Isn’t it just a few days since I wrote a piece on Hock Lian Seng? I must be on fire! Excited about sharing what I have learnt about these new companies I have bought and let these be kicked around for intellectual loopholes. Everyone wins from that and hopefully learn something in the meantime!
This time round, I am writing about this China based company that is listed on SGX and that’s China Aviation Oil. If you are going to sigh and close this browser after hearing the word “China”, please give it a chance and finish reading it. And that’s the world we are in right now, with everyone shunning investments in China. And that’s when bargains appear.
Introduction
China Aviation Oil (Singapore) Corporation Ltd (CAO) was listed on the SGX since 2001. Subsequently the company collapsed due to trading losses from risky oil derivative bets, and its CEO at the time was sentenced to jail. The company underwent restructuring and resumed trading in 2006 and has been profitable every single year since. CAO is the largest fuel jet trader in the Asia Pacific region and a key supplier of imported jet fuel to the civil aviation industry of the People’s Republic of China. Its key shareholder is China National Aviation Fuel Group Limited (“CNAF”), which holds 51.31% of the total issued shares of CAO. CNAF is a state-owned enterprise which we would revisit the implications later in the article.
Along the lines of what I had mentioned before, this would be another one of those names that carry a substantial cash balance that’s not to be ignored. On top of the balance sheet strength, I would be discussing why I think the company is undervalued and focusing on what I believe is a trend towards recovery.
Sum of parts
One of the various valuation methodologies is the sum of parts. Basically, it postulates that a company’s worth can be derived by summing up the value of its individual parts. We are going to look at CAO using this methodology but only at the most significant portions of it. I always like to quote John Maynard Keynes.
'It is better to be roughly right than precisely wrong.'
First, let’s dive straight into the released financial statement for 1H 2023. Do note that at the point of writing, CAO is trading at S$0.94 per share, which is roughly S$814 million in market capitalisation.
Source: 1H 2023 Financial Statements
From the above, you can see a staggering US$534m in cash that is sitting on their balance sheet. One might just take that figure and carry on with that for assumptions. However, if you look at the comparison from 6 months ago, that seems a tad high, along with higher payables and lower inventories. This is when we reference figures from the last few years.
Source: CAO 2022 Annual Report
From the above, I would assume that the average cash balance sits around US$400 million after years of accumulation of profit. That is S$540 million on a 1.35 USDSGD FX rate basis. The company is debt free.
Up till this point, readers might point towards the equity value attributable to shareholders, as presented in the balance sheet at US$905m (S$1,222m equivalent) as a gauge for a valuation buffer to the downside. Reason why I am not using that is because, this figure is significantly understated due to the equity accounting treatment for the companies’ associates. This means that the investment is initially recorded at cost and then subsequently adjusted to reflect the investor’s share of the net assets of the associate. The investment is not fair valued. Out of these associates held by CAO, I would like to highlight the gem of the pack. Shanghai Pudong International Airport Aviation Fuel Supply Co Ltd (“SPIA”). This is marked by the star in the organisation chart as follows.
Source: CAO 2022 Annual Report
In the 2022 Annual Report, SPIA is held at US$174 million on the balance sheet as of 31 December 2022. This massively understates the value of the associate. In fact, I am of the opinion that if the Chinese aviation scene recovers to pre Covid levels, just SPIA alone would be worth at least the current market capitalisation in terms of value. And having such a conviction necessitates support which I hope readers have gotten used to by now.
Source: CAO 2022 Annual Report
As per the description in the Annual Report, the company is the exclusive supplier of jet fuel at Shanghai Pudong International Airport. The exclusivity is a huge advantage for SPIA and allows us to have a glimpse at the correlation between profits and flight volume.
As of time of writing, the information for SPIA as of Dec 2023 is not available yet. Looking at the historical trend, the profit for SPIA is highly correlated to the number of flights going in and out from Shanghai Pudong Airport, and more so for international flights than regional and domestic flights. This makes sense since international flights would use more fuel than the shorter routes. From the above, domestic flights have surpassed 2019 levels with international flights still on the path to recovery. Recent news in China have indicated a very busy travel period during the Lunar New Year holidays.
Assuming a recovery to 2016 volume of international air travel in 2024, we could potentially be looking at earnings of US$60 million attributable to CAO, which is S$81 million. Giving it a 10x P/E ratio would value the SPIA stake at S$810 million, which is roughly where the market capitalisation of CAO is trading at. Would 10x P/E multiple be considered cheap for such a stable, exclusive supplier of jet fuel? I would think it’s a steal!
Source: IATA
The fluctuations in profitability would also depend on the price action of jet fuel as indicated on the screen above. The crash in oil prices in the first half of 2020 contributed to the lowest half year profits during this period. The drop in oil prices damped the recovery in profits for 1H 2023 as well. This is likely the inherent nature of the business of loading up inventory to provide as fuel for aircraft. The chronological order would allow SPIA to reap higher margins if the oil price increases in an orderly manner during said period. Please refer to the next figure for an updated graph of oil prices. The prior one was edited at the point when I started researching into the company.
Source: IATA
My interpretation of the data above is that SPIA’s performance mainly depends on volume. It’s a volume business. The more flights there are, the further those flights go, the more fuel they sell. An increasing or stable fuel price is beneficial to their profitability. Additionally, due to the world trading of oil being largely quoted in US dollars, the company holds its cash mostly in US dollars. This has shielded them from yuan depreciation over the years. And most importantly, SPIA distributes nearly all the money it makes every year to its shareholders. This is partly why CAO has such a huge build up in cash balance.
Dividend expectations
The company has a dividend policy for distributing 30% of profits. If CAO is able to return to its peak profitability of nearly US$100 million a year and assuming US$20 million of interest income from its cash balance to get to a total of US$112 million a year (interest income in 2019 was US$8 million). 30% of that would be roughly S$45 million in dividends a year which is roughly 5.5% dividend yield. Pretty decent and sustainable.
What has piqued my interest is the coincidental article ("China Aviation Oil could see 2023 earnings take off as international, domestic travel demand rises | The Straits Times") over the weekend by Ven Sreenivasan from Straits Times. In it, Ven has mentioned “The Chinese government has directed its listed state-owned enterprises, which include CAO, to return excess capital to major shareholders via higher dividend payouts.”. I didn’t particularly think along this line but after some searching on the internet, there has been word of such actions by the Chinese government, presumably to boost consumption and investments. Again, not factoring in expectations that it would happen, but definitely nice to have!
Conclusion
China Aviation Oil is an attractive investment and forms part of my portfolio while majority of the investing public is probably shunning Chinese names. It has a wide margin of safety, a moat on its crown jewel Shanghai Pudong International Airport Aviation Fuel Supply Co Ltd, visible recovery to China’s incoming and outgoing flights in the first two months of 2024 and a large cash pile earning interest that has not been seen in the past decade of record low interest rates. The asymmetrical return profile is exactly what I look for in an investment. Not to forget that CAO has a gamut of other businesses. Those would probably take much more time to dive into, but at the current price its trading at, it's akin to getting those businesses for free.
Disclaimer: All posts on The Squirrel's Drey are for informational and discussion purposes only. This is not a recommendation to buy or sell securities discussed. Please do your own due diligence before investing.