kong.