China Aviation Oil — Update 27 February 2017

CAO is the largest physical jet fuel trader in the Asia-Pacific region and the sole supplier of imported jet fuel to the civil aviation industry of China. The company relisted a decade ago and in that time it has internationalised its business; 52.5% of its revenues came from China in 2015, compared to 80% in 2010. It is the second largest provider of fuel to LA International Airport (LAX) after Chevron, and its growth strategy is to expand into other geographies. The group also trades other oil products and owns investments in oil-related businesses such as storage, pipelines and airport refuelling facilities. The Chinese government owns a 51% stake through China National Aviation Fuel Group Corporation (CNAF) and BP owns 20%, leaving 29% in free float.

Strategic direction is encompassed in long-term plans. The current Vision 2020 was launched in 2013 and provides the basis for CAO’s expansive strategy. The company is seeking to become one of the largest transportation fuel providers in the world, leveraging its strong position in Asian jet fuel supply to continue to expand both its product offering and territories served. It is already a global player, has expanded into other transportation fuels, has an integrated supply chain and developed very strong trading and risk management skills.

CAO‘s closest peer comparator is World Fuel Services, which currently trades at a 48% premium to CAO. In our opinion, this is unwarranted given its unique exposure to the fast growing Chinese aviation market. We value the core CAO operations using a DCF given the relative stability offered by being a physical jet fuel supplier as well as trader. Paper trading of oil contracts is limited to 10% of total trade volume, with 90% backed by physical contracts substantially de-risking the activity. The cost plus per barrel nature of the sole source import supply contract to China provides further stability as well as a gross margin premium return compared to normal trading activity. Using our calculated WACC of 10.4% implies a core CAO valuation of US$0.80/share (S$1.12). To value the substantial associates contribution appropriately, we use a simple P/E combined with two DCF valuations of the dividends. This provides a composite value of US$0.64 (S$0.90) per share. Our total DCF-based fair value for CAO is thus US$1.44 (S$2.02) per share. Including higher peer group multiples increases the fair value to US$1.45/share (S$2.04).

CAO is a well-capitalised and cash-generative company. The stability afforded by the associates’ large contributions also acts as a buffer against undue oil market volatility. With a positive net cash inflow in 2016, CAO currently has cash balances of c US$187m. This supports the expansionary strategy based on organic growth and M&A. As CAO grows its international standing, augmenting the rapid growth likely to be driven by Chinese air transport, returns should be enhanced further. Management’s commitment to a 30% payout ratio from 2015, as opposed to the fixed dividend previously, is increasing shareholder returns, with a 50% dividend rise in FY16. This is especially true if the company can secure resilient and progressive growth, as per its Vision 2020 strategy.

Given price fluctuations for oil products, the volatile nature of fuel supply markets and the inherent risks in trading activities, albeit well managed utilising sophisticated strategies, the consistent achievement of growth expectations in any territory is challenging. However, the ability of a shift in government policies to interfere and disrupt markets is very real.

China Aviation Oil (Singapore) Corporation (CAO) was incorporated on 26 May 1993 and was floated on the main board of the Singapore Stock Exchange in 2001. Its shares were suspended from trading in 2004 and relisted in 2006 after a significant restructuring. The company has two major shareholders: China National Aviation Fuel Group Corporation (CNAF) owns 51% of the company and the oil major BP owns just over 20% (see Exhibit 1). CNAF is state owned and is the largest provider of aviation transportation logistics services in China. CAO’s chairman is always a member of the CNAF board.

CAO is the largest physical trader of jet fuel in Asia and has the sole import licence for bonded jet fuel into China. It has two divisions, as shown in Exhibit 2: Middle Distillates and Other Oil Products.

Middle Distillates generated 78% of the group’s revenue in FY15. It supplies bonded jet fuel for international travel at all international airports across China, including the major gateways to the country: Beijing Capital International Airport, Shanghai Pudong, Hongqiao International Airport and Guangzhou Baiyun International Airport. It also supplies jet fuel to airlines at 43 international airports outside mainland China. Most notably, in FY14 CAO successfully penetrated the Los Angeles Airport (LAX) fuel consortium, and in FY15 exported jet fuel from China to the US for the first time. LAX was the seventh busiest airport in the world in 2015. The division’s volume was split 70:30 in FY15 between China and international supply. Notably, CAO doubled the volume of jet fuel it supplies to non-Chinese carriers. The Aviation Marketing arm of the Middle Distillates division is effectively an enabler. It is trying to grow CAO’s global presence by identifying new market opportunities and establishing co-operation agreements with strategic partners.

Other Oil Products is the much smaller of the two divisions, generating 22% of group revenue in FY15. It was established in 2008 with petrochemicals to diversify CAO’s product offering. The petrochemical offering has been withdrawn and its current offering is gas oil, fuel oil and aviation gas (avgas). Historically, it has been a small percentage of traded volumes, but as of Q316 Other Oil Products was 44% of the group’s total volume supplied and traded. However, market conditions have negatively affected the profitability of this business since FY14. Aviation gas (avgas) is used in small piston engine-powered aircraft. Worldwide avgas volumes are low, because although avgas-fuelled aircraft outnumber jet-fuelled aircraft, they are much smaller and make shorter flights. However, in 2015 CAO increased its volume of avgas supplied, due to expanding its business into India, Indonesia and Saudi Arabia. Fuel oil is used in the maritime market, while gas oil (essentially diesel) is used in the commercial and agricultural sector for equipment such as cranes, bulldozers, tractors and combine harvesters as well as automotive markets, especially in Indonesia.

CAO has five associate companies, as shown in Exhibit 3. In FY16 the associates represented 68% of group operating profit, of which Shanghai Pudong International Airport Aviation Fuel Supply Company (SPIA) contributed 91%. SPIA is the fastest growing major international airport in the world and passenger capacity is set to increase when the fifth runway is completed at the end of 2017, and a new passenger hub is added by 2019.

Over the past decade, CAO has undergone an impressive transformation. In 2004 it reported estimated losses of c US$550m caused by the then CEO, Chen Jiulin, speculatively trading oil derivatives. After a total corporate restructuring, which saw BP become a strategic investor, CAO is now established as the largest physical supplier of jet fuel in Asia, with an enviably exclusive position in China. Vision 2020 (launched in 2013) elucidates the current management’s strategy to globalise CAO while continuing to exploit forecast aviation growth in Asia, in order to be “a constantly innovating global top-tier integrated transportation fuels provider”.

CAO benefits from cost-plus pricing for the bonded jet fuel it supplies to China. This means it has the opportunity to improve its margin through its trading strategy. CAO trades higher volumes when the market is in contango (spot price is lower than the forward price). During periods of backwardation (spot price is higher than the forward price) orders are procured as close to when they are needed as possible. Crucially, 90% of volumes traded must be backed by physical orders from customers, so CAO is a supplier, not so much a trader of jet fuel. The price for jet fuel supplied outside China is fixed with the customer one month before delivery so whilst the oil price impacts revenues, the margin is well protected (see Exhibit 5).

The competitive dynamic in the jet fuel industry varies across the globe and CAO is in an ideal position to exploit the current landscape. China is a closed market where CAO has the sole import licence. This situation does not look likely to change in the near future; we discuss this further in the sensitivities section on page 9. Singapore is a partially closed market where a company has to be a member of the jet fuel consortium CAHFI. Europe is a partially open market because it does not produce enough jet fuel to fulfil its own demand and the US is an entirely open market. CAO has a myriad of competitors across the globe (although none in China), which range from big oil majors such as Chevron to small specialist oil traders.

The management team is experienced in the Chinese Oil market and has benefited from the involvement of BP since 2006. Meng Fanqiu has been CEO for the past 10 years and previously worked for CNAF and CAAC. He has been on board throughout CAO’s restructuring and has been the driving force behind internationalising the business. Jean Teo, the chief operating officer, previously worked for BP Singapore, during which time she was seconded to the position of head of trading at CAO. She is now a full CAO employee and is responsible for developing and executing trading strategies.

Aerospace is widely acknowledged to be an industry in a period of structural growth. International travel from China is increasing four times faster than the global average, so CAO is exposed to a sweet spot in the market. The International Civil Aviation Organisation (ICAO) estimates that revenue passenger kilometres (RPKs, the number of revenue-paying passengers x distance flown) grew at an average of 6.1% over the past five years and at 7.1% in 2015, as shown in Exhibit 6. Asia-Pacific is forecast to lead world passenger traffic growth over the next 10 years, at an average rate of 6.1%, compared to global growth of 5.0%. By 2035, half of the top 20 traffic flows will involve Asia-Pacific.

Chinese air travel grew 15% in 2015. The domestic Chinese market is triple the size of the international Chinese market, but international travel is growing much faster. It grew at an average of 16% in 2014, 25% in 2015 and 32% in 2016 (Exhibit 7). CAO has exposure to Chinese domestic travel through its investment in SPIA, which refuels all aircraft, but its exclusive refuelling rights are for the fast-growing Chinese international market. We estimate RPK growth of 10% in 2017 and 2018, implying a traffic multiplier of 1.54x GDP growth of 6.5% (last five years’ average 1.83x). This drives our revenue forecasts for CAO. CAO is therefore exposed to an end-market with very strong prospects and can be seen as a proxy for growth in international travel to and from China.

The middle classes in Asia are expected to double to over 2.5 billion people over the next 20 years. Chinese middle class households already exceed the number in the US and will be more than double by 2024, according to Oxford Economics.

While an individual’s propensity to travel is driven at the most fundamental level by wealth, it is clear that the Chinese government is the force propelling growth in China’s aviation industry. The 12th Five-Year Plan published in 2010 listed aviation as “one of seven major strategic industries”. Public investment in aerospace over those years totalled US$230bn, a 50% increase over the comparable period in the previous five-year plan, and 10 times as much as the US Federal Aviation Administration’s budget for capital improvements and airport construction during the same period.

China’s “One Belt, One Road” initiative introduced in the 13th Five-Year plan is intended to improve links between China, East Asia and Europe by building infrastructure and developing trade ties. Countries on the ‘belt and road’ have become the focus of international route expansion by Chinese airlines, which are increasingly competing with international airlines. This is an unusually outward-looking initiative by the Chinese government and is supportive of CAO’s globalisation strategy. The ASEAN–China Air Transport Agreement of 2010 has been a significant driver in increasing the number of routes in the region. In 2009 there were 78 airport pairs, but in 2014 the figure had doubled to 156. Airbus’s 2016 Global Market Forecast states that 13,239 new aircraft will be delivered to Asia over the next 20 years. 32% of these will replace the existing fleet, but 68% will create new capacity.

We believe there are two issues that mean CAO’s volumes will grow slightly slower than RPKs:

CAO’s development strategy, known as Vision 2020 (see Exhibit 5 on page 6), makes it clear that CAO sees itself developing hand in hand with the Chinese government’s “One Belt, One Road” policy. It wants to benefit from development of not only airports, but also roads, railways and ports by increasing its supply locations and volumes, to become a “global top tier integrated fuel supplier”. CAO has a strong net cash position and we therefore expect the group to pursue acquiring assets, which are synergistic to its jet fuel supply and trading business.

We expect the Aviation Marketing business to expand into more airports outside mainland China and Other Oil Products to continue to pursue its diversification strategy, particularly in building structural advantages for its fuel oil business.

The current management team has successfully diversified CAO’s geographic customer base. In FY10, 80% of revenues came from China compared to 52.5% in FY15 (see Exhibit 9). However, only 12.3% of revenues came from outside Asia in FY15 (6% from the US in FY15, 2.8% from Europe and 3.5% from Australia), so there should be the potential to grow international revenues.

Longer term, we see an opportunity for CAO in alternative sources of jet fuel. China is the focus for efforts by Boeing (in partnership with the Chinese government) to extract fuel from more efficient biological sources. It has been successfully proved that algae produce hydrocarbons, which can be converted to a form of oil. However, the trick is growing algae and harvesting their oil at a large enough scale and a low enough cost to be a plausible substitute for regular petroleum. Boeing has calculated that you would need algae facilities the size of Belgium and an oil price of $90/barrel to make algae-based fuel economical once production techniques are improved. As a part state-owned company, CAO is likely to be at the forefront of any green fuel developments.

CAO is a very different company from 2004, when the CEO’s poor trading strategy nearly bankrupted the business. The current CEO, Mr Meng Fanqiu has been in the post for almost 10 years and has a background in the Chinese civil aviation industry. He has worked extremely closely with executives from BP, who came on board in 2005. BP was one of CAO’s biggest creditors in 2004, was owed $32m for fuel supplies and had a vested interest in righting the company. BP has two members on the nine-person CAO board, and for the past decade CAO’s head of trading and head of risk management have both been secondees from BP. CAO’s sophisticated risk management policy has been devised by BP. It is detailed in the Annual Report and in this risk management presentation.

A new chairman, Dr Xi Zhengping was appointed in February 2017, replacing Mr Lin Wanli, who had been in place for two years as part of standard rotation at Chinese state owned enterprises (SOs). CAO’s non-executive chairman is always a director from its parent company, CNAF. The Annual General Meeting on 18 April will be Dr Zhengping’s first opportunity to address the investment community.

Investors should be aware of several issues that could influence the performance of the company and the share price. Most are high level, but some relate to the nature of the business, although management has adopted a rigorous risk management regime since the derivatives speculation scandal that damaged the company over a decade ago.

While CAO is quoted in Singapore, exposure to the Chinese air transport market presents both an opportunity and a risk for investors. The opportunity is the rapid growth of air travel, but the potential for disruption to performance due to policy changes in China must be considered. Today the opportunity would appear to far outweigh the risk, despite the relatively restricted free float.

CAO has few direct peers as competition often comes from much larger international oil companies, banks and more general commodity traders. The closest comparison is with World Fuel Services, which currently trades at a near 58% premium to CAO. In our opinion, this is unwarranted given the latter’s unique exposure to the fast growing Chinese aviation market. However, the core CAO operations can be valued on a DCF basis given the relative stability provided by being a physical jet fuel supplier as well as a trader. The paper trading of oil contracts is limited to 10% of total trade volume, with 90% backed by physical contracts substantially de-risking the activity. In addition, the cost plus per barrel nature of the sole source import supply contract to China provides further stability as well as a gross margin premium return compared to normal trading activity. Using our calculated WACC of 10.4% implies a core CAO valuation (including US$187m FY16 year-end net cash) of US$0.80 (S$1.12), to which must be added a value for the associates and joint ventures.

With 68% of operating profit and >100% of operating cash flow in FY16 generated by the five associate and joint venture entities these must be valued appropriately. Applying net income at the group FY17 P/E multiple of 9.2x is conservative in our view given peer multiples and growth rates. Thus we consider two cash-based valuations of the dividend stream to provide a composite value, which currently stands at US$0.64 (S$0.90) per share. Our total DCF-based estimate of fair value for CAO overall is thus currently US$1.44 (S$2.02) per share, a modest premium to the current share price.

The average of our various peer and cash based valuations methodologies is US$1.45 (S$2.04) per share, suggesting continued potential for the shares despite the performance in 2016.

The direct peer group for CAO is quite limited as comparators tend to be parts of large international oil companies or banks, or larger more general commodity trading houses, both quoted or unquoted. World Fuel Services in the US is probably the closest match and currently trades on a 13.6x FY17e P/E multiple. CAO currently trades on 9.2x Edison FY17e EPS (9.7x consensus). While some of the disparity to peers might be justified by global scale, we would suggest the exposure to Chinese growth warrants a closure of the relative rating.

We have also compared CAO to an air transport peer group including Chinese airports, as well as Asian airlines and comparable oil supply companies. Overall these trade on an FY17e P/E of 14.1x, which again suggests some potential for CAO investors

As we expect CAO’s wholly owned trading and supply activity to continue to grow for many years to come, we use our capped DCF methodology. This values cash flows in the longer term as a perpetuity, rather than allowing for any growth in the terminal value. NPV is calculated at a WACC of 10.4%, which is a modest premium to a weighted Chinese and Singapore country WACC, to reflect the reliance on the Chinese aviation market, especially for valuing the associate.

The valuation is dominated by the input for the associates that provide a large proportion of annual cash flow. With the dividend likely to grow over time, we see three valuation methods as appropriate.

Adding these to the core enterprise DCF value and the current net cash balances implies a valuation per CAO share of (a) US$1.44 (S$2.03), (b) US$1.36 (S$1.91) and (c) US$1.50 (S$2.11). Taking an average of these gives a value of US$1.44 (S$2.01) per share, which also suggests an opportunity for investors. The sensitivity of the calculation to differing WACC and terminal growth assumptions is reflected in Exhibit 10 below.

Revenues are generated principally by the supply and trading activities of CAO. Split between two divisions, Middle Distillates (primarily jet fuel) and Other Oil Products, the revenue performance has fluctuated dramatically with the oil product prices in recent years. Oil volumes have continued to grow significantly since 2010, with growth in jet fuel supply both to China and international markets contributing to increased volumes. The growth of activity in other oil products has also grown strongly from a standing start in 2008, with a very strong rise in FY16 as the company extended its supply of crude oil to China and of fuel oil to the Middle East

Revenues suffered from the sharp fall in fuel prices seen in 2015, which affected both jet fuel and other oil products. The pace of reduction slowed on average in 2016 and spot prices have stabilised into 2017. Gross margin for the Middle Distillates area has remained relatively robust through this decade, with the cost plus a fixed contribution per barrel for oil supplied into China acting as both an enhancement and a stabilising influence. The activity’s gross margin has ranged from 0.24% in 2014 to 0.58% in 2010. The gross margin in FY16 was 0.54% (FY15 0.53%). Low gross margins are typical of this kind of trading activity. The Other Oil Products area has been more variable, but since suspension of petrochemical operations in 2015 a move into the black appears sustainable, given the increased scale of the activity. It produced a modest positive margin of 0.06% in FY16, having generated losses in the previous two years.

The development of the two main associates is a reflection of the growth experienced by airports in China which they serve. This is reflected in the growth in passenger numbers travelling through the airport, which provide a proxy for fuel demand, although the fall in global jet fuel prices clearly influences revenue. Whilst SPIA transacts in US dollars, it pays its dividend to CAO in renminbi in the second half of the following year and therefore the devaluation of the renminbi affects translation of performance into US dollars, CAO’s accounting currency.

As Exhibit 15 shows, Shanghai Pudong International has been one of the fastest growing airports in the world and this is set to continue with the addition of a fifth runway due to become operational this year. CAO’s exposure through its 33% stake in SPIA looks set to grow rapidly. TSN PEKCL, which operates the pipeline servicing Beijing Capital and Tianjin Binhai also appears to be strongly underpinned by the development of air traffic at these hubs.

Cash flow generation for the group remains strong with a robust operational performance for the past decade, excepting 2013. Very low capital expenditure requirements and the strong stream of associates’ dividends have seen net cash develop strongly through the last decade. The company currently carries $100m of short-term debt. Gross cash at the end of FY16 was US$287m.

While we have adopted a cautious stance towards operational cash development, this may prove to be conservative given the historic performance. Nevertheless, the strength of the balance sheet supports both the expansionary ambition of the group, together with the now established progressive dividend policy for shareholders.