Fly The Friendly (Chinese) Skies

You’ve likely heard the quote from Warren Buffett about the airline industry from his 2007 letter to shareholders:
“The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down." This is how Buffett defines a gruesome industry, and while not alone in being gruesome, airlines are a textbook example. They are in constant demand for capital and are rarely profitable.
It has been a little over a century since the world’s first airline passenger flew in an open cockpit biplane in Florida. On New Year’s Day 1914, just over 10 years after the Wright Brothers proved their aircraft could fly, Abe Pheil became the first fare-paying plane rider after winning an auction for his seat at a bid of $400.
Last year, 3.6 billion passengers followed in Pheil’s footsteps.
But while the flying experience has transformed from a rickey biplane to perks such as personal TVs and a seat that transforms into a bed, for investors, airlines carry much the same risks as that first passenger flight in Florida.
Margins are thin, costs are fluid, the industry rarely if ever is able to cover its capital costs, competition is high, and customers aren’t loyal buying the cheapest fare rather than their preferred carrier.
Sven Carlin, daily contributor to our free Investiv Daily newsletter, wrote a great article this past week about airlines and other gruesome industries that’s worth a read and is available  .
In this article, he made an excellent point that has inspired today’s article. His point was that while an industry may be gruesome, that doesn’t mean it can’t present us with great trading opportunities.
I discovered one such trading opportunity late this week that we’ll discuss today, and since Sven has also got me thinking about emerging markets—his Global Growth Stocks newsletter which looks for great growth picks in emerging markets is launching in a few weeks, if you haven’t already added your name to the list to receive updates, my pick for today’s article is also based in an emerging market.
The company is China Southern Airlines (NYSE: ZNH).
China Southern Airlines was one of the four carriers created in 1984 when the Chinese government decentralized its Civil Aviation Administration. Today, the company is 40% owned by the Chinese government, and is publicly traded on the Hong Kong, Shanghai, and New York Stock Exchanges.
The airline has been rapidly expanding both domestically and internationally in the last several years and today is the world’s fourth-largest airline in passengers carried and largest airline in China.
ZNH’s growth is compelling. Its passenger capacity increased 10.5% year-over-year (YOY), its cargo capacity 8.1% YOY, and its revenue is the fastest growing among the top 3 Chinese airlines.
The stock has been in a downtrend since June 2015 mostly due to a decrease in revenue growth and slower Chinese growth. And the surprise devaluation of the yuan in August 2015 cost ZNH $225 million in currency loses.
Let’s take a look at ZNH’s chart:
Today, ZNH trades at a discount to its 2015 high, and its moving up.
As the current price is just above ZNH’s lowest low ($25), the downside is pretty minimal. The upside on the other hand, is pretty good.
By taking the two extreme points on our chart above, the June 2015 high and the subsequent low in September 2015, I’ve drawn the 38.2% retracement line at a price of $41, which is where I think ZNH is on its way to.
That gives us upside of just over $12—and an increase of 42%—while our downside is only about $3 if the price goes in the opposite direction, so I’d put that $25 low as my trailing stop. Generally, the ideal risk/reward ratio to look for is 1:3, so at a ratio of 1:4, ZNH looks like a great trading opportunity from a technical perspective.
From a fundamental perspective, its valuation is pretty attractive compared to its peers. Its P/E ratio is 11.3, which is good, and it offers a decent dividend at 2.16%.
However, ZNH does have a significant amount of debt on its balance sheet. While this is a concern, ZNH is optimizing its debt structure from USD-denominated obligations to RMB-denominated obligations, and the company is 40% owned by the Chinese government, so if debt really becomes an issue, I imagine it will be bailed out.
The other potential threat for ZNH in the next year is increasing oil prices. Rising oil prices increase fuel costs which eats into company profits. But while Chinese airlines don’t usually hedge against fuel costs, ZNH did report in August 2016 that while it didn’t expect fuel prices to rise dramatically, they would “carry out hedging operations” if fuel prices reach a certain level.
I’ve only touched on fundamentals here, so do your due diligence before taking a position. While the airline industry may be gruesome and not a great investment, ZNH certainly does look like a good trading opportunity.