Over the last month, US-China trade war fears have been hogging the headlines as global stock markets were sent into turmoil. Trade tensions and uncertainties were finally allayed last week, when China’s President Xi Jinping pledged that “China’s doors will not close, but will only open wider.”

In representation of a champion for free trade, Xi promised greater openness of China’s economy which include easing access and raising foreign ownership to its financial sector, lowering of auto tariffs of imported cars, as well as greater enforcement of intellectual property rights protection. The speech was made at the Boao Forum in China, which was also dubbed the “The Davos of Asia” – a high profile summit attended by foreign heads of government and business leaders in Asia.

Yet, despite its status as a formidable economic powerhouse, China’s aviation industry has yet to reach its true potential. According to Ctrip.com, an internet-based travel platform giant in China, only about 120 million or just about 8.5 percent of Chinese citizens own a passport.

The staggeringly underwhelming number of Chinese citizens not owning a passport indicates tremendous growth potential for Chinese air travellers. In this issue, we take a look at yet another aviation-related company listed on our stock market, China Aviation Oil (CAO).

Industry Outlook

CAO is principally engaged in the supply and trading of jet fuel, with a monopoly in China and is largest jet fuel trader in the Asia Pacific region. The company supplies jet fuel to 17 international airports across Mainland China, including major PRC gateways such as Beijing Capital International Airport, Shanghai Pudong (SPIA) and Hongqiao International Airports and Guangzhou Baiyun International Airport.

Backed by state-owned enterprise (SOE) China National Aviation Fuel Group’s (CNAF) majority stake of 51.3 percent, CAO’s position is protected with a huge investment moat. The parent, CNAF, is the largest aviation transportation logistics and services provider in China, providing aviation fuel procurement, storage and transportation, as well as refueling services at 219 airports in the Mainland.

With its extensive and strategic network, CAO stands to benefit from China’s aviation boom. Based on data from Civil Aviation Administration of China, total passenger volume in December 2017 grew at double-digit rate of 13 percent to 551.6 million passengers. Meanwhile, the number of citizens owning a passport is expected to double to 240 million by 2020, indicating that passenger volume is expected to continue growing at rapid double-digit rate.

Further cementing this notion, global aviation body International Air Transport Association estimates that China is set to become the largest aviation market by 2030, displacing the US. By 2036, another 1 billion of new passengers are expected to be added to bring the total passenger volume to almost 1.5 billion passengers!

Financial Performance

Despite a promising outlook for China’s aviation industry, CAO’s FY17 was largely lackluster. For FY17, revenue grew of 39 percent to US$16.3 billion as trading volumes of jet fuel, which grew 8 percent in FY17. However, net profit dipped 4 percent to US$85.3 million, despite solid contributions to the bottom line of US$71.5 million from associates. CAO’s 33-percent stake in SPIA was the main driver amongst associates, contributing US$64.2 million to earnings for the year.

Low gross profit margins have been plaguing CAO’s financial performance. In FY17, gross profit sank 12.1 percent to US$38.7 million from US$44.1 million last year, even though revenue has rocketed. As of the latest FY17, CAO’s gross margin was sitting at just 0.2 percent, suggesting that the company is “compensating” for the growth of Chinese airlines. Given the nature that CAO is an entity of a SOE, this should not come as unusual as it may be part of the Chinese government’s strategy to bolster is airline sector. However, this comes on the expense of shareholder value for CAO.

Potential Price Catalysts

Reforms in the industry to allow more private and foreign ownership could alter the course for CAO, though its monopolistic position would be diminished. This is because in an environment where there is greater degree of private ownership, CAO would be induced to be more profit-driven. For perspective, Thailand-based peer Bangkok Aviation Fuel Services’ achieved a gross margin of 55.2 percent in FY17.

While reform-driven rise in profitability for the jet fuel trader may not be foreseeable in the near-term horizon, CAO is set to benefit from SPIA’s fifth runway that would soon commence operations. In addition, a satellite terminal is expected to be added to SPIA by 2019. These additional capacities would drive air traffic, boosting the contributions from the associate to CAO while at the same time feeding more demand for the company’s jet fuel.

Notwithstanding that, CAO has built up a cash balance of about US$300 million. Net of debt, the company is in a sweet net cash position of US$180 million. The vast financial headroom would allow CAO to gear up and undertake value-accretive acquisitions to boost its bottom line.

Valuation

Currently, shares of CAO is changing hands at $1.62 per piece, translating to a trailing 12-months price-to-earnings (P/E) multiple of just 12.2 times. The company declared dividend of $0.045 per share, representing a decent dividend yield of 2.8 percent. Given that that the company has amassed a record cash pile of US$300 million in FY17 from US$81 million five years ago in FY12, we believe the current dividend payout is sustainable, with potential to increase.

In addition, CAO is also trading at a lower valuation compared to Bangkok Aviation Fuel Services’ P/E multiple of 25.3 times. Going into 1Q18, investors will be looking for any news on potential acquisitions, as well as whether stronger contributions from SPIA materialise. If it does, at the current share price, CAO does not even look slightly demanding.

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