Asian Insights SparX – Aviation Aircraft Leasing Refer to important disclosures at the end of this report DBS Group Research . Equity 10 February 2017 HSI : 23,575 Asian Lessors in the Ascendancy Asian lessors have, notably via acquisitions, muscled Analyst • Paul YONG CFA +65 6682 3712 in amongst the top players globally in recent years [email protected] [email protected] With 3 players now listed in HK and a myriad of Singapore Research Team Asian names linked with potential deals in this • space, the sector should continue to garner interest Backed by firm long-term secular growth in air passenger travel globally, we are positive on the prospects of aircraft leasing, which provides better • returns and earnings visibility compared to airlines Our top pick is BOC Aviation (BUY, TP HK$48.40) and we initiate coverage on China Aircraft Leasing Stocks • (CALC) with a BUY call and HK$11.60 TP Mkt 12-mth Price Cap Target Performance (%) Price 3 mth 12 mth Stable cash flows and returns attract Asian investors. HK$ US$m HK$ Rating Faced with lower growth and returns in other assets, and BOC Aviation 41.30 3,632 48.40 (2.6) NA BUY helped by cheaper cost of debt funding, we believe Asian CALCChina 9.23 733 11.60 (3.5) 61.9 BUY investors of all types – banks, insurance companies and even CDB Financial Leas 1.94 3,129 2.01* 0.0 NA NR family funds, are looking towards aircraft leasing assets to provide stable and predictable cash flows and returns. Closing price as of 9 Feb 2017 * Potential Target Source: DBS Bank Long-term air travel growth underpins prospects for aircraft leasing. Global air passenger traffic, driven by growth of the middle class in emerging markets, is projected to grow at a CAGR of 4.8% over the next two decades. This, coupled with replacement demand, is why Boeing expects the market to add nearly 40,000 new aircraft and require at least US$3 trillion in funding needs, of which aircraft leasing is projected to at least maintain its 42% market share. This should provide plenty of opportunities for lessors to grow, organically or inorganically. Key risks. We believe that the risk of aircraft oversupply is hugely mitigated by the Airbus-Boeing duopoly, which should ensure rationality between the two major manufacturers and keep the supply-demand dynamic balanced. Lessors will also manage their interest rate risk by matching floating leases with floating-rate debt, active hedging and trading of aircraft. ASIAN INSIGHTS VICKERS SECURITIES ed: JS / sa: YM Industry Focus Aircraft Leasing The DBS Asian Insights SparX report is a deep dive look into thematic angles impacting the longer term investment thesis for a sector, country or the region. We view this as an ongoing conversation rather than a one off treatise on the topic, and invite feedback from our readers, and in particular welcome follow on questions worthy of closer examination. Table of Contents Investment Summary 3 Global air traffic is on a long term secular growth path 5 Aircraft demand and fleet development 8 Aircraft financing 11 Aircraft leasing: A background 13 Strategies commonly employed by top lessors 15 The emergence and growth of aircraft lessors in Asia 18 Chinese lessors to the fore 19 Japanese lessors: Re-emerging once more 21 Other non-traditional lessors 22 Hong Kong’s tycoons join the party 23 Potential transactions in the aviation leasing space 23 The attractiveness of aircraft leasing 24 Valuations and Equity picks 25 Key Risk Factors 27 Appendix Aircraft leasing 101 30 What’s driving the popularity of aircraft leasing? 32 Critical success factors for aircraft lessors 33 Drivers of aircraft value 37 Company Profiles BOC Aviation 42 China Aircraft Leasing (Initiation) 49 CDB Financial Leasing (Equity Explorer) 69 . ASIAN INSIGHTS VICKERS SECURITIES Page 2 Page 2 Industry Focus Aircraft Leasing Investment Summary Global air passenger traffic on a firm long-term growth trend. being linked to all manner of activity in the sector, including According to the International Air Transport Association 1) acquisition of aircraft portfolios such as AirAsia’s leasing (IATA), global air passenger traffic rose 5.9% year-on-year in arm and top-10 lessor AWAS, and 2) potential initial public 2016 and is projected to grow 5.1% in 2017. Based on offerings of lessors such as Minsheng Financial Leasing or the Boeing’s estimates, global RPKs (revenue passenger leasing arms of the Chinese banks, following the listing of kilometres) will almost triple by 2035 to reach 17 trillion CDB Financial Leasing and BOC Aviation in Hong Kong. passenger-kilometres (p-km), which represents a compound Meanwhile, even Hong Kong’s tycoons such as Cheong annual growth rate (CAGR) of 4.8% for a 20-year growth Kong’s Li Kashing and Chow Tai Fook’s Dato Dr. Cheng Yu- period from 2015 to 2035. tung have amassed aircraft-leasing assets in recent years, and are still looking to grow their aircraft portfolios. The growing middle class in emerging economies is a key driver of demand for air travel. Looking ahead, the expanding Sector valuations and peer comparison. Listed aircraft lessors middle class is expected to drive growth in global spending. in the US and HK are trading at an average of 9.7x current The middle-class population is forecast to expand almost earnings, declining to 8.6x forward earnings. In Hong Kong, 73% from 2.8 billion in 2015 to 4.8 billion by 2035. BOC Aviation is the cheapest in terms of price-to-earnings at Supported by firm global economic growth, a rising middle- 8.5x currently. Other than CALC, which is trading at 2.2x class population, higher expected spending power, current price-to-book-value, against a projected current ROE globalisation, and greater air connectivity, we expect trips of 22.6%, the rest of the aircraft lessors are generally trading undertaken per-capita (and thus propensity to travel) to at around 1x to 1.1x current P/B. While on average the sector remain on a steady uptrend over the long term, with strong only offers a dividend yield of 2.1%, CALC is offering a growth in emerging markets such as China and India. decent prospective yield of 3.9%. Robust demand for new aircraft and its financing in the next Our equity calls and picks in the aircraft-leasing sector. Our two decades. Based on Boeing’s estimates, the global fleet top pick is BOC Aviation (BUY, TP HK$48) and we initiate will more than double to 45,240 by 2035 to cater for coverage on China Aircraft Leasing (CALC) with a BUY call increased air travel demand. Of the 22,510 in-service aircraft and HK$11.60 target price. in 2015, 18,330 are slated to be retired from service while another 1,440 are expected to be converted to freighters to Key Risks: further extend their useful lives. Thus, Boeing expects that Aircraft oversupply - The most common concern for investors about 39,620 new aircraft will be required and delivered seems to be that of aircraft oversupply. Our view is that given between 2015 and 2035, and would require financing of at the duopoly in aircraft manufacturing, aircraft supply-demand least US$3 trillion in 2015 dollar terms. should be balanced in the long term as it is in the ’s interest of the original equipment manufacturers (OEMs) to promote The growth and importance of the aircraft-leasing sector. a balanced situation. In the short term, we also see the From less than 1% share in the 1970s, aircraft leasing has aircraft supply-demand environment as relatively benign as 1) since grown its market share of the global fleet to over 40% global load factors are near historic highs, 2) OEM production and has held steady at around 42% in the last decade. growth rate is matching expected demand growth 3) order Aircraft lessors play an important role in financing the books are strong, and 4) aircraft storage/retirement are substantial funding requirements for aircraft, and distributing already at low rates. aircraft capacity more efficiently globally. Interest rate risk - A key feature or driver of an aircraft lessor’s Asian lessors have muscled in on the game in recent years. earnings is the net spread (the difference between average Today, five of the twelve largest aircraft lessors hail from Asia, yield on aircraft portfolio and average cost of debt) that a and a sixth is from Australia. Most of these have prominently lessor earns. In an environment of rising interest rates, grown through the acquisition of another leasing company, investors may have reason to fret. Generally speaking, aircraft and in the case of HNA Group’s, two – Avolon and CIT. lessors are well aware of this risk and manage it via 1) natural Chinese lessors figure prominently among the top 12, hedging where fixed-rate leases are funded by fixed-rate including the largest player Avolon/CIT while Japanese lessor debt, and floating-rate leases are matched with floating-rate SMBC Aviation is also among the top 5 lessors globally. debt, 2) active interest-rate hedging using derivatives such as caps and swaps, and 3) trading (sale) of aircraft in the Transactions and M&A activity remain buoyant in the leasing portfolio. sector, with Asian players firmly in the mix. Asian lessors are ASIAN INSIGHTS VICKERS SECURITIES Page 3 Page 3 Industry Focus Aircraft Leasing Emergence and Growth of Aircraft Lessors in Asia ASIAN INSIGHTS VICKERS SECURITIES Page 4 Page 4 Industry Focus Aircraft Leasing Global air traffic is on a long term secular growth path Rosy outlook for global aviation traffic.