BOC Aviation (2588 HK)

Transcription

1 BOC A China Industrials 17 October 2016 BOC Aviation (2588 HK) Target price: HKD50.00 Share price (14 Oct): HKD41.70 Up/downside: +19.9% Initiation: cruising with a strong tailwind In the sweet spot of rising Asia Pacific air traffic demand But solid growth prospects yet to be reflected in share price Initiating with a Buy (1) rating and TP of HKD50 Kelvin Lau (852) kelvin.lau@hk.daiwacm.com Jason Mok (852) jason.mok@hk.daiwacm.com Investment case: We initiate coverage of BOC Aviation (BOCA), one of the world s top aircraft lessors, with a Buy (1) rating and DCF-based 12- month target price of HKD50. We expect long-term global air traffic demand growth to remain solid from , and believe BOCA s backlog will help it capture this growth opportunity. Catalysts: Strong order book and deliveries the major growth drives. Even though BOCA is already the largest Asia-Pacific-based aircraft operating lessor by fleet size, we still see strong earnings growth prospects for the company. At the end of June 2016, BOCA had an order book of 218 aircraft, representing 82% of its owned and managed fleet of 265 aircraft. In addition to further purchase and lease-back transactions, we forecast its lease rental income to see a CAGR of 13% from Aircraft disposal gains also support bottom line. Since its inception in 1993 up until the end of 2015, the company had sold more than 210 aircraft, proving its expertise in managing and maintaining a young and indemand fleet by acquiring widely used aircraft models while disposing of aged aircraft and generating positive gains. We forecast gains from aircraft disposals to account for 13-15% of the company s profit before tax for Low funding cost advantage. Due to its higher-than-peer credit rating and diversified funding channel, the company s funding cost was only % in , among the lowest of its rivals. Its low funding cost is one of its major competitive advantages, and also supports its ROE, which we forecast to reach % in , outperforming its global peers. Share price performance (HKD) (%) Jun-16 BOC Avia (LHS) Source: FactSet, Daiwa forecasts Sep Relative to HSI (RHS) 12-month range Market cap (USDbn) m avg daily turnover (USDm) 3.31 Shares outstanding (m) 694 Major shareholder Sky Splendor Limited (70.0%) Financial summary (USD) Year to 31 Dec 16E 17E 18E Revenue (m) 1,175 1,390 1,591 Operating profit (m) Net profit (m) Core EPS (fully-diluted) EPS change (%) Daiwa vs Cons. EPS (%) PER (x) Dividend yield (%) DPS PBR (x) EV/EBITDA (x) ROE (%) Valuation: The stock is trading currently at x E PBRs, in line with its global peers average, but significantly lower than its closest Hong Kong-listed peer, China Aircraft Leasing s (CALC) (1848 HK, HKD9.54, Buy [1]) x, based on our forecasts. Considering the company s: 1) rich order book and delivery schedule, 2) low-cost funding advantage, 3) higher-than-peer ROEs, and 4) leading market position in the Asia-Pacific region, we believe the value of BOCA has not yet been fully priced in by the market. Our TP implies x PBRs, which we see as justified against our earnings forecast CAGR of 19% and ROE of %. Risks: The key risks to our call are a lower-than-expected spread between the company s lease rate factor and its financing cost, a sudden and significant decrease in aircraft value, and a macro slowdown resulting in a delay in aircraft deliveries. See important disclosures, including any required research certifications, beginning on page 79

2 How do we justify our view? Growth outlook Valuation Earnings revisions Growth outlook We forecast BOCA s earnings to grow at a CAGR of 19% for on: 1) strong order book deliveries during the period (an average of 62 aircraft per year in E), 2) improving sales gains from aircraft disposal (on average 39 aircraft to be sold annually from E with improving per aircraft sales gains), and 3) ongoing benefits from lowcost funding. We see our forecast as achievable given that 100% of the company s scheduled order book deliveries for 2016 and 67% of its 2017 deliveries had been placed on lease (ie, placed but not yet delivered) by end-june The company s young, modern and in-demand fleet should also support its aircraft value and sales gains. BOCA: net profit and net profit growth ( E) (USD m) % % 18% % 11% E 20 17E 20 18E Net profit (LHS ) YoY Growth (RHS) Source: Company, Daiwa forecasts 25 % 20 % 15 % 10 % 5% Valuation BOCA: 12-month forward PER (since listing in June 2016) The stock is trading currently at x E PBRs, based on our estimates, in line with global peers and its average since listing in June 2016, but significantly lower than the x for its closest Hong Kong-listed peer, CALC. Given its advantage in obtaining low-cost funding and potential to post a strong earnings CAGR of 19% over , we believe the stock deserves to trade at a premium to its peers. As such, our 12-month TP implies x E PBRs, which we see as justified due to the stock s superior ROE ( E ROE of 14% vs. peers average of 10-11%). (PBR) Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 PBR Average PBR Source: Bloomberg, Daiwa forecasts Earnings revisions The market started to revise up BOCA s EPS forecasts in late August, when the company announced strong 1H16 interim results. Our E EPS are 3-5% higher than consensus as we are more confident about the company s outlook, expecting new aircraft demand, especially in the APAC region to which the company has high exposure, to remain robust and drive leasing demand and support aircraft value. BOCA: consensus earnings revisions ( E) (USD) Jul-16 Aug-16 Sep-16 Oct E 2017E Source: Bloomberg 22

3 Financial summary Key assumptions Year to 31 Dec E 2017E 2018E Aircraft deliveries (units) n.a. n.a Aircraft sold (units) n.a. n.a Managed aircraft (units) n.a. n.a Fleet size (units) n.a. n.a Profit and loss (USDm) Year to 31 Dec E 2017E 2018E Lease rental income n.a. n.a ,041 1,222 1,389 Net gain on sales of aircraft n.a. n.a Other Revenue n.a. n.a Total Revenue n.a. n.a ,091 1,175 1,390 1,591 Other income n.a. n.a. (28) (10) (12) (17) (16) (18) COGS n.a. n.a SG&A n.a. n.a. (45) (56) (64) (68) (81) (93) Other op.expenses n.a. n.a. (351) (396) (400) (417) (479) (532) Operating profit n.a. n.a Net-interest inc./(exp.) n.a. n.a. (136) (151) (169) (201) (238) (268) Assoc/forex/extraord./others n.a. n.a. (48) (23) (44) 0 (6) (7) Pre-tax profit n.a. n.a Tax n.a. n.a. (34) (44) (58) (59) (83) (98) Min. int./pref. div./others n.a. n.a Net profit (reported) n.a. n.a Net profit (adjusted) n.a. n.a EPS (reported)(usd) n.a. n.a EPS (adjusted)(usd) n.a. n.a EPS (adjusted fully-diluted)(usd) n.a. n.a DPS (USD) n.a. n.a EBIT n.a. n.a EBITDA n.a. n.a ,015 1,090 1,293 1,480 Cash flow (USDm) Year to 31 Dec E 2017E 2018E Profit before tax n.a. n.a Depreciation and amortisation n.a. n.a Tax paid n.a. n.a. 0 (0) (0) (59) (83) (98) Change in working capital n.a. n.a Other operational CF items n.a. n.a Cash flow from operations n.a. n.a ,112 1,058 1,228 1,398 Capex n.a. n.a. (2,503) (3,143) (3,410) (3,880) (3,788) (3,420) Net (acquisitions)/disposals n.a. n.a ,316 2,092 1,846 1,943 1,943 Other investing CF items n.a. n.a Cash flow from investing n.a. n.a. (1,589) (1,827) (1,318) (2,035) (1,845) (1,477) Change in debt n.a. n.a Net share issues/(repurchases) n.a. n.a Dividends paid n.a. n.a. (113) (139) 0 (42) (130) (155) Other financing CF items n.a. n.a. (143) (263) (192) (220) (257) (286) Cash flow from financing n.a. n.a Forex effect/others n.a. n.a Change in cash n.a. n.a. (112) (269) 139 (28) (14) 30 Free cash flow n.a. n.a. (1,588) (915) (231) (1,002) (647) (112) Source: FactSet, Daiwa forecasts 23

4 Financial summary continued Balance sheet (USDm) As at 31 Dec E 2017E 2018E Cash & short-term investment n.a. n.a Inventory n.a. n.a Accounts receivable n.a. n.a Other current assets n.a. n.a Total current assets n.a. n.a Fixed assets n.a. n.a. 9,594 11,015 11,717 13,354 14,739 15,702 Goodwill & intangibles n.a. n.a Other non-current assets n.a. n.a Total assets n.a. n.a. 10,149 11,403 12,474 14,084 15,459 16,457 Short-term debt n.a. n.a ,023 1,113 1,163 Accounts payable n.a. n.a Other current liabilities n.a. n.a Total current liabilities n.a. n.a ,044 1,215 1,287 1,405 1,482 Long-term debt n.a. n.a. 6,569 7,272 7,649 8,249 9,149 9,649 Other non-current liabilities n.a. n.a ,170 1,189 1,189 1,189 Total liabilities n.a. n.a. 8,222 9,307 10,034 10,724 11,743 12,320 Share capital n.a. n.a ,158 1,158 1,158 Reserves/R.E./others n.a. n.a. 1,319 1,489 1,832 2,202 2,559 2,979 Shareholders' equity n.a. n.a. 1,927 2,096 2,440 3,360 3,717 4,137 Minority interests n.a. n.a Total equity & liabilities n.a. n.a. 10,149 11,403 12,474 14,084 15,459 16,457 EV n.a. n.a. 10,484 11,659 11,970 12,659 13,663 14,183 Net debt/(cash) n.a. n.a. 6,754 7,929 8,240 8,929 9,933 10,453 BVPS (USD) n.a. n.a Key ratios (%) Year to 31 Dec E 2017E 2018E Sales (YoY) n.a. n.a. n.a EBITDA (YoY) n.a. n.a. n.a Operating profit (YoY) n.a. n.a. n.a Net profit (YoY) n.a. n.a. n.a Core EPS (fully-diluted) (YoY) n.a. n.a. n.a Gross-profit margin n.a. n.a EBITDA margin n.a. n.a Operating-profit margin n.a. n.a Net profit margin n.a. n.a ROAE n.a. n.a ROAA n.a. n.a ROCE n.a. n.a. n.a ROIC n.a. n.a. n.a Net debt to equity n.a. n.a Effective tax rate n.a. n.a Accounts receivable (days) n.a. n.a. n.a Current ratio (x) n.a. n.a Net interest cover (x) n.a. n.a Net dividend payout n.a. n.a Free cash flow yield n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. Source: FactSet, Daiwa forecasts Company profile Founded in 1993, BOC Aviation is principally engaged in aircraft leasing and associated businesses, such as the sale of used aircraft. Based in Singapore, the company started its business by acquiring its first aircraft in BOC Aviation was acquired by Bank of China back in 2006, and became the bank s 100% owned subsidiary. With the support of its parent company, and efforts made by management, the company had developed a fleet of 265 owned and managed aircraft by end-june 2016, with 218 aircraft on order, emerging as a top global aircraft lessor. 24

5 Strong order book and stable lease rate factor Strong order book supports fleet expansion and lease rental growth Rich order book is a valuable asset Order book should boost growth BOCA had an order book of 218 aircraft as at end-1h16, comprising 106 Airbus aircraft and 112 Boeing aircraft. Over 90% of the aircraft on the order book are well-accepted single-aisle aircraft, including the Airbus A320 current engine option (CEO) family aircraft and Boeing 737 next generation (NG) family aircraft, while some of them are new technology models, such as the A320 new engine option (NEO) and B737 MAX8 aircraft. These models are widely used by airlines in operating short/medium-haul routes. We view BOCA s rich order book, which comprises in-demand aircraft types, as a valuable asset to support its lease rental income growth over our forecast horizon. BOCA: delivery schedule ( ) Aircraft type Narrowbody Aircraft Airbus A320CEO family Airbus A320NEO family Boeing 737NG family Boeing 737 MAX Widebody Aircraft Airbus A Boeing ER Total Source: Company Note: data as at 12 October 2016 BOCA: order book by model 2, 1% BOCA: order book by aircraft type 4, 2% 61, 28% 40, 18% Airbus A320CEO family Airbus A320NEO family Airbus A330 family Narrow body aircraft 49, 23% 64, 29% Boeing 737NG family Boeing 737 MAX 8 Boeing ER 214, 98% Wide body aircraft 2, 1% Source: Company, Daiwa Note: *includes all commitments to purchase aircraft including those where an airline customer has the right to acquire the relevant aircraft, data as of end-1h16 Source: Company, Daiwa Note: includes all commitments to purchase aircraft including those where an airline customer has the right to acquire the relevant aircraft, data as of end-1h16 25

6 Purchase and lease back provides further upside for fleet expansion Purchase and lease back another growth factor Besides placing direct orders with manufacturers, BOCA also purchases aircraft through purchase and lease back (PLB) transactions with airlines. Under a PLB agreement, the company takes over aircraft purchase commitments that airlines have with aircraft manufacturers or purchases aircraft from airlines, then leases them back to the airlines. Airlines sometimes prefer to use PLB transactions over direct purchases as it reduces the need for a large upfront capital investment and allows them to reserve cash for other use. After carrying out as many as 17 PLBs in 2013 and 16 in 2014, the company only entered into 6 such transactions in 2015, and we estimate it will complete 7 transactions each in , as we believe it will face capex constraints due to a strong delivery schedule (55-61 aircraft in on our estimates) that will hinder it from taking on more PLBs given the high order book delivery. However, we expect the company s PLB transactions to rebound back to 20 aircraft in 2018 on the back of lower scheduled delivery of 37 aircraft. Going forward, BOCA will likely continue to expand its fleet through both order book purchases and opportunistic market PLB transactions, which we see as the most important driver of lease rental income growth. BOCA: historical aircraft deliveries ( E) Aircraft delivery (units) Source: Company E 2017E 2018E From order book From PLB transactions High visibility due to industry practice Aircraft lessors and lessees usually confirm contracts months prior to aircraft delivery. According to management, 100% of its scheduled order book deliveries for 2016 and more than 60% of its 2017 deliveries had been placed on lease by end-june Hence, we believe its fleet expansion plan is very much on track. We now assume the company s owned aircraft will expand from 227 at end-2015 to 296 by end-2018, or a CAGR of 9%. BOCA: number of owned aircraft No. of owned aircraft (units) E 2017E 2018E Source: Company, Daiwa forecasts 26

7 We expect BOCA s lease rate factor to remain stable Stable lease rate factor which may see minor expansion The lease rate is one of the most important factors driving an aircraft lessor s rental income. Aircraft operating lessors also compete by providing more competitive lease rates to lessees. From an historical perspective, various factors may affect a lessor s lease rate, including aircraft demand-supply dynamics, the global economic outlook, change in air traffic demand from passenger or air cargo services, change of regulations, fluctuations in the interest rate and jet fuel costs, etc. From , BOCA s lease rate factor, defined as the lease rental income divided by the average net book value of an aircraft, was stable, ranging from 9.7% to 9.9%. We see this as being due to a combination of robust aircraft demand and the company s fleet management strategy, which focuses on widely-used single-aisle aircraft. The lease rate factor usually moves in line with interest rates. Therefore, we expect the company s lease rate factor to edge up from 9.9% at end-2015 to % for E, assuming the company sees rising funding costs and the US raises interest rates. BOCA: lease rate factor ( E) 12% 10% 8% 6% 4% 9.7% 9.8% 9.9% 10.2% 10.3% 10.3% 2% 0% E 2017E 2018E Source: Company, Daiwa forecasts Note: The lease rate factor is calculated as lease rental income divided by average net book value of aircraft In short, given favourable factors such as solid air traffic growth and the resulting aircraft demand, as well as stable lease rates, we see strong growth potential for BOCA s lease rental income. Lengthy remaining lease term enhances lease revenue visibility and mitigates risks Lengthy remaining leases Meanwhile, for H16, the average remaining lease term of the company s aircraft was years, one of the highest among its global peers. In terms of expiration pattern, the distribution is well-dispersed, with few near-term expirations. The relatively longer remaining and dispersed lease term not only raises the visibility for its lease income stream, but also prevents a concentrated expiration of a large number of leases. Generally speaking, the remaining lease term of a fleet is inversely related to its age. BOCA tends to sell aircraft around 5 years before the lease matures, in order to maintain a young fleet. 27

8 BOCA: average remaining lease term (years) H16 Source: Company Note: Weighted by net book value of owned fleet BOCA: long-term contracted lease revenue (no. of leases) (%) % 70% % 4.2% 4.9% Source: Company Note: Owned aircraft with leases expiring in each calendar year, excluding any aircraft with lease or sale commitments as at 31 March 2016, weighted by net book value (unless otherwise indicated); all data as at 31 December of relevant year unless otherwise indicated 8.3% 11.6% and beyond No. of leases expiring (LHS) Percentage of aircraft net book value with leases expiring (RHS) 60% 50% 40% 30% 20% 10% 0% 28

9 Further upside from aircraft sales BOCA s fleet consists of young and in-demand aircraft BOCA has expertise in managing its fleet Fleet structure matters As mentioned, BOCA tends to sell aircraft around 5 years before the lease matures, in order to maintain a young fleet. Thus, compared to its peers, BOCA owns a modern and young fleet comprising new and widely-used aircraft models. Over 80% of its fleet, in terms of aircraft units, consist of Airbus A320 family and Boeing 737 family aircraft, which are the dominant single-aisle aircraft types that airlines operate on short- to medium-haul routes. Further, its fleet age was only 3.3 years at end-june 2016, among the youngest of its peers. We believe all these factors are important for the company to maintain favourable disposal values when it decides to dispose of aircraft in its fleet. BOCA: fleet portfolio (in terms of aircraft units) 5% 6% 5% 1% 1% Single-aisle aircraft accounts for 88% of owned aircraft Airbus A320CEO family Boeing 737NG family Embraer E190 family 49% Airbus A330 family 34% Boeing ER Boeing 787 Freighters Source: company Note: only counts owned aircraft; data as of 30 June 2016 Comparison of average fleet age of selected aircraft operating lessors (2014) BOCA CALC AerCap Aircastle Air Lease AWAS* Avolon ACG Average Fleet age (years) Source: company reports, Flightglobal Fleets Analyzer Note: *year-ended 30 November, 2014 Management s expertise in selling used aircraft reduces execution risk Proven track record in selling aircraft BOCA has sold 150 aircraft since 2007, and 21, 33 and 43 aircraft were respectively traded in 2013, 2014 and The buyers included other leasing companies, airlines and investors. We believe BOCA s sales history demonstrates its competence in selling used aircraft. Meanwhile, the company has sold the last four aircraft it had acquired prior to 2007 in 1H16. As such, no aircraft in its fleet is currently older than 10 years. Further, BOCA announced in late 2015 its first-ever portfolio sale of aircraft, a deal that was completed in early The deal included 24 aircraft, consisting of 11 Airbus A320 family, 7 Boeing 737NG, 2 Embraer E190, 2 Airbus A330 and 2 Boeing 777 aircraft. We believe the deal has opened up the potential for similar transactions in the future. 29

10 BOCA: unit of aircraft sold ( ) Aircraft sold (units) Source: Company 30

11 Competitive funding cost Diversified and economical funding driving ROE Better-than-peer credit rating Benefits from its higherthan-peer credit rating Most of the global aircraft lessors are rated at between a lower medium grade (BBB-) and non-investment grade speculative (Ba1/BB+) level by the credit agencies. However, BOCA is rated A- (stable) by both Standard & Poor s and Fitch, an investment grade credit rating. We see the company s above-peer credit rating as a major advantage because a corporate with a high credit rating can often obtain easier and cheaper funding. The company s higher-than-peer credit rating and its resulting lower funding cost are likely to raise its competitiveness, especially as aircraft leasing is a capital-intensive business. Credit rating of selected aircraft lessors BOCA AerCap Aircastle Air Lease AWAS Avolon ACG Credit rating Moody's NA Ba1 Ba1 NA Ba3 NA NA Standard & Poor's A- BBB- BB+ BBB- BB+ NA BBB- Fitch A- BB+ NA NA NA NA BBB- Source: Companies Note: rating as of 9 May 2016 Diversified funding source ensures sufficient funding facilities BOCA s diversified financing portfolio also suggests it is able to access different sources of funding. The company has built relationships with more than 60 banks and financial institutions across Asia, Australasia, Europe, the Middle East and North America. In addition to its outstanding credit rating, BOCA is able to obtain competitively priced funding from loan financing, debt capital markets and other channels, such as US Exim and European Credit Agency Supported Financing. According to the company s 1H16 data, loans, debt capital market and ECA/EXIM accounted for 43%, 43% and 14% of its total funding. Well-supported but not fully reliant on parent company As a subsidiary of Bank of China, BOCA is supported by its parent company. Bank of China has provided the company with a USD2.0bn committed unsecured revolving credit facility which matures in April The facility has not yet been drawn down by the company to date. According to management, as at end-1h16, about 9% of its total funding came from the Bank of China Group, which we see as a reasonable and manageable level. We believe the company will continue to be supported by its parent, while not becoming over-reliant on it. Further, the company s diversified financing portfolio is likely to effectively reduce its credit risk and allow it to acquire low-cost funding. BOCA: funding sources 42.8% 14.4% 34.3% 8.5% Loans - other parties Loans - BOC Group Debt Capital Markets ECA/ EXIM Source: Company Note: data as of end-june

12 Low-cost funding allows the company to offer attractive lease terms As mentioned, aircraft leasing is a capital-intensive industry, which requires immense upfront capital investment. For instance, the list price for an A320 and B737 aircraft can reach USD100m each. Meanwhile, aircraft buyers are often required to make a predelivery payment (PDP), an instalment paid to manufacturers typically beginning 24 months prior to the scheduled aircraft delivery, which can be as much as 30-50% of the aircraft s total purchase price. Therefore, lessors rely heavily on external financing resources when acquiring new aircraft. This explains why interest expenses typically account for 20-40% of an aircraft lessor s total operating expenses. BOCA also possesses a similar cost structure to its peers. Its interest costs accounted for 24% of its total operating expenses in 2015, which was its second-largest cost component after aircraft depreciation expenses. Interest cost/total operating cost ratio of selected aircraft lessors BOCA: cost structure (2015) BOCA % 24% 24% AerCap 34% 35% 31% 29% 28% AirLease 23% 33% 34% 34% 32% AirCastle 40% 34% 34% 34% 32% Average 32% 34% 30% 30% 29% 9% 11% 24% Interest expense Depreciation SG&A 55% Others Source: Companies, Daiwa Source: Company, Daiwa Low-cost funding is BOCA s major competitive advantage Given the capital-intensive nature and cost structure of the aircraft leasing business, lowcost funding can give a lessor a major competitive advantage. BOCA s interest cost was a low % for due to its strong credit rating, and was lower than the peer average of 4%. Therefore, though BOCA s lease rate factor is lower, it is still capable of earning a competitive spread compared to its rivals. Meanwhile, from the perspective of a lessee, a lower lease rate factor implies a more attractive offer to rent an asset as the market price of a brand-new aircraft should be comparable across different lessors. We believe that BOCA s financing cost advantage could result in a major competitive edge. BOCA: funding costs Average funding cost (%) 7% 6% 5% 4% 3% 2% 1% 0% 1.9% 1.9% 2.0% BOC Aviation AerCap AirLease AirCastle Source: Company, compiled by Daiwa Note: AirLease data calculated as rental of flight equipment/ average fleet net book value BOCA: lease rates offered to customers Lease rate factor (%) 15% 14% 13% 12% 11% 10% 9.7% 9.8% 9.9% 9% 8% BOC Aviation AerCap AirLease AirCastle Source: Company, compiled by Daiwa 32

13 Financial review Robust order book and stable fleet utilisation support lease rental growth Lease rental income is the major earnings driver Lease income should grow steadily driven by a strong order book The company delivered 27 aircraft in 1H16, and seeks to deliver a further 40 in 2H16. It plans to deliver 60 and 37 aircraft, respectively, in 2017 and 2018; and in , it targets to deliver on average 30 aircraft per year. BOCA is also opportunistic in taking PLB transactions, as suggested by its track record. After considering its capex burden, we now estimate the company will conduct 7 PLB transactions in 2016, 7 in 2017, and 20 in 2018, which will translate into total deliveries of 68 aircraft in 2016, 62 in 2017, and 57 in We believe BOCA has strong deal-sourcing and execution ability, as indicated by its high lease rental collection and fleet utilisation ratio which reached an average of 99.6% and 99.8%, respectively, from H16. Therefore, we expect the company to be able to maintain its high lease rental collection and fleet utilisation ratio over our forecast horizon. According to management, 100% of the company's 2016 order book scheduled deliveries and more than 60% of its 2017 deliveries had been placed on lease by end-june This also increases the lease income visibility, in our view. BOCA: delivery schedule ( E) BOCA: historical collection rate and fleet utilisation rate (2008-1H16) (unit of aircraft) Average collection rate: 99.6% Average fleet utilisation: 99.8% % 100.0% 100.0% 100.0% 99.8% 99.0% 99.0% 100.0% 100.0% % % % % 99.4% 100.9% 99.8% 97.2% 100.4% 99.9% 100.4% 100.0% 40% % 0 Source: Company Delivered aircraft in 1H16 Airbus Boeing Source: Company BOCA: historical and forecast aircraft delivery ( E) Aircraft delivery (units) Source: Company, Daiwa forecasts % H Collection rate Fleet utilisation E 2017E 2018E From order book From PLB transactions Increasing fixed rate debt is expected to lead to a rise in financing costs Increasing fixed rate debt likely to drive interest costs up The company s number of leases with fixed rate terms has been increasing since 2013, rising from 26% in 2013 to 48% in 1H16. We believe such a change may be due to the market s expectation of a USD interest-rate hike at some point in the future. In response, BOCA s fixed rate debt proportion (including floating rate debt swapped to fixed rate liability) also increased from 14% in 2013 to 36% as at end-june In our view, the 33

14 company will continue to adjust its floating rate debt proportion in order to mitigate interestrate risk. In addition to the expected rate hike and rising LIBOR, we expect its funding costs to rise mildly in BOCA: lease-type by fixed and floating rate* (2013-1H16) 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 74% 26% 65% 35% Source: Company Note: *by net book value; **excludes 1 aircraft on ground 56% 52% 44% 48% 2013** H16 Fixed rate Floating rate BOCA: proportion of fixed/ floating rate debt (2013-1H16) 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 86% 88% 14% 13% 81% 20% Source: Company Note: *fixed rate debt included floating rate debt swapped to fixed rate liabilities 65% 36% H16 Fixed rate* Floating rate We expect its lease rate factor to catch up with the rise in funding costs but lease rate factor should also edge up accordingly As such, the company s 1H16 average cost of funds rose to 2.3% from 2.0% in 1H15. Against the backdrop of an expected rise in interest rates, we forecast BOCA s financing cost to edge up from 2.3% in 2016 to 2.5% by However, in general, the aircraft lease rate factor is aligned with interest-rate movements. Therefore, a slow rate hike path, which is mostly expected by the market, should allow the company to transfer most of its increasing borrowing cost onto its customers. Hence, we forecast its lease rate factor to expand accordingly from 9.9% in 2015 to 10.2% in 2016, and remain at the 10.3% level in Combining all the above-mentioned factors, we forecast the company's lease rental income to reach USD1.0bn, USD1.2bn and USD1.4bn in 2016, 2017 and 2018, respectively, translating into 7%, 17% and 14% YoY growth, and remaining the most important earnings growth driver for BOCA over our forecast horizon. BOCA: lease rate factor and cost of funding ( E) 10.4% 2.3% 2.4% 2.5% 10.2% 1.9% 1.9% 2.0% 10.0% 9.8% 10.2% 10.3% 10.3% 9.6% 9.9% 9.8% 9.7% 9.4% E 2017E 2018E Lease rate factor (%, LHS) Cost of funding (%, RHS) Source: Company, Daiwa forecasts 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% BOCA: lease rental income and growth ( E) (USD m) (YoY %) 1,600 20% 1,400 17% 17% 1,200 15% 1,000 14% % 600 7% 400 4% 5% ,041 1,222 1, % E 2017E 2018E Lease rental income (LHS) Growth (YoY %, RHS) Source: Company, Daiwa forecasts We expect BOCA to actively participate in trading aircraft in order to generate gains and quicken its cash flow Aircraft disposal gains pose upside potential The company is likely to stay active in aircraft trading Looking back over , aircraft disposal accounted for about 6% of the company s revenue on average, but reached about 17% of its pre-tax income. As mentioned, aircraft disposal is also a crucial way for the company to optimise its fleet structure and reduce residual value risk. 34

15 The company sold 21 aircraft in 2013, 33 in 2014 and 43 in 2015, relatively more aggressive than the average of 8 aircraft it sold per year from Given the robust scheduled order book deliveries for and occasional PLB transactions, we expect the company to remain opportunistic in selling its fleet so as to speed up cash inflow and reduce its capex burden. Hence, we assume aircraft will be sold in each of Gain per aircraft should improve given the company s continued efforts at fleet modernisation Gain per aircraft sold should improve BOCA announced on 20 June 2016 that it had disposed of the final 4 owned aircraft it had acquired prior to As a result, no aircraft in its fleet is now older than 10 years. As at end-june 2016, the average fleet age of its owned fleet was only 3.3 years weighted by net book value, one of the youngest in the industry. In our view, the June transaction marked the successful implementation of the company s fleet management strategy. We forecast the company s per aircraft disposal gain to gradually improve from USD1.6m in 2015 to USD m in given its young and modern fleet structure. Management revealed, during the interim results announcement on 25 August, that the average aggregate value of its owned fleet as assessed by 5 independent appraisers is USD11,015m, which is about a 14% premium to its net book value of USD9,693m. Further, the company recorded no aircraft impairment loss in 1H16, compared to the USD13.6m charged in 1H15. We see all this as evidence supporting our argument that the per aircraft disposal gain should improve over our forecast horizon. BOCA: units of aircraft sold ( E) Aircraft sold (units) E 2017E 2018E No of owned aircraft sold Source: Company, Daiwa forecasts BOCA: gain on disposal of aircraft ( E) (USD m) (USD m) E 2017E 2018E Net gain on sales of aircraft (LHS) Net gain per aircraft sold (RHS) Source: Company, Daiwa forecasts Interest-rate risk not an excessive concern Reducing lease-debt mismatch mitigates interest-rate risk As at end-1h16, 52% of the company s total leases, by net book value, are linked to floating rate, but 64.5% of its liabilities are in floating rate. Therefore, interest rate risk has arisen due to the mismatch in lease rentals and borrowings. Interest-rate sensitivity reduced as a result of increased hedging ratio BOCA targets to hedge at least 50% of its mismatched interest-rate exposure through different financial instruments. As at end-2015, it had hedged about 60% of its mismatched interest-rate exposure. Given that more lessees now opt for fixed rate contracts, the company raised its hedging ratio to around 80% of its mismatched interest-rate exposure at end-june Hence, its interest-rate sensitivity to a 10bps increase in interest rates, dropped from a USD1.7m decline in net profit at end-2015 to about a USD1m decline at end-june Our analysis shows that a 10bps rise in interest rates would result in a 0.2% decrease in our 2016 net profit forecast. As such, we believe interest-rate risk should not be an excessive concern for investors. 35

16 BOCA: fixed vs. floating leases and debt 10 0% 80 % 60 % 40 % 20 % 48% 52% Hedged 80% of mismatched floating rate ex posure as at end-1h16 36% 64% BOCA: interest rate sensitivity analysis Assumes 10bp increase in interest rates, 2016E net profit would change by (%) End-2015 interest rate sensitivity: -0.4% End-1H16 interest rate sensitivity, after increasing fixed rate debt proportion: -0.2% 0% Le ases Floatint rate Debt Fixed rate Source: Company Note: fixed rate debt included floating rate debt swapped to fixed rate liabilities; data as of end- 1H16 Source: Company, Daiwa estimates Gearing fell significantly in 1H16 following the IPO in June 2016 Capex likely to remain high over due to order delivery schedule Management intends to have a 30% payout ratio going forward Strong 1H16 earnings growth Balance sheet review Gearing BOCA s gearing ratio (calculated as gross debt/total equity) had declined to 2.9x at end- 1H16, an improvement from 3.7x at end Management attributed the decline to its IPO in June 2016, which generated net proceeds of about USD550m and enlarged its equity base. Management expects the gearing ratio to rise back to x gradually, by the end of 2018, which management sees as acceptable to ratings agencies. Capex The company s order book for comprises: 67 aircraft to be delivered in 2016, 60 in 2017 and 37 in In addition to ad hoc PLB opportunities and its PDP instalment, we expect its capex to reach USD bn per year throughput this period. Given such a strong delivery pipeline, we expect BOCA to sell aircraft during the same period, which would enable it to accelerate cash inflow and generate disposal gains. In sum, we forecast the company s net capex to be about USD bn over Payout ratio The company paid a dividend of USD113m in 2013 (representing a payout ratio of 41%) and USD139m in 2014 (payout ratio of 45%), but paid no dividends in Management has stated its intention to maintain a 30% dividend payout, and we use this as our assumption. Considering the company s capex needs and its stable cash flow as a result of its steadily growing lease rental business, we assume a 30% payout ratio over our forecast horizon, which translates into 2016, 2017 and 2018E dividend yields of 3.5%, 3.9% and 4.6%, respectively. 1H16 results review BOCA s 1H16 revenue came in at USD579m, up 8.2% YoY. The largest component, its lease rental income business, saw a 5.7% YoY increase in revenue, due mainly to an increase in the USD LIBOR on its floating rate rental contracts and because it signed more new fixed lease rate contracts. The revenue from net gains made on its aircraft sales grew by 35.3% YoY, driven by more aircraft sales over the period. On the cost front, its depreciation for plant and equipment (mostly relating to aircraft) declined by 3.7% YoY, on the increase in aircraft sales in 1H16 and the disposal of all aircraft more than 12 years old that were depreciated at 4.5% per annum vs 3.6% of aircraft less than 12 years old. Its finance expenses increased by 23.8% YoY as a result of the rising USD LIBOR and a higher proportion of fixed-rate debt for hedging purposes. Hence, the company recorded a pre-tax profit of USD240m, up 20.3% YoY. Its tax expenses declined by 1.2% YoY, due to write-backs on its tax provisions. As such, its net profit expanded by 23.8% YoY. 36

17 All of the aircraft scheduled for delivery in 2016 have been placed on lease Asia Pacific is likely to lead its business growth Operating update The company delivered 27 aircraft in 1H16. As at 30 June 2016, BOCA had a fleet of 226 owned and 39 managed aircraft. In 1H16, the company sold 22 aircraft, including its 4 last remaining pre-2007 acquired aircraft. The average age of its fleet, therefore, was only 3.3 years as at 30 June 2016, one of the youngest among its peers. In 2H16, the company is scheduled to deliver 30 aircraft on its order book. Moreover, 100% of its scheduled order book deliveries for 2016 and 67% of its 2017 deliveries had been placed on lease by end- June Based on BOCA s run-rate, management sees more visibility over 2H16 and 2017 earnings and is confident about the long-term prospects. Asia Pacific should continue to drive business growth Some 54.8% of the company s 1H16 lease rental income was derived from the Asia-Pacific region, vs. 48.9% in 1H15. Management continues to see this region as one of the fastestgrowing in terms of new aircraft demand. It also sees opportunities in North America and Europe, driven by aircraft replacement demand. BOCA: 1H16 results summary (USDm) 1H15 1H16 YoY % Lease rental income % Interest and fee income % Other income: Net gain on sale of aircraft % Other income % Total revenue and other income % Depreciation of plant and equipment (193) (186) -3.7% Finance expenses (82) (101) 23.8% Staff costs (28) (32) 13.1% Other operating costs and expenses (19) (20) 7.3% Impairment of aircraft (14) % Total cost and expenses (336) (340) 1.1% Profit before income tax % Income tax expense (28) (27) -1.2% Net profit % EPS (USD) % DPS (USD) n.a. Source: Company 37

18 Valuation and recommendation We use DCF to value aircraft leasing companies Valuation methodology We use DCF as our valuation methodology The cash stream from aircraft leasing is relatively predictable due to its long-term nature (lease terms usually range 8-12 years) and stable lease rates. In most cases, manufacturers, lessors and lessees usually discuss the new leases months prior to aircraft delivery, which also provides visibility for lessors lease rental income. Thus, we apply DCF as our valuation methodology as we believe it better captures the value of the company s future leases. Besides, while PER and PBR comparisons may provide reference values to investors to compare different companies, we believe metrics such as earnings growth and ROE should also be considered. Recommendation Initiate coverage with a Buy (1) rating and 12- month TP of HKD50 We initiate coverage on BOCA with a Buy (1) rating and DCF-based 12-month target price of HKD50. We think the company is well positioned to capture growing opportunities in the emerging Asia-Pacific aircraft leasing market on rising air-traffic demand. Its strong order book, competitive low funding cost, and modern and in-demand fleet also allows the company to stand out from its peers. Further, we are confident in management s execution capability given BOCA s operating history. BOCA: DCF valuation FY end 2017E 2018E 2019E 2020E 2021E 2022E 2023E 2024E 2025E Years ahead Discount rate Revenue 1,390 1,591 1,697 1,767 1,787 1,819 1,841 1,873 1,907 EBIT ,003 1,030 1,023 1,026 1,018 1,019 1,021 Tax on EBIT (118) (137) (145) (149) (148) (149) (148) (148) (148) After-tax EBIT Add: Depreciation & Amortization Minus: Capex (1,845) (1,477) (1,184) (823) (982) (946) (1,091) (1,091) (1,091) Minus: Increase of NWC Free Cash Flow (647) (112) PV of FCF (620) (103) Source: Daiwa estimates BOCA: DCF calculation Target gearing (debt/capital) (%) 80 Market risk premium (%) 10.6 Risk-free rate (%) 0.9 Cost of debt (%) 2.5 Cost of equity (%) 12.6 WACC (%) 4.2 Terminal Value Terminal Growth Rate (%) 1.0 Terminal WACC (%) 4.2 DCF Valuation NPV of Forecasts (USDm) 2,031 NPV of Terminal Value (USDm) 11,378 Enterprise Value (USDm) 13,409 Less: Net Debt (USD) -8,929 Equity Value (USDm) 4,480 BOCA: DCF sensitivity analysis Discount rate NPV of FCF (USD m) Enterprise Value (USD m) Equity Value (HKD m) Equity Value Per Share (HKD) 3.7% 2,107 16,179 56, % 2,092 15,546 51, % 2,076 14,956 46, % 2,061 14,406 42, % 2,046 13,891 38, % 2,031 13,409 34, % 2,016 12,956 31, % 2,001 12,529 27, % 1,987 12,127 24, % 1,972 11,747 21, % 1,958 11,388 19, No. Shares (m) 694 USD HKD exchange rate 7.75 Per Share Equity Value (HKD) Source: company, Daiwa estimates Source: Daiwa estimates 38

19 Attractive valuation at current share-price level, in our view Valuation comparison We think superior ROE deserves a valuation premium Among the 3 Hong Kong-listed aircraft leasing companies (BOCA, CALC and CDBL), BOCA is trading at the lowest average PER of x, based on our forecasts. In terms of average E PBR, the stock is trading at x, which is comparable to CDBL s x, but significantly lower than that of its closest Hong Kong-listed peer, CALC, at x. BOCA: 12-month forward PER (since listing in June 2016) (PBR) Source: company, Daiwa forecasts Global aircraft leasing peers: valuation comparisons Our target price implies an average E PBR of 1.3x, higher than the average of its peers, at x. However, judging by what we see as the company s superior ROE of % for , compared to peers %, we think our target price is justified and achievable. Our 12-month target price of HKD50 represents upside potential of 20% from the current share-price level, which we see as a good entry point. We forecast a dividend yield of around 4%, which we think also raises the attractiveness of the stock. Name Bloomberg Trading Share price Rating PER (x) PBR (x) EV/EBITDA(x) Div yield (%) ROE (%) Code Currency 14-Oct-16 FY16E FY17E FY16E FY17E FY16E FY17E FY16E FY17E FY16E FY17E Aircraft leasing China Aircraft Leasing Group * 1848 HK HKD 9.54 Buy BOC Aviation Ltd * 2588 HK HKD Buy China Development Bank Finan 1606 HK HKD 1.92 NR n.a. n.a n.a. Bohai Financial Investment-A CH CNY 7.18 NR n.a. n.a Aircastle Ltd AYR US USD NR Aercap Holdings Nv AER US USD NR n.a. n.a Air Lease Corp AL US USD NR Fly Leasing Ltd-Adr FLY US USD NR n.a Weighted average High Low Median Source: Bloomberg, *Daiwa forecasts 0.9 Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 PBR Average PBR Delays in aircraft delivery could cap the company s growth Risks Delayed aircraft deliveries The global large single-aisle aircraft manufacturing market, to a large extent, is controlled by the duopoly of Airbus and Boeing, and we do not expect the market landscape to change radically in the near future. Currently, BOCA s order book is filled entirely with Airbus and Boeing aircraft. Therefore, if these manufactures decide to slow down or face disruptions in their production process, BOCA s scheduled deliveries and its lease rental growth would be affected. That said, given the piled-up order book of Airbus and Boeing and the continued strong market demand for narrow-body aircraft, we see little chance of these two companies suddenly reducing their production capacity of narrow-body aircraft significantly within our 39

20 forecast horizon, and both Airbus and Boeing plan to ramp production for in-demand single aisle aircraft such as the A320 and B737, instead of cutting production. Delays or failures in receiving lease rentals pose a credit risk Credit risk A typical aircraft operating leasing contract for a new aircraft often lasts years. Therefore, credit risk arises whenever any lessee delays or fails to pay lease rentals, as most of the lessors fund their aircraft purchases through debt financing. To address this risk, BOCA requires customers to pay their rent mostly in advance and provide security deposits and pay maintenance reserves. Thorough appraisals are made before it approves new leases, while regular reviews are also carried out of existing contracts. The average lease payment collection rate for was 99.6%, implying the company s measures have effectively controlled its credit risk, in our view. Market competition In terms of the value of owned aircraft, BOCA is the largest aircraft operating lessor based in Asia, and it ranked among the top-5 global aircraft operating lessors in We think its strategy and cost advantages are the major reasons for the company s leading position in the industry. Rising Asia-based lessors could lead to more intense market competition BOCA s interest risk could be mitigated by its hedging policy, while However in recent years, many Asia-based lessors, especially from China, have been seeking to gain a foothold in the market. For example, Bohai Leasing acquired Avolon Holdings, another top-5 Asia-Pacific-region lessor, for USD2.6bn in ICBC Leasing and AVIC Capital were also reported to be interested in bidding for AWAS, an Irish lessor. NWS Holding (659 HK, not rated) acquired a 40% stake in Goshawk Aviation in 2015 to expand into the aircraft leasing business. We think the eagerness of new players to enter the market will drive up the aircraft transaction price, which could lead to a lower lease rate factor. As such, we would see this as a risk to our Buy (1) call on the stock. Interest rate risk Similar to other lessors, BOCA offers lessees contracts on fixed- or floating lease terms. As at end-1h16, 52% lease of the company s total leases, by net book value, are linked to floating rate, but 64.5% of its liabilities are in floating rate. Therefore, interest rate risk has arisen due to the mismatch in lease rentals and borrowings. As such, any increase in interest rates would lead to a drop in the company s earnings due to this type of lease-debt mismatch. As at end-june 2016, the company hedged about 80% of its mismatched interest-rate exposure. Our analysis shows that a 10bps rise in the interest rate would result in a 0.2% decrease in our 2016 net-profit forecast. maintaining its investment grade credit rating is crucial for obtaining low-cost funding going onward Any sudden or significant drop in the value of its aircraft could harm the company's value Further, the company is now rated at an investment grade credit rating by both Standard & Poor s and Fitch, which enables the company to borrow at low cost. Any failure to maintain its credit rating is likely to result in a surge in borrowing costs and would adversely affect its profitability, in our view. Residual risk Unlike finance leases, the structure of operating leases places the residual value risk on the lessors, and this residual value can only be realised when the leased-aircraft is sold or disassembled. Therefore, residual value risk exists if there is any sudden and significant decrease in aircraft value. Nonetheless, BOCA s fleet comprises mostly modern and young aircraft (ie, single-aisle aircraft). The company sold its last 4 pre-2007 acquired aircraft in 1H16, bringing the average age of its fleet to only 3.3 years weighted by net book value. As at end-june 2016, the average of 5 independent appraisers aggregate values for its fleet was about a 14% premium to its net book value. We think all these factors provide a buffer for the company 40