SINGAPORE (July 23): On July 16, Maurice Obstfeld, chief economist at the International Monetary Fund, warned that the broad global expansion that began roughly two years ago has plateaued and become less balanced. Even US growth is projected to decelerate over the next few years, as the long cyclical recovery runs its course and the effects of temporary fiscal stimulus wane.
According to Obstfeld, the risk of current trade tensions escalating further — with adverse effects on confidence, asset prices and investment — is the greatest near-term threat to global growth. “Global current account imbalances are set to widen, owing to the US’ relatively high demand growth, possibly exacerbating frictions,” he says, repeating the warning that other economists have made. The US has already or will start to impose a series of tariffs on countries and regions such as China, the EU, Japan, Canada and Mexico. It is likely to face retaliatory actions from them.
“Our modelling suggests that if current trade policy threats are realised and business confidence falls as a result, global output could be about 0.5% below current projections by 2020. As the focus of global retaliation, the US finds a relatively high share of its exports taxed in global markets in such a broader trade conflict, and it is therefore especially vulnerable,” Obstfeld says.
Emerging markets have borne the brunt of the selloff in reaction to the tariff wars. Closer home, Singapore’s non-oil domestic exports (NODX) slowed sharply in June as electronics exports continued to contract while non-electronics exports eased their pace of growth. Maybank Kim Eng is holding on to its 3.5% forecast for 2018, but warns that there are risks to the downside in 2H2018. “Recent property measures appear ill timed and overly harsh, coming on the back of a visible growth slowdown and an escalating US-China trade war,” Maybank Kim Eng says.
The Straits Times Index has lost 7.7% year-to-date. The Shanghai Composite Index is down 16% YTD.
The share price of China Aviation Oil (CAO), a company which as at Dec 31, 2017 was in a net-cash position, has fallen a much more severe 25%. Yet, this is a company with a deep economic moat and a competitive advantage that should be relatively unaffected by an unsettling geopolitical environment. Its business model is not likely to be easily replicated by competitors. This moat should be seen as a margin of safety for value investors. Any further selloff could provide an opportunity to gain exposure.
China’s aviation sector to stay stable
The global airline industry group anticipates that 7.8 billion people will travel by air by 2036, CNN says. And China will leapfrog the US to become the largest aviation market in the world by 2022, with rapid expansion of more international routes. CAO is seen as a relatively stable proxy for the Chinese aviation market, given the volatile nature of airline stocks.
The company is the largest physical jet fuel trader in Asia-Pacific, with 47% of sales derived from China in 2017. It supplies jet fuel to over 17 international airports across China, including Beijing Capital International Airport, Shanghai Pudong International Airport, Hongqiao International Airport and Guangzhou Baiyun International Airport. In addition, the company supplies aviation fuel to 48 airports in 20 countries outside of China. CAO is 51%-owned by China National Aviation Fuel Group, a state-owned enterprise (SOE). CNAF is the largest aviation transportation logistics service provider in China; it handles fuel procurement, storage and refuelling for 219 airports in China.
For FY2017, CAO recorded revenue of US$16.3 billion ($22.3 billion), up 39% y-o-y. Of its total revenue, US$10.3 billion was from jet fuel supply and trading volume, and US$6.03 billion was from supply and trading volumes of other oil products. Geographically, China contributed 47.4% to revenue, Singapore 13.6% and Hong Kong 8%, with other regions making up the remainder.
Orders for jet fuel are placed three months ahead of delivery and priced one month ahead prior to delivery. CAO claims to have near-term order visibility and hedges its downside risk before undertaking trades. At least 90% of trading activities are backed by physical demand.
Monopolistic supply the best moat
CAO’s economic moat is in its monopolistic supply of imported jet fuel to China, which is unlikely to be affected, as its major shareholder CNAF is likely to protect CAO’s interest. New local competitors or foreign companies are unlikely to pose a real threat to CAO, owing to CNAF’s SOE status.
A high capital requirement and low returns on capital — profit margins are unattractive in the initial years — are high barriers to entry. Case in point: The profit margin on CAO’s fuel trading activity is on the thin side, a mere 0.24% in the last calendar year. And these margins are sensitive to movements in crude oil prices.
Despite this, CAO is relatively shielded from oil price fluctuation because its supply volume is likely to increase with the continued growth in air traffic in China. Increased connectivity and accessibility are also underpinned by large infrastructure developments. Some 12 of the 48 international airports outside of China to which CAO supplies jet fuel are part of the Belt and Road Initiative economies.
CAO appears to have the financial wherewithal to strengthen its position as Asia’s largest physical jet fuel trader (see Table 1). For FY2017, dividends from associates amounted to US$45.5 million. As a result, CAO was able to report free cash flow of US$20 million.
Its net-cash position as at Dec 31 gives it the headroom to look for accretive acquisitions to expand its global distribution network.
Earlier this month, CAO acquired Navires Aviation (NAL) for US$8 million, giving the Chinese company a foothold in some European airports. NAL has an interest in Aircraft Fuel Supply, a company incorporated in the Netherlands, and holds a concession from the Schiphol Airport Authority to manage the distribution of jet fuel to airlines at Schiphol Airport. NAL also has an established comprehensive jet fuel supply system, with critical supply chain contracts in Europe that enable it to facilitate the sale of jet fuel to local and international airlines at the Schiphol, Frankfurt, Brussels and Stuttgart airports.
Table 2 indicates that the bulk of CAO’s net income — as much as 82% in 2017 — is from its associates. One of them, Shanghai Pudong International Airport Aviation Fuel Supply Co (SPIA), accounted for 90% of associate contribution of US$70.4 million. CAO owns 33% of SPIA.
SPIA is a steady and growing cash cow for the group. It is the exclusive supplier of jet fuel for the second-largest airport in China, Shanghai Pudong International Airport, and it owns and operates all the refuelling services at this airport. SPIA provides jet fuel sale and refuelling services to more than 80 domestic and foreign airlines operating at Shanghai Pudong Airport. SPIA also owns and operates all the refuelling services at Shanghai Pudong Airport. This includes fuel pumps, oil storage and the 42km pipeline connecting the airport to Shanghai Waigaoqiao Port. Shanghai International Airport Co and Sinopec Assets Management Co own 40% and 27% of remaining shares in SPIA respectively.
The exclusive operating licence is almost irrevocable since SPIA claims ownership over all refuelling facilities at the airport. SPIA shares were acquired by CAO in FY2002 for a cash consideration of US$77 million. In the past three years, profit distributed from SPIA was already close to US$180 million. Last year, SPIA provided jet fuel for flights to 273 destinations globally, an increase of 21% y-o-y, while maintaining superior safety standards with zero accident, zero injury and zero contamination. Higher growth is foreseeable, as Pudong Airport’s new satellite terminal is due to commence operations in 1H2019. The airport passenger capacity in 2017 stood at 66 million; it will expand to accommodate 87 million by 2020 with the new terminal.
Operationally, CAO does not need a large capital requirement to fund its core trading activities. Purchases are duly paid, as the average number of days for payables outstanding is only 20. Annual profit-sharing from SPIA provides the bulk of cash inflow every year.
Negative cash flow in 2013 is explained by the piling up of inventory, when the oil price was low, which was also the case in 2016. Despite the huge surge in accounts receivable, only US$5.7 million of gross debt was past 90 days due and it has been duly provided for.
Valuations and dividend
CAO is trading at 10.5 times price-to-earnings ratio and 1.2 times its book value. Its dividend yield currently stands at 3.08% and payout has been fairly consistent in the past years. The dividend payout ratio is around 30% of net profit and the stated dividend policy is growth-based.
Not a blue sky
A key risk is competition in the future. As the Chinese government does not object to opening up China’s aviation fuel supply market, this might remove CAO’s monopoly in aviation fuel trading. In addition, competition from oil majors and the risk of non-renewal on international contracts are significant risk factors. As CAO’s monopoly in bonded jet fuel supply is only restricted to China, it has to engage in open bidding when seeking jet fuel supply contracts from international airlines. In addition, SPIA holds inventories of seven to 15 days, and this inventory value is marked to market. In a declining oil price environment, these factors would impact CAO’s bottom line.
Despite these challenges, CAO’s earnings could prove to be relatively stable as the ill winds of a trade war start to blow.