Steer Clear of This Chinese Industry

I'm going to tell a story about airlines, so the temptation to use metaphors such as smooth takeoff and hard landing will follow me like a first-class passenger chasing a drink cart. But the only metaphor worth knowing is the aviation axiom of balancing lift and thrust against weight and drag.

From an investor's point of view, China's top three airlines have too much weight and drag to stay airborne in world financial markets.

That forecast may come as a surprise as the airlines turn to lavish sales of bonds or generous government injections of capital to reduce debts. But Air China, China Eastern and China Southern, the country's flagship international carriers, have higher-than-normal debt-to-asset ratios and keep expanding their aircraft fleets to keep up with growth in international routes.

The Chinese government has encouraged that growth as a nationalistic means of ensuring that China doesn't rely too much on foreign airlines. Today 30% to 50% of business by Air China and China Eastern goes to flights overseas, with China Southern behind at 10% to 15%.

The nationalism is coming at a cost, and the airlines hardly need any more of that. Efforts this year to raise capital may boost investor confidence for now but won't cure the longer-term expenditure issues facing Chinese airlines.

Like many state-owned firms, the big three carriers are overstaffed. As the government runs Chinese airports as well, the airlines are stuck with flat terminal use fees rather than being set loose to negotiate them as they would in a free-market environment. Jet fuel rates are also set by the government, and prices run extra high in China for lack of an open-market pricing system.

Stock market performances for the big three carriers reflect those burdens as well as fallout from the world economic problems that spun off from Europe in August. Air China share have fallen 35% in a year, with China Eastern down 29% and China Southern off 15%.

So this month China Southern said it would get a 2 billion yuan ($314.7 million) injection of capital from the Chinese government in form of equities. Its debt grew last year to 75.8 billion yuan despite capital raising forays in 2008 and 2010. Earlier this month China Eastern announced plans to sell as much as 8.8 billion yuan in bonds to buy aircraft and repay loans. Its debt came to 92.9 billion yuan as of the end of 2011. Air China, with debts of about 124 billion yuan, said in April it would issue 1.05 billion yuan in shares to its controlling state-run shareholder for debt relief and more capital. Debt-to-equity ratios have generally run higher for Chinese airlines compared to the rest of Asia.

Still, the number of commercial aircraft will double from last year to about 4,000 by 2015, the Chinese civil aviation authority said this month. "Capacity has kept very well with demand," notes Paul Yong, equities research vice president with DBS in Singapore. "Of course (China) comes from a past where these airlines don't have strong balance sheets."

And new aircraft, of course, runs up a bill, while foreign competitors have essentially the same planes. No, they have more. Airlines in Southeast Asia, for example, easily outdo China's in-flight service.

Last I checked, most flight attendants on Chinese airlines could barely speak English. They would know whether you wanted fish or chicken, if you could stomach either, but couldn't field a question about in-flight movies, if there were any. Compare that to the slick service of Thai Airways, the exquisite professionalism of Singapore Air and the games on board Cebu Pacific Air.

Tens of millions of people depart China every year, usually by air. That figure should reach 82 billion passengers by 2014, a growing slice of 1.26 billion people headed abroad by air worldwide that year, the International Air Transport Association predicts. Someone stands to make money on their business.

Because of high fuel costs, mainstream-versus-budget airline competition and the global economic slump of mid-2008 followed by late 2011, airline equities in most any country are considered a risky investment. But that could change for carriers with strong reputations and equally robust fundamentals. Some have already cleaned up.

To pick shares of airlines that fly internationally to China, try Delta Air Lines, whose stock is little changed over the past year, possibly because U.S. airlines have finally moved on from their hardest economic times.

If stock shopping in Asia, try Singapore Airlines. Travelers rate it one of the most well run and friendliest carriers in the world -- that it doesn't cut routes to save money tells customers that it's working for them long term. The airline's stock has fallen 25% since the world economic problems that hit markets in August. Could be a bargain waiting as shares are trading below book value.

Better yet, go straight to the source, bypassing fuel costs, airport fees and other demons that weigh down the airlines. China's chief supplier, Boeing, sells aircraft to China, like just about anywhere else, and its share prices have stayed roughly constant over the past year. Its rival Airbus has seen its shares grow in value by nearly 19% over the same period.

Boeing says mainland China ordered 583 planes from January 2002 through the end of May this year. Its 20-year demand for 5,000 planes will bring in $600 billion, the company adds. Airbus would not disclose cumulative sales to China over the past decade, but its market share is estimated about equal to Boeing's. And neither manufacturer faces the risk of delayed shipments to the aggressively expanding Chinese carriers.

To use just one more metaphor, consider a gate change before investing in one of China's big three airlines.