China Aviation Oil - DBS Research 2016-08-30: Proxy to China’s civil aviation growth

China Aviation Oil  - DBS Vickers 2016-08-30: Proxy to China’s civil aviation growth CHINA AVIATION OIL(S) CORP LTD G92.SI

China Aviation Oil - Proxy to China’s civil aviation growth

  • CAO’s management met with our investors in HK recently.
  • Organic growth to be mainly led by burgeoning Chinese civil aviation growth and extension of CAO’s global distribution network for its aviation marketing business.
  • Strong balance sheet to fund M&A opportunities.
  • Reiterate BUY with TP of S$1.70.



Takeaways from investor meetings; reiterate BUY with TP of S$1.70. 

  • We arranged several investor meetings for China Aviation Oil (CAO) over two days in Hong Kong (25 and 26 Aug) and met with ten different funds – most of which were new to the company. 
  • In the following sections, we present some of the key highlights of the management presentation and questions from investors raised during the sessions.


Sole supplier of imported jet fuel in China with growing international presence. 

  • With monopoly on the supply of bonded jet fuel to China’s civil aviation industry, CAO should benefit from the long-term growth of China’s international air travel market. 
  • Furthermore, with the backing of SOE parent China National Aviation Fuel Group (CNAF), CAO has expanded its business to the marketing and supply of jet fuel at 42 international airports outside China, and further growing its reach, volumes, and ultimately greater economies of scale.


Firm outlook for prized asset 33%-owned associate, SPIA. 

  • As the exclusive supplier of jet fuel to Pudong International Airport, Shanghai Pudong International Airport Aviation Fuel Supply Company (SPIA) has and should continue to benefit from rising air traffic at the airport, which is driven by the continued development of Shanghai as China’s key financial centre. 

Net cash and strong balance sheet could fund acquisition-driven growth. 

  • With net cash of c.US$169m at the end of 1H16, and strong support from its parent CNAF, we believe that CAO could be on the lookout for acquisitions to further grow the scale and reach of its business and profits.

Valuation

  • Our TP of S$1.70 is based on 12x FY17F PE. 
  • We think that 12x earnings against the projected 18% EPS CAGR over FY15- FY17F is reasonable, and believe that the group is poised to see a structural re-rating of its valuation multiple on sustained earnings growth, especially if CAO can utilise its strong cash balance to further accelerate growth through M&A.

Key Risks to Our View

  • Weaker demand for air travel and execution risk. 
  • A sustained slowdown in demand for air travel could impact jet fuel demand and volumes. 
  • Further, the group could also face execution risk in its trading business and prospective M&A activities.





Salient points from management presentation:


1. Strong corporate governance and risk management policies. 

  • CAO, post the 2004 trading scandal, in which both BP and Temasek entered as white knights to restructure the company, is very much a risk-aware and prudent entity now especially in terms of its trading activities. In management’s view, the company has adopted the best of risk management and corporate governance policies, and restructuring steps from BP and Temasek (although Temasek has long divested its 4.9% stake while BP still holds 20%). 
  • Ten years on, CAO has developed its own core competencies and expertise in these vital areas independent of its shareholders, winning several accolades in corporate governance and corporate transparency.

2. Burgeoning Chinese civil aviation growth a key driver for CAO. 

  • For its jet fuel import business in China, CAO benefits from the expected long-term growth of China’s outbound international passenger traffic, which is currently growing at a high single-digit pace. 
  • Meanwhile, its key associate, Shanghai Pudong International Airport Aviation Fuel Supply, will benefit from the overall growth at Pudong airport, which is expanding capacity to cater for future growth. 
  • These two segments, by our estimates, account for more than 70% of the company’s earnings, presenting a sustainable growth trajectory for CAO going forward.

3. Extending global distribution network for its aviation marketing business. 

  • Over the last few years, CAO has been growing its global distribution presence, and currently supplies jet fuel to 42 international airports outside of China. The company continues to look for opportunities to gain access to new airport/markets to grow its global presence. 
  • At the same time, CAO is also confident of growing its market share into recently penetrated regions/markets, such as the US – the world’s largest aviation market today, even as it maintains an entrenched positioning in China’s burgeoning aviation market.

4. Trading segment to help augment margins and opportunistic gains. 

  • Meanwhile, CAO’s trading arm will continue to adopt prudent strategies that help to optimise margins for its aviation fuel supply and marketing business. CAO’s increasing scale and volumes should also help to increase economies of scale and enhance margins. 
  • CAO will also continue to look for opportunistic gains from other types of transportation fuel to boost its bottom line. Underpinning the trading business is the company’s over-arching risk policy that 90% of trading must be backed by physicals, and also that CAO does not speculate on oil price movements but enhance profits through supply optimisation. 

5. Strong balance sheet to fund M&A opportunities. 

  • Besides organic growth, CAO is also on the lookout for acquisitions and/or investments to expand its business. This could be in the form of  access/licenses to grow its distribution network, or equity investments in aviation related assets such as airport refuelling/ pipelines/ storage tanks. 



Key questions raised by investors:


Q1: Will BP look to divest its 20% stake in CAO, and how would that impact CAO? 

  • Management is not aware of any plans by BP to divest its 20% stake (although BP has been selling some of its other assets), however they do note that it’s been 10 years since BP came onboard CAO. CAO has since learnt a lot (in terms of risk management etc.) from BP, and over time has also developed its own risk management culture and practices. Hence, even if BP is no longer a strategic investor, it would not impact CAO’s risk management capability. In our view, BP’s divestment could help the liquidity of CAO if placed to the right investors.

Q2: What is the risk that China will reform aviation fuel supply into China and CAO loses its monopoly? 

  • Management is of the view that CAO will not lose its monopoly in the foreseeable future, and that aviation fuel supply would be one of the last to be reformed, if at all. This is because CNAF, CAO’s parent company who accords the perpetual jet fuel import license to CAO, owns all of the refuelling assets and infrastructure at China’s 210 airports, representing a very high barrier of entry and is of national strategic importance. CAO is also CNAF’s only overseas subsidiary to fulfill the role.

Q3: Why doesn’t CAO pay more dividends given its asset- light, highly cash-generative business model? 

  • CAO’s organic capital expenditure (largely spent on trading/risk management IT systems) is not more than US$250k per year, and may be less in some years while its associates are self- funded and provide dividends hence providing annual cash inflow of c. US$60m. Furthermore, working capital needs are generally well funded internally (AR days usually equal to AP days) so only inventory (in contango markets) need to be funded. 
  • Recognising that CAO’s cash coffers have been accumulating over the last few years (which provides the company with M&A appetite), CAO has already moved from paying out annual dividends of 2Scts to a dividend payout of 30% of net profit.



Paul YONG CFA DBS Vickers | Singapore Research Team DBS Vickers | http://www.dbsvickers.com/ 2016-08-30
DBS Vickers SGX Stock Analyst Report BUY Maintain BUY 1.700 Same 1.700


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