China Aircraft Leasing Company (HKEX:1848)

Please refer to my guide to dividend stocks to understand my approach to this class of stocks. 

China Aircraft Leasing Company (CALC) is an interesting play on the world's largest growing airline market. In the era of the 19th century gold rushes that took place all over the New World, the masses hopped onto the bandwagon and travelled the globe in the hopes of striking gold literally. Few gold miners actually ended up rich, but many more became rich not off gold, but through the selling of shovels, pickaxes, tents and other equipment to miners. 

In a similar vein, the China airline industry has been exploding on the back of rising affluence of the average Chinese; intra and inter country flights have been rising at a very rapid pace. However, airlines operate on volatile margins, subject to the unpredictability of fuel prices. Investment maestros Benjamin Graham and Warren Buffet are prominently known for their aversion towards investing in the aviation sector for these reasons. Likewise, with reference to the business history lesson that we can draw from the 19th century gold rush, we can capitalise on the boom in airline travel by investing into companies that lease planes to airlines, instead investing into airlines stocks itself.

Summary of Investment Thesis

Strengths

1. Large orderbook provides clear profit trajectory
2. Stable and wide profit margins

Weaknesses

1. Highly geared business model- debt-to-equity of 9x
2. Customers are operating in an industry notorious for volatility in profitability

What does CALC do?

CALC is in the businesses of long-term direct aircraft purchase and lease transactions and long-term aircraft sale and leaseback transactions, primarily with leading airline operators in China. Basically, CALC offers aircraft leases to airlines that prefer to lease planes instead of incurring large borrowings on their balance sheet to purchase their own planes. In turn, CALC obtains long term bank borrowings to finance the purchase of these planes. The recurring cash inflows of lease income from its airlines customers are utilised to service CALC's bank borrowings. CALC earns the spread between its bank borrowing costs and that of the lease income. As we will see further on, this is a very lucrative business model. Besides, it also provides airlines with value-adding services, such as trading and re-marketing of used aircraft.

As at June 2018, the company has an aircraft fleet of 115 planes and the bulk of its customers are Chinese airlines. The company has a large backlog of orders for more than 200 planes from Airbus and Boeing that will be delivered in various stages until 2023. This translates into a fleet of over 300 planes by 2023, providing very strong visibility for the company's outlook. It should be pointed out that the company also engages in the sale of its aircraft leases periodically. This essentially means that instead of collecting the lease income stream patiently until the end of the lease tenure, the company opts to sell the lease to institutional investors. The nature of this transaction is complex, but it usually results in the company realizing an upfront profit and return of capital in exchange for the stream of future lease income.

Macroeconomic Analysis

Rise of the world's largest middle class. Air traffic in China has been growing relentlessly as strong GDP growth has translated into robust demand growth for air travel. Even if economic growth slows down in China as the traditional growth drivers of manufacturing and construction sputters, air travel growth is unlikely to slow down. This is because as China transitions from a middle to a high income economy, this will naturally lead to the development of an increasingly complex tertiary (service) sector as well as rising disposable income. An the estimate by McKinsey points to a sizeable upper middle class in China 2022, which has been the driving trend behind this explosive demand for air travel. A combination of rising income levels as well as increasing complexity of the tertiary (service) sector of the economy results in a surge of air travel.

The Civil Aviation Administration of China (CAAC) aims to construct 216 new airports by 2035 to meet the growing demands for air travel. China has a total of 234 civil airports at the end of October 2018, and this number is likely to hit 450 by 2035. China recorded 549 million air passengers and 7.12 million tonnes of air cargo in 2017, a 12.6 and 6.6 percent year-on-year increase respectively. The following chart with data from the CAAC illustrates the strong growth of air traffic in China.

Company Analysis

Major Shareholders

As at June 2018, the largest shareholder was China Everbright Limited (CEL), with a 33.58% stake in the company, followed by the CEO, Mr Poon Ho Man with a 29.69% stake. CEL is part of the Everbright Group, a State-Owned Enterprise (SOE), and is wholly owned by Central Huijin Investment. CEL initially took up a 40% stake in the company in July 2011. Despite having CEL as the largest shareholder, CALC is still regarded as an independent player in the market, unlike the other major players that are explicitly SOE-backed.

Being regarded as an independent has led to higher borrowing costs, as banks have traditionally preferred the relative safety of lending to SOEs. Also, this has led to lower stock valuations compared to its SOE peers. Yet recent measures taken by the central government is expected to be beneficial for CALC, including the directive for banks to ramp up lending to the private sector. This, coupled with various measures to boost banking system liquidity, is expected to lower borrowing costs for CALC.

Business Analysis

CALC's fleet size has been expanding steadily on the back of the rapid explosion of air travel in China. In 2017 and 2018, CALC has accumulated a sizeable backlog of orders, ensuring the strong growth will accelerate in the coming years. Based on the order backlog, CALC is expected to triple its fleet size by 2023, from 2018 levels.

Understanding a leasing company's business model is crucial in analysing the CALC's financial statements. As this company functions in certain ways like a bank, it is important to keep this in mind. Just as a bank would take a deposit while promising a certain deposit interest rate, and then proceed to lend it out at a marked-up interest rate, CALC (as with all leasing companies) operates under a similar model. CALC borrows funds from a bank or the bond market, uses that funds to purchase an aircraft for its customer under a lease agreement, and then receives a stream of lease payments for the tenure of the lease agreement. For 2017, CALC was borrowing at a rate of 4.4% while collecting lease payments with a gross lease yield of 7.9%. The difference of 3.5% is the net lease yield which represents CALC's gross profits.

Essentially, the company's business model relies on incurring large amounts of debt to fund the asset purchases. As a result, CALC is heavily geared, typical of leasing companies and banks. The company's gearing ratio (debt-to-equity ratio) stands above 9.0x, though this has remained stable since its IPO. This indicates that the rapid expansion of CALC's fleet has not increased the financial stress on the company.

The company typically borrows at fixed interest rates, or hedges its floating interest rates loans, thus locking in the margins on its existing leases. However, the company is subject to market interest rates when signing on new loans as the business expands which is a function of market rates and the company's credit profile. This is usually a major determinant in a leasing company's operating margins, as lease yields are controlled and capped by market forces (not unlike housing mortgage rates which typically does not vary much from bank to bank in a particular market due to competition). The company still has leeway in managing the interest rates of its debt, as the company can refinance its bank borrowings when interest rates decline.

The major risk that leasing companies such as CALC faces however, is default by its customers who are typically in financial distress. However, these planes are easily re-sold in the aircraft market given the commoditization of commercial planes, limiting the losses for the lessor should a customer default.

CALC's operating currency is USD as the aircraft purchases, leases terms and debt are denominated in USD terms. As such, CALC is more sensitive to changes in USD bond yields and interest rates such as LIBOR. Although US interest rates have been rising for the last 3 years, the Federal Reserve will not raise rates much further than its current level of 2.50%. As global economic growth is slowing and with rising market expectations of a recession over the next 2 years, we can expect US interest rates to stay flat for the next one year before declining gradually. This bodes well for CALC's debt costs, given the company's heavily leveraged balance sheet. Also, given the recent measures by the central government to encourage banks to lend to the private sector, this will result in lower borrowing costs for CALC.

Financial Analysis

The rapid expansion of CALC's fleet size has translated into an even more rapid growth of its revenue and profits. This trend is expected to be sustained in the coming years given the sizeable order backlog. However, it should be noted that CALC is a recipient of government subsidies, which accounted for a third of CALC's 2017 profits. The subsidies are given as part of the government's initiative to promote the development of China's airline industry. Nevertheless, subsidies peaked in 2016 at HKD 261 million, and have been declining as a percentage of profits since 2015. While accounting for 2/3 of net profit in 2015, subsidies declined to 1/4 of net profit by 2017 and we can expect this figure to become less significant as CALC's underlying revenue and operating profit growth continues to rise rapidly.

Since the company is able to match its recurring lease income against the bank borrowings required to service the asset, this allows the company to lock in its margins at the point of the lease's inception. This has resulted in a remarkably stable and hefty profit margin for CALC, in contrast with the volatile revenue and profit margins of its customers. The chart below shows the extraordinary profit margins of CALC since its IPO. The wider profit margins is assurance that CALC will be able to maintain its profitability even as government subsidies have been falling since 2016. 

As a result of steady overall growth, dividends have been rising steadily over the years. The company has maintained a dividend payout ratio of 55% for the last 3 years. As the company's fleet of planes expand rapidly, we expect revenue to continue growing, and dividends to follow suit.

More importantly, for a dividend stock, we have to analyse the cash flow to assess the company's real capability to pay out dividends. The company's operating cash flow has turned positive since 2016, indicating that the business is generating cash from its day-to-day business. More importantly, the dividends that are being paid out constitute a fraction of operating cash flow, indicating that the company has ample headroom to raise its dividends in the coming years. That does not mean that the company will necessarily do so, since it has committed to a payout ratio of 55%, tying its dividend growth to profits rather than operating cash flow. Nevertheless, we can treat this healthy stream of operating cash flow as a cushion for dividends in the event that the company hits a speed bump in terms of profit growth.

Market Valuation

CALC's valuation are quite attractive, given the sell-down in the Hong Kong market following the outbreak of the US-China trade war in early 2018. Since the commencement of the trade war, CALC has been trading at a PE of 7x only, with a dividend yield of about 8%. Taking into account the strong growth momentum of the business, I expect the dividend yield to rise above 9% in 2019 at current market price of HKD 8.20. 

Conclusion

CALC is an excellent proxy to the rapidly growing China airline industry. Owing to its business model of leasing aircraft at a pre-determined lease yield, this allows CALC to enjoy remarkably wide and stable profit margins. Its rapid revenue and profit growth has translated into rising dividends since 2014, with plenty of headroom for growth in the coming years. The trade war has given markets an excellent opportunity to pick up such a gem at a bargain-basement price.