August 30, 2017 / 1:06 PM / a year ago

UPDATE 1-Chinese airlines face storm of higher costs, falling returns

* Profits crimped by declining passenger yields, rising fuel price

* Air China H1 profit falls 3.8 pct, China Southern down 11.6 pct

* Jefferies says airlines are failing to pass on higher costs (Updates with broader airline sector results, analyst comment)

By Brenda Goh

SHANGHAI, Aug 30 (Reuters) - A potent cocktail of rising costs and falling returns are behind declining first-half core profits at China’s largest airlines, in a sign of the stronger headwinds they face as they compete to expand their route networks.

The state-owned airlines serve the world’s fastest growing air travel market but their margins are being dampened by their aggressive expansion of plane fleets and unhedged positions on fuel which has made them vulnerable to a 28 percent rise in price over the period.

Air China and China Southern Airlines respectively posted a 3.8 percent and 11.6 percent decline in profits. China Eastern Airlines’s profit rose 34.5 percent, but this was boosted by a sale of its air freight unit.

Costs grew significantly, with China Southern saying that its flight operation expenses rose by 30.5 percent while China Eastern’s operating expenses increased by 11.7 percent on a 45 percent jump in its total aircraft fuel costs.

“We forecast pre-exceptional earnings to continue to decline as Chinese airlines struggle to pass through the higher costs,” Jefferies analyst Andrew Lee said in a note.

Shanghai-based Juneyao Airlines, one of China’s largest private carriers, similarly blamed higher fuel costs for its 12 percent fall in first-half net profit.

Yields on international routes in particular declined over the period for the three big airlines.

Apart from capacity expansion, analysts also said cancellation of lucrative routes to South Korea as Beijing pressured South Korea over Seoul’s deployment of a U.S. missile defence system, played a role.

China Eastern’s international passenger yields, excluding the fuel surcharge, fell 1.1 percent while China Southern’s yields on international routes declined 7.5 percent. Air China’s yield on overseas routes dipped 3.2 percent.

Domestic routes fared better in comparison with China Southern experiencing flat yield growth and China Eastern’s rising 1.5 percent.

“We believe that competitive pressure could continue to suppress passenger yield in the second half,” said BOCOM International analyst Geoffrey Cheng in a note about China Southern’s performance.

China Southern said in its report that it was confronted with a variety of “adverse factors,” such as “increasingly severe security situation at home and abroad, acceleration of high-speed railways and increasingly intensified market competition.”

A stronger yuan, however, is helping to support earnings and keeping investors bullish despite the mixed results, analysts say.

The airlines’ Hong Kong-listed shares closed between 3.1 to 5.6 percent higher on Wednesday after the yuan strengthened to breach the psychologically important 6.6 per dollar level for the first time since June 2016. ($1 = 6.5874 Chinese yuan renminbi) (Reporting by Brenda Goh; Editing by Himani Sarkar and Keith Weir)

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