China Aviation Oil: Flying high

China Aviation Oil is one of the few SGX-listed companies which offers both growth and value.

China is the fastest aviation growth market in the world with Boeing predicting Chinese outbound passenger traffic to grow 3x from 2017-37. But how can one invest in this trend? Buying airline shares can be risky because of fierce competition while Chinese internet travel companies such as Ctrip are trading at lofty valuations. With a trailing 10x P/E, China Aviation Oil offers a safer and cheaper way for me to benefit from China’s high growth aviation industry.

China Aviation Oil has the sole import license for bonded jet fuel for international travel from Chinese airports and is also the largest physical jet fuel supplier and trader in Asia.

Steady cash growth machine

In the last ten years, China Aviation Oil has grown its revenue by 8x. Meanwhile, net profit grew by almost 3x which works to a healthy 10% growth rate. Strong earnings growth has been accompanied by healthy cash flow and a strong balance sheet with the company consistently having more cash than debt. The company’s strong free cash flow has allowed CAO to acquire other oil-related businesses to diversify beyond China. In 2017, revenue from China made up 47% of total revenue compared to 80% in 2010. Return on equity has also been strong and was 12% as of end 2017.

I see three reasons to buy China Aviation Oil.

Firstly, growing Chinese demand for international travel will allow CAO to grow earnings at 10-14% per year. CAO has the sole import license for bonded jet fuel which is used for international travel from Chinese airports. According to a 2018 Bloomberg interview with the CEO of Ctrip, only 120 million people (~10% of the total population) in China currently have passports and that number is expected to double by 2020. The company has a cost plus arrangement for importing jet fuel into China and is the preferred fuel supplier for Chinese airlines in other countries.

Secondly, 60-70% of CAO’s pretax profit is derived from its Shanghai Pudong Airport (SPIA) associate which supplies jet fuel to Shanghai Pudong airport. Pudong airport is the one of the fastest growing international airports in the world and passenger capacity is set to increase 14% to 80 million passengers annually when a new passenger hub is added by 2019. SPIA is the exclusive supplier of jet fuel at Shanghai Pudong airport and owns all the refueling infrastructure at the airport which includes hydrant systems, storage facilities and a dedicated pipeline linking the airport and Waigaoqiao terminal.

Lastly, CAO benefits from a low valuation and is trading at 10x trailing earnings which is similar to its 10 year average. The company’s dividend works out to a 3% trailing dividend yield and has room to grow since it works out to around 30% of earnings.

Risks

CAO is a state-owned entity which could be a problem if the government’s interests is not aligned with minority shareholders. China National Aviation Fuel (CNAF) owns 51% of CAO and grants CAO its jet fuel import license.  CAO is currently importing jet fuel on a low-risk fixed price per barrel basis which could be affected if China introduces a more competitive jet fuel market. However, CNAF owns the jet fuel assets and infrastructure in China’s airports which is a major barrier to entry for new jet fuel importers.

CAO has been fair to minority shareholders. Earnings per share and net profit has been growing at a similar pace over the 2014 to 2017 period. CAO has also changed its dividend policy in 2015 to allow shareholders to benefit from growing earnings by increasing its annual dividend from SGD0.02 per share to an earnings-based dividend. CAO’s current dividend policy involves paying 30% of its annual net profit to shareholders.

Falling oil prices could also hurt CAO since SPIA holds 15 days of inventory. Falling oil prices would result in marked to market losses for SPIA which will affect CAO’s net profit.  In the fourth quarter of 2014, CAO reported a 50% year on year drop in associate results because of impairment provisions on SPIA’s inventory.

Conclusion

Given the above risks, I’m taking a conservative approach to this investment and will start with a small position. With earnings set to grow by 10-14% over the next five years and a 3% trailing dividend yield, CAO should be able to deliver double digit annual returns for my portfolio.