China Aviation Oil: Set to Fly?

China Aviation Oil (G92.SI)
Website:
www.caosco.com/

China Aviation Oil (CAO) is a jet fuel supplier and trader. They also supply and trade other oil products such as crude oil. The major shareholders of CAO are China National Aviation Fuel Group Corporation, a Chinese state owned enterprise, and BP plc.

PROS

1.  Barrier to entry
CAO is the sole supplier of imported jet fuel to the civil aviation industry of China.

2.  Key contributor
Associate company Shanghai Pudong International Airport Aviation Fuel Supply Company Ltd (SPIA) is the exclusive supplier of jet fuel at Shanghai Pudong airport, which has the second highest air passenger traffic in China. The airport is undergoing expansion, with a fifth runway and terminal expected to be built by 2018.

 Source: 1Q 2017 Report (SPIA contributed around half of the earnings after tax)

3. Growth driver 1
China aviation industry is set to grow as the number of Chinese middle class increases. They not only travel abroad, they also spend a lot. In 2015, Chinese tourists spent $215 billion:

http://money.cnn.com/2016/03/21/news/economy/china-travel-tourism-record-spending/

 Source: http://knowledge.ckgsb.edu.cn/2017/04/17/airline-industry/china-aviation-industry-becoming-global-force/

The spending power of Chinese tourists can be seen from China's boycott of South Korea recently. With the decrease in Chinese tourists, the tourism sector in South Korea has suffered:

http://www.channelnewsasia.com/news/asiapacific/s-korea-tourist-numbers-plummet-in-china-boycott-8790590

This spending power can translate to increased air travel for overseas holidays.

4. Growth driver 2
The Civil Aviation Administration of China (CAAC) targets to build 74 new civil airports and expand 139 others by 2020, as stated in their 13th Five Year Plan (2016 - 2020).

http://www.chinaaviationdaily.com/news/60/60893.html

5. Benefiting from contango currently
CAO can buy and store jet fuel, then sell it later at a higher price due to the difference in spot price and futures price. This disparity in spot and futures price is called contango. However, contango does not happen all the time. Nonetheless, CAO is able to leverage on this.

 Source: FY2016 Annual report, CEO's message

I did not study finance and found this layman's explanation useful:

https://www.mercatusenergy.com/blog/bid/106289/A-Layman-s-Explanation-of-the-Famous-Crude-Oil-Storage-Trade

6. Expanding worldwide
CAO supplies jet fuel to 43 airports outside of China, including Los Angeles International Airport (LAX), which has the fourth highest air passenger traffic in the world.
https://en.wikipedia.org/wiki/Los_Angeles_International_Airport

Source: FY 2016 Annual report

7. Low capital expenditure
Based on the latest trailing twelve (TTM) month figures, US$1 of capex gives about US$470 of earnings after tax. Past years financials show similarly low capex compared to earnings.

CONS

1. Competition with high speed rail
With the One Belt One Road initiative, there will be more high speed railways constructed. This may result in lesser air passenger traffic for domestic flights or travel within the Asia continent.

2. Low profit margin
In absolute terms, rather low. However, the profit margin has almost doubled from 0.4% in 2012 to 0.7% based on TTM. Return on equity averages around 12%.

3. Low dividend
Dividend payout ratio averages around 20%. Dividend yield is now below 2% with the recent rise in its price.

4.  Scandal in 2003
CAO speculated on the price of oil using options, lost money and did not disclose it in the financial statements. The group has since restructured successfully in 2006, providing proper risk management.

Source: http://www.caosco.com/phoenix.zhtml?c=164043&p=irol-riskmagmt

Details on the scandal here:
https://financetrainingcourse.com/education/2014/04/china-aviation-oil-singapore-corporation-limiteds-jet-fuel-scandal-2005-casestudy/

5. Currency risk
CAO does not hedge foreign currency exposure.

Source: FY 2016 Annual Report

US dollar has been strengthening against Renminbi in the past 2 years.

 USD/CNY chart
Source: https://www.bloomberg.com/quote/USDCNY:CUR

VALUATION

Price at the time of writing this post: $1.70

Price/Earnings (P/E) ratio is 11.5 currently. Earnings per share (EPS) is US$0.104 currently. Given the growth drivers present, if we were to assume 5% of growth, EPS will be about US$0.11

Estimated intrinsic value 1
= P/E ratio x EPS x SGD/USD rate
= 11.5 x 0.11 x 0.7215
= S$1.753

Using the same line of thinking, current Price/Sales (P/S) ratio is 0.8 and current sales or revenue (TTM) is US$13.5 billion. Assuming 5% growth in sales, sales will be around US$14.1 billion. Total number of shares are 866 million.

Sales per share (SPS)
= 14,100 / 866
= 16.278

Estimated intrinsic value 2
= P/S ratio x SPS x SGD/USD rate
= 0.8 x 16.278 x 0.7215
= S$1.805

This valuation is more conservative as the compounded annual growth rate (CAGR) from 2012 to 2016 is around 6.5%, while a growth rate of 5% was assumed.

Vested at $1.62