Reflections on Ratios for China Southern Airlines

Sales:

The first thing I looked at with China Southern Air (CSA) was what is happening with sales. Sales have been steadily increasing over the past 4 years. To me, this means that customer numbers are growing, more airfares, more cargo and freight are being sold…and are expected to be increasing. So, it makes me curious if sales are increasing, why is net profit decreasing? Net profit after tax was steadily increasing from 2015 to 2017, then there was a dramatic dip in profits in 2018, from $6,898 mill RMBs to $3,364 mill RMBs. What happened to cause this drop? What else affects profits besides sales? My immediate assumption was an increase in expenses, but what expenses and why?

Profit Margin:

I didn’t really understand what profit margin meant or what a good measure is supposed to be. So, I did a quick Google search and found that it tells you how well a firm uses its income. In a nutshell, profit margin shows how much profit is generated per each dollar of sales. A high profit margin is considered to 20%, or 20cents of profit is made from each dollar of sales, 10% is about average or ‘good’ and 5% is low. CSA has a terrible profit margin over the past 4 years but, currently it is the worst. In 2015 at a rate of 4.3%, CSA slowly increased its margin in 2016 at 5.1% and 5.4% in 2017. However, something triggered a dramatic drop in 2018 to create a profit margin of just 2.3%. Yes, last year they were only making 2.3cents of profit to each dollar of sales. Why??? Again, I began thinking about the cost of operations, expensive new planes, increasing fuel prices and load factors from passengers and cargo. Looking at the financial statements revealed so many factors that potentially could be influential.

NOA and ATO:

I then chose to see what’s happening with assets. CSA has progressively increased NOA over the past 4 years. The most recent increase occurred recently from $168,478 mill in 2017 to $192,005 mill 2018. The total asset turnover ratio is high, holding steady at 0.6 over the past 4 years. Their current asset turnover is even higher, from 8 in 2015 and 2016, slowly declining from 7 in 2017 to 6 in 2018. ATO has ratios from 77% - 80%, I interpret this to mean the company is good at generating sales from its assets, or in other words, use their assets very efficiently. But what does that mean in terms of profitability?

RNOA:

The return on net operating assets (RNOA) reveals very low percentages, which doesn’t look good for efficiency. Rising from 4.3% 2015 to 4.9% 2016 to 5.3% 2017 and then another dramatic drop in 2018 to just 3.1%.  I will need to compare other ratios in the airline industry to see if this is normal or not. If anyone reading this has an airline, please leave your comparisons in the comments or feel free to contact me via email. There is no doubt in my mind that assets are a major factor of the economic and business drivers for CSA, but I also know that there is more to the story.

KCQ's Chapters 5 & 6

KCQ’s Chapter 5 - Predicting the Future

Of course, it’s difficult to predict the future. I wouldn’t pay someone to look into a crystal ball or read my hand and rely on their predictions. However, I believe in patterns and that they can give us a valid insight into the future. That’s what I think of when I research the economic drivers of my firm. Patterns of behaviour within the firm and the industry, patterns from their competitors and business in general, political, environmental, social and technological factors, all combine to paint the future picture. I think that would be more accurate than predicting what someone might pay for an equity investment in the future.

I think there is some merit in comparables, but I’m not sure the market value of a firm’s assets really tells us much about how they add value or their future performance. Industry wise, it would be useful to compare similar firms, conducting similar operations.

It’s starting to sink in that the equity economic profit requires forecasting Return on equity (ROE), the required rate of return on equity (P_ϵ ) and book value of ordinary shareholders equity (BV), to form parts of the abnormal earnings equation or expected value creation. This is the first time I’ve noticed the mention of a firm’s enterprise economic profit and I’m wondering what the perceived similarities of return on net operating assets (RNOA), the required rate of return on a firm’s operations (WACC) and the book value of Net operating assets (NOA). Economic Profit = (RNOA – WACC) x BV. Could it be possible to understand how a firm creates value by revealing what is happening with it’s operating assets? Is this a better way to predict a firm’s future than comparing with other firms and focusing on share prices?

It makes sense to incorporate changes into calculating the expectations for future, since changes in NOA affects the free cash flow, FCF = OI - ∆NOA. So, it flows that forecasting FCF means forecasting OI, NOA and WACC. I can see the relationships between PM, ATO and sales growth and the effects on OI which also impacts FCF. I can also see the relationship with forecasting NFO and equity economic profit, due to the firm’s ability to fund future operations and invest in profit making assets, but I at this point I don’t understand why we won’t need to for enterprise economic profit.

I am beginning to understand the real economic drivers of my firm and how they affect decisions about assets and operations. It will be difficult to be specific and find solid connections between the qualitative and quantitative data. It will be so satisfying when I am able to do this for real.

Forecasting RNOA

It’s interesting to note that we will not need to forecast the leverage aspect of ROE. It’s also kind of a relief because of the difficulties involved already in identifying the economic and business drivers. I am forming judgements on these drivers for my firm and trying to connect them to the accounting drivers. The main ideas surround the assets and their efficiency, which relates to RNOA. I will have to carefully dissect these ideas to make an educated forecast.

Accounts are Passengers

It makes sense that the accounts are merely passengers, the business is the vehicle and the board of directors, CEO, shareholders and other relevant stakeholders are the drivers. Some of these are at the wheel, steering the business, others are influencing the direction. I think it’s important to know who’s driving and what’s influencing to forecast with a degree of accuracy. I’m curious to unearth how this firm adds value and where it’s revealed in the accounts. I aspire to acquire the skills to analyse the financial statements with above average future predictions.

Economic and business Drivers

I like the idea of creating art with my analysis. I hope to make it something beautiful, something constructive and worthwhile. Change is inevitable but I believe we can make accurate predictions. Turning the perceived qualitative drivers into qualitative data will be a challenge. I think the best way to face this challenge will be to throw out some ideas on my blog, Facebook and the forums and entice some discussion. The areas of interest will be thoughts on future airline sales, changes with the implementation of innovations and what might influence ATO.  How will others be quantifying their drivers?

Accounting Drivers of NOA

So easy to forget as I did in class, so as a reminder again:

Economic profit = [RNOA_t - (WACC-1)] x NOA_t-1

The greater the economic profit, the more value the firm is adding. To dissect it even further, we can examine the effect sales has on NOA.

∆NOA   =  ∆ (Sales x  1/ATO)

So, the drivers of the BV of NOA are changes in sales and changes in NOA needed to make sales!!! It will be our mission to find these drivers. It makes sense that operating assets are needed to make sales, so we need to predict changes in order to make forecasts.

We need to be mindful that sales growth does not always mean value creation. Changes that reduce ATO will increase NOA but reduce RNOA will negatively affect economic profit. I suspect this the case with airlines. It will be interesting to pinpoint value erosion. I hope to apply my marketing skills in this area. One of the things I’ve learned about marketing and strategy is to know the competition. Predicting the future better means gaining a competitive edge. My firm intends to focus on brand building, so I am wondering how they will do this and how much are they spending.

Economic and Business Drivers of NOA

I feel the main barrier in identifying the economic and business drivers of my firm is wading through the barrage of information, as it is overwhelming and time consuming. How can we narrow down the most relevant stuff? What is the most relevant economic and industry data and where can I find it? It would be impractical to actually visit China Southern Air or even take a flight, so I began discussing things with my Chinese college, Chen for a cultural insight. I’m sure as I discover more, the discussion points will continue and the picture will begin to develop, much like a fog lifting. Discussion seems to be key in this ‘fishing expedition’ and using multiple platforms is like ‘netting’ for answers.

Forecasting NOA

What is likely to affect sales and ATO? What would those things look like as an accounting driver? We need to focus on sales growth and how much NOA is necessary to support that growth. The main revenue stream for China Southern Air is air traffic sales for passengers, cargo and freight. To understand sales, I’m thinking I need to understand the customer. Who is flying with this airline and why? What is the target market? There are many questions surrounding the sales and ATO relationship and while I can’t expect to find all the answers, I hope to collect enough to make an intelligent, convincing assessment.

KCQ’s Chapter 6 – Focus on the Enterprise

The enterprise is the firm’s operations, their business activities, things that add value without the concern of finance. I think this is a great way to clear some junk clouding the realities of the business, so we can focus where is the value of the enterprise. It makes sense to use the DCF because lack of cash is the only way a business dies and also, the economic profit because investors are looking for value for cash. An investor is also interested in risks, educated risks, credible and intelligent risks, which is why it makes sense to focus on risks of operations and not changes in the cost of capital. Price to book ratio is new to me, and it’s interesting to see leverage being discussed as the relationship between company leverage and enterprise leverage and non-leverage. At this stage it is a bit confusing.

Economic Profit Framework

It seems weird that abnormal earnings and forecasted abnormal earnings could be expected to be zero??? It does make sense that the accuracy of financial statements is dependent on errors, availability of information, changes in accounting practices and bias. Profit is not a fact, it is a construct and can be manipulated. I understand the measure of some assets and liabilities would be closer to the true market value, as they are subject to greater scrutiny. So, it does make sense not to include net assets in abnormal earnings due to the zero value contribution.

Different Abnormal Earnings Measures

This only gets weirder and weirder…It might take some time to wrap my head around abnormal earnings. I find this area in particular, very confusing. In a nutshell, the present value of abnormal OI replaces the present value of abnormal earnings on equity and financing by equity or debt can be eliminated.

These are the important formulas:

Abnormal OI_t = [RNOA_t – (WACC-1)] x NOA_t-1

RNOA_t = OI_t//NOA_t-1

Where the drivers of Abnormal OI are:

• Return on net operating assets (RNOA)

• Cost of capital for operations (WACC-1)

• Net operating assets (NOA) put in place to earn the RNOA

I have not studied business finance and as such, find this area complicated. I do notice that the market value is prominent, could this give rise to the connection to the external influencing values rather than internal accounting values? Is that a more realistic measure of value?

Cost of Capital Interact

I like that we’re given an illustrated example using Ryman Health. We know that it has superior abnormal earnings and can compare that as a benchmark for our nominated company. Formula wise, I see that ρ_D or ρ_E refers to the WACC, weighted average cost of capital for operations. This is important to be able to quantify the cost of capital driven by debt or equity which reflect the inherent risks of operations. Therefore, there is an interaction between the capital markets, risks of operations and the required rate of return on investment by investors (based on the capital they have and the risks of alternative investments).

Ρ_E = WACC + V_O^D /V_O^E(WACC – ρ_D)

Where equity risk and the cost of capital comprise of:

1.      Operational risk (WACC) and

2.      Financial risk, comprising leverage (V_O^D/ V_O^E) and spread (WACC – ρ_D)

The example shows that as leverage increases, the required rate of return increases. I can see further relationships with ROE and RNOA if NBC is positive and is unchanged with leverage. I also noticed if a firm is financed by debt or equity has an affect on the cost of capital and the accounting return. Increasing ROE will increase the value of a firm but increasing p_E will reduce the value of a firm. Can it really be true that under certain circumstances there is no ability for a firm to add value for investors through it’s financing activities? If this is true, then China Southern Air is not adding value to its equity investors through the generous capital injections by the Chinese government. I find that very interesting.

‘Good’ and ‘Bad’ Earnings Growth

It seems amazing that abnormal OI will remain unchanged from changes in the financial gearing but, will change the price to book ratio. What does that mean for the equity investor? Is it a good thing or a bad thing? This all seems complicated and beyond my comprehension. This is where experience comes into play and we go with flow until we have that experience. I know from experience that the accounts can be manipulated, which does not mean they are not useful, we just need to be wary. Same goes with earnings growth, some adds value to the equity investor, and some does not. We need to be wary of earnings growth created by financial leverage, investments and changes in accounting practices. Good earnings growth adds value. When I was thinking changes in accounting practices, I thought of depreciation and revaluations but, now I am also looking at provisions. Provisions are just an accounting construct, they are not real. These are the imitators of earnings and we need to be aware of their affects.  

Levered and Unlevered Ratios

This is also a fresh new area beyond my experience and to comprehend might take years of experience. However, I can appreciate that P/B ratio is influenced by the extent to which the book value of a firm’s Net operating assets (NOA) diverge from their market value and the level of a firm’s leverage. I guess the key take out is that levered ratios relate to the company and unlevered ratios to the enterprise. Although our focus needs to be on the enterprise, we need to be aware of the relationships between the company and the effect it has on abnormal earnings.

Conclusion

The simplified economic framework:

V_O^E = BV of Equity + PV of Abnormal OI

The firm’s operational risk is WACC and the financial risk comprises of leverage (V_O^D/V_O^E) and  spread (WACC – p_D).

Be wary of manufactured growth by changes in financial leverage, poor investments and changes in accounting practices.

The financial media refers to levered ratios, company ratios and we need to focus on unlevered ratios, enterprise ratios to gain a real perspective for equity investment. By focusing on the firms’ operations (enterprise) rather than equity (the company) we can see what activities are adding value to equity investors and which are not.

Be wary of simplification that is does not overlook something of significance.

“Exercise caution, for I have advised many people” – George Carmen