Asian Insights SparX – Aviation Aircraft Leasing Focus Aircraft Leasing ASIAN INSIGHTS VICKERS...

ASIAN INSIGHTS VICKERS SECURITIES ed: JS / sa: YM

Asian Lessors in the Ascendancy

• Asian lessors have, notably via acquisitions, muscled in amongst the top players globally in recent years

•

With 3 players now listed in HK and a myriad of 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 (CALC) with a BUY call and HK$11.60 TP

Stable cash flows and returns attract Asian investors.

Faced with lower growth and returns in other assets, and helped by cheaper cost of debt funding, we believe Asian investors of all types – banks, insurance companies and even family funds, are looking towards aircraft leasing assets to provide stable and predictable cash flows and returns.

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.

HSI : 23,575

Analyst Paul YONG CFA +65 6682 3712 [email protected] [email protected]

Singapore Research Team

Closing price as of 9 Feb 2017 * Potential Target Source: DBS Bank

DBS Group Research . Equity 10 February 2017

Asian Insights SparX – Aviation

Aircraft Leasing Refer to important disclosures at the end of this report

Stocks Mkt 12-mth Price Cap Target

PricePerformance (%)

HK$ US$m HK$ 3 mth 12 mth Rating

BOC Aviation 41.30 3,632 48.40 (2.6) NA BUYCALCChina 9.23 733 11.60 (3.5) 61.9 BUYCDB Financial Leas 1.94 3,129 2.01* 0.0 NA NR

Industry Focus

Aircraft Leasing

ASIAN INSIGHTS VICKERS SECURITIES

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 .

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Industry Focus

Aircraft Leasing


Investment Summary

Global air passenger traffic on a firm long-term growth trend. According to the International Air Transport Association (IATA), global air passenger traffic rose 5.9% year-on-year in 2016 and is projected to grow 5.1% in 2017. Based on Boeing’s estimates, global RPKs (revenue passenger kilometres) will almost triple by 2035 to reach 17 trillion passenger-kilometres (p-km), which represents a compound annual growth rate (CAGR) of 4.8% for a 20-year growth period from 2015 to 2035.

The growing middle class in emerging economies is a key driver of demand for air travel. Looking ahead, the expanding middle class is expected to drive growth in global spending. The middle-class population is forecast to expand almost 73% from 2.8 billion in 2015 to 4.8 billion by 2035. Supported by firm global economic growth, a rising middle-class population, higher expected spending power, globalisation, and greater air connectivity, we expect trips undertaken per-capita (and thus propensity to travel) to remain on a steady uptrend over the long term, with strong growth in emerging markets such as China and India.

Robust demand for new aircraft and its financing in the next two decades. Based on Boeing’s estimates, the global fleet will more than double to 45,240 by 2035 to cater for increased air travel demand. Of the 22,510 in-service aircraft in 2015, 18,330 are slated to be retired from service while another 1,440 are expected to be converted to freighters to further extend their useful lives. Thus, Boeing expects that about 39,620 new aircraft will be required and delivered between 2015 and 2035, and would require financing of at least US$3 trillion in 2015 dollar terms.

The growth and importance of the aircraft-leasing sector. From less than 1% share in the 1970s, aircraft leasing has since grown its market share of the global fleet to over 40% and has held steady at around 42% in the last decade. Aircraft lessors play an important role in financing the substantial funding requirements for aircraft, and distributing aircraft capacity more efficiently globally.

Asian lessors have muscled in on the game in recent years. Today, five of the twelve largest aircraft lessors hail from Asia, and a sixth is from Australia. Most of these have prominently grown through the acquisition of another leasing company, and in the case of HNA Group’s, two – Avolon and CIT. Chinese lessors figure prominently among the top 12, including the largest player Avolon/CIT while Japanese lessor SMBC Aviation is also among the top 5 lessors globally.

Transactions and M&A activity remain buoyant in the leasing sector, with Asian players firmly in the mix. Asian lessors are

being linked to all manner of activity in the sector, including 1) acquisition of aircraft portfolios such as AirAsia’s leasingarm and top-10 lessor AWAS, and 2) potential initial publicofferings of lessors such as Minsheng Financial Leasing or theleasing arms of the Chinese banks, following the listing ofCDB Financial Leasing and BOC Aviation in Hong Kong.Meanwhile, even Hong Kong’s tycoons such as CheongKong’s Li Kashing and Chow Tai Fook’s Dato Dr. Cheng Yu-tung have amassed aircraft-leasing assets in recent years, andare still looking to grow their aircraft portfolios.

Sector valuations and peer comparison. Listed aircraft lessors in the US and HK are trading at an average of 9.7x current earnings, declining to 8.6x forward earnings. In Hong Kong, BOC Aviation is the cheapest in terms of price-to-earnings at 8.5x currently. Other than CALC, which is trading at 2.2x current price-to-book-value, against a projected current ROE of 22.6%, the rest of the aircraft lessors are generally trading at around 1x to 1.1x current P/B. While on average the sector only offers a dividend yield of 2.1%, CALC is offering a decent prospective yield of 3.9%.

Our equity calls and picks in the aircraft-leasing sector. Our top pick is BOC Aviation (BUY, TP HK$48) and we initiate coverage on China Aircraft Leasing (CALC) with a BUY call and HK$11.60 target price.

Key Risks: Aircraft oversupply - The most common concern for investors seems to be that of aircraft oversupply. Our view is that given the duopoly in aircraft manufacturing, aircraft supply-demand should be balanced in the long term as it is in the ’s interest of the original equipment manufacturers (OEMs) to promote a balanced situation. In the short term, we also see the aircraft supply-demand environment as relatively benign as 1) global load factors are near historic highs, 2) OEM production growth rate is matching expected demand growth 3) order books are strong, and 4) aircraft storage/retirement are already at low rates.

Interest rate risk - A key feature or driver of an aircraft lessor’s earnings is the net spread (the difference between average yield on aircraft portfolio and average cost of debt) that a lessor earns. In an environment of rising interest rates, investors may have reason to fret. Generally speaking, aircraft lessors are well aware of this risk and manage it via 1) natural hedging where fixed-rate leases are funded by fixed-rate debt, and floating-rate leases are matched with floating-rate debt, 2) active interest-rate hedging using derivatives such as caps and swaps, and 3) trading (sale) of aircraft in the portfolio.

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Industry Focus

Aircraft Leasing


Emergence and Growth of Aircraft Lessors in Asia

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Industry Focus

Aircraft Leasing


Global air traffic is on a long term secular growth path

Rosy outlook for global aviation traffic. According to the International Air Transport Association (IATA), global air passenger traffic rose 5.9% year-on-year in 2016 and is projected to grow 5.1% in 2017. Based on Boeing’s estimates, global revenue passenger kilometers (RPKs) will almost triple by 2035; reaching 17,093 billion passenger-kilometres (p-km) which represents a compound annual growth rate (CAGR) of 4.8% over a 20-year growth period from 2015 to 2035.

World traffic flow forecast (RPKs in billions) for the next 20 years

4,9395,262 5,585 5,898 6,246 6,664

17,093

0

5000

10000

15000

20000

2010 2011 2012 2013 2014 2015 2020 2025 2030 2035

RP

Ks

per

bill

ion

Source: Boeing, DBS Bank

Key drivers of air traffic demand:

1. Prevailing economic conditions, which dictate traveldemand needs.

2. Improving inter- and intra-region route connectivity,helped by liberalisation of airspace and low-cost carriers.

3. Favourable demographic trends (i.e. population growth,rising middle class population, and higher discretionaryspending).

Drivers for air traffic and aircraft fleet growth

Source: Airbus, DBS Bank

World average GDP to grow at 2.9% per annum over the long term. Anticipating a world GDP growth rate of 2.9% p.a. over the next two decades – which should help spur trade flows, human capital movement, tourism, and ultimately, demand for global air travel, Boeing predicts air passenger traffic will grow at an average of 4.8% p.a. into 2035. This is supported by historical trends, where global air travel has consistently outpaced world GDP growth at 1.5x to 2x.

Breakdown of global annual GDP forecasts by region (2015-2035)


Bulk of growth led by Asia-Pacific, Africa and the Middle East. Between 2016 and 2035, global growth is expected to be largely driven by the Asia-Pacific region, which is poised to log an annual GDP growth rate of about 4.1%, far exceeding the global average of 2.9%. Following closely behind are the Middle East’s estimated 3.8% and Africa’s 3.7%.

Growing air connectivity and the rise of mega aviation hubs. The gradual liberalisation of airspaces through open skies and bilateral air transport agreements, coupled with the expansion of low-cost carriers, have played a central role in driving inter- and intra-region air connectivity and the formation of new mega aviation hubs.

To illustrate, Shanghai Pudong Airport is now ranked the eighth busiest airport (by passengers) in 2016 from the 34th position in 2009 after passenger traffic more than doubled from nearly 32 million in 2009 to over 66 million in 2016. Over this period, the market share of low-cost carriers in China also strengthened significantly from around 8% in December 2009 to more than 20% in December 2016.

Airbus estimates that by 2035, the number of aviation mega-cities (which it defines as cities with more than 10,000 daily long-haul passengers) will rise to 93, from 55 in 2015.

Economy

Demographics

Connectivity

Air Traffic Growth Increased

demand for aircraft

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Industry Focus

Aircraft Leasing


Growth and dominance of the middle class by 2035. Looking ahead, global spending power will largely be driven by the growing middle class population, which is forecast to expand by almost 73% from 2.8 billion in 2015 to 4.8 billion by 2035. Based on estimates by Airbus and Oxford Economics, the middle class population will likely account for over 55% of the world’s total population by 2035 – the bulk of which should stem from emerging economies.

Burgeoning middle class population (in millions) between 2015 and 2035

848 864 861206 310 441

17382602

3528

0

1000

2000

3000

4000

5000

6000

2015 2025 2035

Emerging Economies Developing countries Mature countries

Forecast

World pop.(bn)

% World pop.

7.2 8.1 8.8

55%46%38%

2,792

3,776

4,830

*Households with yearly income between $20,000 and $150,000 at PPP in constant 2014 prices Source: Airbus, Oxford Economics, DBS Bank

Strong growth in discretionary spending. Based on estimates by Airbus and Oxford Economics, discretionary spending globally will rise from US$8 trillion to US$13.2 trillion by 2025, driven by higher spending in emerging economies. The share of discretionary spending by emerging economies is expected to expand from 39% in 2015 to 46% by 2025.

Discretionary spending in 2015 vs 2025

39%

61%

Emerging Economy

Rest of the world

46%

54%

2015 2025

US$8.0tn US$13.2tn

*Spending on recreational goods and services (2010 $US, PPP)

Source: Airbus, Oxford Economics, DBS Bank

Expect higher propensity to travel over the next 20 years

-4.00

-2.00

-

2.00

4.00

6.00

8.00

- 50,000 100,000 150,000 200,000 250,000

Tri

ps

per cap

ita

GDP per capita

Year: 2035

Year: 2026

Year: 2016

Source: Airbus, Boeing

Propensity to travel to remain on a steady uptrend. Thanks to firm global economic growth, rising middle class population, higher expected spending power, globalisation, and greater air connectivity, we expect trips undertaken per capita (and thus propensity to travel) to remain on a steady uptrend over the long term.

Demand for travel in emerging markets set to outpace that of mature regions. In 2015, average trips undertaken annually per capita in mature regions such as North America and Europe stood at 1.8 and 1.2, respectively, far above that observed in emerging economies such as China’s 0.3 and less than 0.1 for India.

Airbus forecasts the travel demand gap between mature and emerging markets will narrow by 2035 on the back of rapid economic growth, with China set to see a multi-fold increase in air travel to 1.3 trips per capita. In absolute terms, given its population of over 1.37 billion, China’s air travel market holds vast potential. Similarly, India is also poised to deliver significant trip per capita growth, albeit on a smaller scale.

Trips per capita for selected countries & regions (2015 vs 2035)

0.08

0.3

1.2

1.8

0 1 2 3

India

PRC

Europe

North America

2015 Trips per capita

2035 Trips per capita

2.4

2.2

1.3

0.3


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Industry Focus

Aircraft Leasing


Asia-Pacific, the single most populous region, to continue leading global air traffic. Home to approximately 4.4 billion people in 2015, Asia-Pacific accounts for almost 60% of the world’s population but only represents around 30% of global RPK.

Continued growth in China’s domestic aviation sector could see the mainland overtake the United States as the single largest aviation market by 2030.

Mostly driven by strong demand in China and traction in other fast-growing Asian economies (such as India), Airbus believes that air traffic in Asia-Pacific will grow at 5.5% CAGR, to represent 36% of global RPK by 2035.

Global air traffic to grow at 4.5% CAGR into 2035

Regions % of 2015

World’s RPK

% of 2035

World’s RPK

20-year

CAGR

Asia-Pacific 30% 36% 5.7%

Europe 25% 22% 3.5%

North

America

24% 19% 2.9%

Middle East 9% 11% 5.7%

Latin America 5% 5% 4.8%

CIS 4% 4% 4.1%

Africa 3% 3% 4.5%

Global Average 4.5%


Ranked the second and third largest aviation markets by RPK in 2015, the European and North American regions represented 25% and 24% of global RPK, respectively. With 20-year growth expected to steady at 3.4% CAGR for both Europe and North America (below the global average of 4.5%), Airbus estimates that their global shares will taper slightly to 22% and 19% respectively, in 2035.

Middle East to lead long-term traffic growth. Leveraging its geographical advantage and gulf carriers’ rapid expansion, Airbus expects the Middle East to deliver industry-leading 20-year traffic growth at 6.2% CAGR, to grow its share of global RPK from 9% in 2015 to 11% by 2035.

Emerging and developing economies are the ones to watch. Representing nearly 86% of global population, or 6.2 billion people, air traffic growth in emerging and developing economies are expected to surpass that of advanced economies as (1) the former’s living standards improve, (2) more air travel infrastructure are put in place, and (3) as new routes (especially between secondary cities) are formed.

Emerging/developing economies offer higher RPK growth prospects

Economies Countries & Region Population

(2015) RPK

CAGR

Emerging/ Developing

Asia China India Middle East Africa CIS Latin America Eastern Europe

6.2bn c.5.6%

Advanced Western Europe North America Japan

1.0 bn c.3.7%


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Industry Focus

Aircraft Leasing


Aircraft demand and fleet development North America had largest global fleet share in 2015… Boeing estimates there were approximately 22,510 passenger aircraft in service globally in 2015. Of which, North America had the largest fleet share of about 31% or 6,910 aircraft. The second-largest fleet was found in Asia-Pacific with 6,350 aircraft, which represented about 28% of the global fleet. Europe, with about 4,610 aircraft and a 20% share, ranked third. Breakdown of 2015 global fleet by region

6,3506,910

4,610

1,370 1,5501,030

690

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

Asia North America

Europe Middle East

Latin America

C.I.S. Africa

Source: Boeing, DBS Bank ...with a largely ageing fleet that needs to be replaced. According to the fleet database from the Centre for Aviation (CAPA), the North America region is currently home to some of the world’s oldest passenger fleet, with an average fleet age of about 18 years. Meanwhile, the youngest stems from Latin America, with average fleet age of about 9.1 years. While fleet age is viewed as a lagging indicator, it can still provide insight into varying demand trends across regions and direction with regard to fleet renewal. Average passenger fleet age by region as at 8 August 2016

13.1

14.815.7

10.9

17.7

9.1

0

2

4

6

8

10

12

14

16

18

20

Asia Pacific Middle East Africa Europe North America Latin America

Source: CAPA, DBS Bank Passenger fleet grew 4% p.a. on average over last decade. Based on data from CAPA, we estimate the global in-service passenger fleet grew by 3.5% in 2015 and 4% in 2016, registering a long-term average growth of 3.9% p.a. over the last decade.

For 2017F, IATA estimates that global fleet growth will taper slightly to 3.6%. Global fleet growth over the past few years

Source: CAPA, IATA, DBS Bank

Similarly, Boeing expects global passenger fleet to grow at 3.6% CAGR between 2015 and 2035. Boeing forecasts traffic (RPK) growth of 4.8% CAGR between 2015 and 2035, and believes that global passenger fleet should grow at 3.6% CAGR to satisfy this growing demand for air travel. Asia-Pacific’s fleet to grow at 5% CAGR, followed by the Middle East’s 4.8% and Africa’s 4.4%. Given the region’s strengthening economy, improving air transport connectivity, and with over 100 million new passengers set to enter the air travel market each year, the Asia-Pacific region is poised to see the largest fleet growth (at 5% CAGR) among peers.

Meanwhile, the Middle East is expected to expand its fleet by 4.8% per year, in line with expected RPK growth of 5.9% CAGR. As such, fleet growth in advanced markets such as Europe and North America will likely be outpaced by that of emerging and developing markets. Fleet growth rate by region between 2016 and 2035

5.00%

1.80%

2.70%

4.80%

4.40%

3.10%

3.80%

3.60%

0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 6.0%

Asia

North America

Europe

Middle East

Latin America

CIS

Africa

World Average


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Industry Focus

Aircraft Leasing


According to Boeing, global fleet could more than double by 2035. Based on Boeing’s estimates, global fleet will more than double to 45,240 to match increased aviation demand. Of the 22,510 in-service aircraft in 2015, 18,330 are slated to be retired from service while another 1,440 are expected to be converted to freighters to extend their useful lives and are likely to be narrow-body aircraft. Boeing also expects about 39,620 new aircraft deliveries to be made between 2015 and 2035.

Global fleet could double by 2035

22510

56200

10000

20000

30000

40000

50000

2015 2035F

Growth Replacement Retained

39

,62

0

45,240


Deliveries by region – Asia to account for 38%. Of the 39,620 new aircraft deliveries expected into 2035, Asia will account for c.38% or 15,130 aircraft. This is followed by the North American (21%) and European (19%) regions which account for 8,330 and 7,570 aircraft, respectively. We see this as largely in line with their respective future air traffic demand needs, and as they seek to replace ageing fleet with newer technologies which are often more fuel-efficient to optimise operating costs.

Global new deliveries by region

Asia 38%

North America 21%

Europe 19%

Middle East 8%

Latin America 8%

C.I.S. 3% Africa 3%

New deliveries39,620


Aircraft types. Broadly speaking, there are three distinct aircraft types: 1. Wide-body: Typically larger commercial aircraft with twin

aisles typically with medium to long range and can havepassenger capacity from 160 to upwards of 480. Suchaircrafts can have 2 to 4 engines and be rated transatlanticor transcontinental. At list prices, a wide-body such as aB787-8 cost about US$224.6m.

2. Narrow-body: They are smaller aircrafts with a single aisleconfiguration with a passenger capacity of up to 200 andmainly ply short to medium haul routes. At list prices, anarrow-body B737-700 cost about US$80.6m.

3. Regional jets: Regional jets can be defined as a set ofnarrow bodies typically with passenger capacity up to 100and are mostly used for connecting regional hubs and witha shorter range. These can include turboprops aircraft.

Aircraft orders by type: The popularity of narrow-body Of the new aircrafts to be delivered by 2035, approximately 71% (or 28,140 hulls) will be narrow-bodies, while 23% (9,100 aircraft) will be wide-bodies. The remaining 2,380 are regional jets. The popularity of narrow-bodies among carriers is largely attributable to:

1. Cost efficiency: Narrow-bodies tends to come with shorter,lighter engines which are typically more fuel efficient.

2. Route flexibility: Narrow bodies provide carriers – especiallythose who are also looking to operate new complementaryshort-haul routes, with wider redeployment opportunities.Additionally, as these routes typically involve smaller hubswith lower passenger traffic, carriers run a lower risk ofunfilled seats.

Breakdown of global deliveries by aircraft type

Wide-body, 9100

Narrow-body, 28140

Regional Jet, 2380

39,620

22% 23%

66% 71%

12% 6%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2015 2035

Regional jet Narrow-body Wide-body

Share of fleet Delivery units 2015-2035


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Industry Focus

Aircraft Leasing


Replacement needs and tighter regulation also drive aircraft demand. Travel demand aside, replacement needs and emergence of new regulations may also drive demand for newer aircraft. As compared to older models, newer aircraft offer the advantages of: (i) Lower operating costs, especially improved fuel burn (the best way to hedge fuel cost exposure) and lower maintenance costs; (ii) Improved payload and range capability (important for opening new markets) and despatch reliability; (iii) Advanced cockpits and cabins (weight savings either reduce costs or offer greater revenue potential from increased seat density. Often, older aircraft are uneconomic to refurbish); and (iv) Availability (the option to upgrade an older aircraft is driven by available supply of new aircraft).

The airline industry is also subject to regulations, particularly on the safety and operational axes. The latter may impact fleet strategy and aircraft values. Another form of regulation which can potentially impact aircraft liquidity is aircraft importation age restrictions, which are used in certain countries to prevent the import of aircraft older than a certain age (typically 10, 15 or 20 years). According to aviation consultant Ascend, such regulations can be found in approximately 44 countries today, but only half of these are currently in effect.

Firm order backlog represents >50% of current fleet, with emerging markets contributing the lion’s share. We estimate that the order backlog of passenger aircraft from Airbus and Boeing totaled 9,676 as at 6 Feb 2017.At present production / delivery rates, this is equivalent to approximately ten years’ worth of deliveries and represents c.54% of the current installed fleet.

With the exception of Africa, emerging and developing markets such as Asia Pacific and the Middle East, generally have higher backlog-to-current fleet ratios relative to their mature counterparts (Europe and North America). While order backlogs in North America and Europe only represent 36% and 42% of their respective fleet, the respectively, they absolute aircraft or order remains substantial at 1,501 and 1,978 aircraft respectively. With majority of the order backlog already firmly committed towards airline’s fleet growth plans and replacement needs, both Airbus and Boeing have announced plans to lift production rates for the Airbus A320 and Boeing 727 families of aircraft to capitalise on the strong demand for passenger jets. Separately, based on CAPA’s fleet data, we also estimate that c.27.5% or 2,660 of the current order backlog actually accrue to lessors. Expected to be delivered through 2025, we believe the firm backlog of nearly 10,000 aircraft from Airbus and Boeing alone, demonstrates the robust long-term demand for new commercial jet airliners.

Order backlog (as disclosed by customers) as at 6 Feb 2017*

Region Africa Asia-Pacific Europe Lat in America Middle East North AmericaOrder Backlog 190 4,006 1,978 719 1,282 1,501

% Share 2% 41% 20% 7% 13% 16%Current Fleet 587 6,240 4,708 1,130 1,127 4,114

Backlog as % of Current Fleet 32% 64% 42% 64% 114% 36%

*for Airbus and Boeing passenger aircraft only

Source: CAPA, DBS Bank

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Industry Focus

Aircraft Leasing


Aircraft financing

Actual value of new deliveries total c.US$3 tn. Based on the 39,620 new fleet deliveries number between 2016 and 2035 as estimated by Boeing, the total value of aircraft based on list prices would be worth at least c.US$5.96 trillion in 2015 dollar terms, but closer to US$3 trillion in reality.

% of aircraft type by delivery value (2015 vs 2035)

Wide-body48%

Narrow-body50%

Regional Jet2%2015

Market

Wide-body24%

Narrow-body70%

Regional Jet6%2035

Market


Asia to account for the bulk of aircraft fleet delivery costs. In the next two decades (2016-2035), in line with the expected fleet expansion and deliveries - Asia will bear the bulk (approximately 40%) of actual fleet delivery costs, which is typically at a discount to list price and estimated overall costs is around US$1.195 trillion. Europe is expected to have a 19% share or about US$570 billion of actual fleet value, while the North American market will contribute a further 17%, which represents an actual fleet value of approximately US$524 billion.

While costs acrruing to Latin America, Africa and C.I.S are expected to remain small. According to Boeing, Latin America, Africa and C.I.S will likely account for c.US$178bn (6%), c.US$86bn (3%) and c.US$72bn (2%) of actual fleet deliverycosts, respectively. We believe that this is mainly a result ofreflection of their preference/demand for secondary puchases ofolder aircraft (usually from developed markets), as opposed tooutright purchases of newer models.

Aircraft delivery value by region from 2016-2035 (List prices)

Asia40%

Europe19%

North America17%

Latin America6%

Middle East13%

C.I.S.2%

Africa3%

Value (2015, US$): 5,960 bn


Growing need for aircraft financing. To support the strong demand for newer technologies and fuel-efficient aircraft going forward, we anticipate that the aviation industry would require even larger amounts of funding – above and beyond that in 2015, which Boeing estimates to be in excess of US$100 billion p.a. According to their projections, annual aircraft financingrequired for new deliveries alone will likely reach US$172 billionby 2020, which represents a CAGR of 5.9% between 2015 and2020.

Aircraft financing needs to grow at 5.9% CAGR into 2020

122 127 130142

161172

0

20

40

60

80

100

120

140

160

180

200

2015 2016F 2017F 2018F 2019F 2020F


Primary sources of aircraft financing. Of the US$127 billion in new aircraft financing estimated for 2016, a majority (87%) will be attributable to capital markets, bank debt, and cash. Capital markets will likely serve as the single largest source of financing, satisfying about 36% of new aircraft financing needs. Bank debt and cash will likely represent 27% and 24%, respectively.

Meanwhile, export credit provided by export-import banks and tax equity should account for the remaining 13% for new aircraft financing. Given ample liquidity in commercial markets, the popularity of export credit as a source of financing has diminished over time, but remains a key source of financing in emerging markets.

Sources of aircraft financing sources in 2016F

2%

11%

27%

36%

24%

Tax Equity

Export Credit

Bank Debt

Capital Markets

Cash

2016F


Page 11

Industry Focus

Aircraft Leasing


Capital markets. Capital markets play a huge role in aircraft financing. The largest users have been aircraft lessors, who have the financial sophistication and experience. In 2015, aircraft leasing companies tapped the capital markets frequently and accounted for a 45% share of capital market financing. The second-largest user of the capital markets for aircraft financing has been the US airlines as it is a cheaper source of financing than traditional commercial loans. Non-US airlines form the other bulk of the main user of capital markets. Users of capital market for aircraft financing

Source: Boeing, DBS Bank Commercial bank debt. The largest players that provide commercial lending are led by China and Japan, who have been extremely active and aggressive in the space. China accounts for almost 29% of commercial lending for aircraft financing. Japan is the second-largest lender at 15% globally. Commercial bank debt by country for 2016F

China29%

Japan15%

Germany13%

France9%

Australia7%

Middle East6%

USA5%

Others16%


Aircraft lessors play a big role in supporting new deliveries Airlines are growing to meet the continued aviation transport demand globally, particularly new players such as the low cost carriers (LCCs) and start-up airlines in Asia. However, new aircraft are expensive and ties up large part of a carrier’s balance sheet as its fleet expands. Hence, aircraft leasing companies will continue to support and play a big part in financing new commercial aircraft deliveries through direct purchases and purchase-and-leaseback agreements as they assist airlines in growing their fleet. Sources of funds by aircraft leasing companies. Aircraft leasing companies use a wide range of financing tools such as asset-backed securities, debt capital markets, unsecured borrowings, etc. From the time series, it is evident that lessors are tapping more and more of the capital market – from 36% of all lessor deliveries in 2012 to 53% in 2015. Share of funding for aircraft lessor deliveries

16%9% 8% 6%

30%35%

21% 20%

36% 37%

49% 53%

18% 19% 22% 21%

0%

50%

100%

2012 2013 2014 2015FCash Capital Markets Bank Debt Export Credit

Source: Boeing, Company filings, DBS Bank

Lessors45%

US airlines30%

Non-US airlines25%

2015 US40+bn

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Industry Focus

Aircraft Leasing


Aircraft leasing: A background

A brief history of aircraft leasing. Aircraft leasing started almost five decades ago in the 1960s, just as commercial aviation was taking off. In 1968, airframe maker McDonnell Douglas was the first to introduce a vendor aircraft finance business solution to support its aircraft sales in an attempt to compete with its rivals. This eventually led to the founding of modern day aircraft lessors Guinness Peat Aviation (GPA) in 1975 in Ireland and International Lease Finance Corporation (ILFC) in 1973.GPA and ILFC were eventually respectively taken over by General Electric Capital Aviation Services (GECAS) and AerCap, who are currently the world’s top two lessors.

Aircraft leasing today. From less than a 1% share in the 1970s, aircraft leasing has since grown its market share of the global fleet to over 40% and has held steady at around 42% in the last decade while the global fleet continued to grow. (For more on the basics of aircraft leasing, please refer to the appendix.)

Top aircraft leasing companies. While there are over 160 operating lessors globally, the sector is dominated by players with 50 or more aircraft in their portfolios. Among these, AerCap and GECAS dwarf their peers with over a thousand aircraft each, while the next closest player would be the Avolon/CIT Group (acquisition in-progress) with around 600 aircraft. Of the top 12 lessors currently, four are from China, whereas there were none just ten years ago.

Top global aircraft lessors (>100 seats)

Lessor In-service On order Total

AerCap 1,127 408 1,535GECAS 1,203 256 1,459HNA/Avolon/CIT 593 262 855Air Lease Corp 276 373 649 SMBC Aviation Capital 389 201 590BOC Aviation 272 216 488ICBC Leasing 279 133 412BBAM LLC 389 0 389 Aviation Capital Group 248 101 349 AWAS 233 15 248Macquarie AirFinance 198 40 238 CDB Leasing 158 54 212

Source: Bloomberg Intelligence, DBS Bank

Operating leases as a % of global aircraft fleet

Source: Ascend

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Industry Focus

Aircraft Leasing


Asia Pacific and Europe are core markets for aircraft leasing. Currently, there are nearly 800 airlines in about 160 countries operating almost 20,000 passenger jets of 100+ seats and their freighter equivalents. According to data from CAPA, the global airline fleet is currently dominated by the Asia-Pacific region with a 34% market share as at 7 Feb 2017. Europe follows with 26% and North America with 23%. A breakdown of the global leased fleet shows similar trends, with Europe and Asia-Pacific holding higher shares of around 30% each, and a lower share in North America of less than 20% - which indicates that the core aircraft operating lease markets are in Asia-Pacific and Europe, while the tax regime in North America encourages profitable airlines to own aircraft on their balance sheets.

Breakdown of global fleet as at 7 Feb 2017

Source: Ascend, DBS Bank

Largest carriers lessees are from Asia-Pacific and Europe. Based on Air Finance data, the largest lessee by number of aircraft comes from Europe and Asia-Pacific respectively. The single largest carrier lease is American Airline that accounts for almost 430 aircrafts. Coming up in second is Air-France KLM as well as IAG (“International Airline Group”) which includes British Airways, Aer Lingus, Iberia, Vueling airline brands under its umbrella.

Top Asia-Pacific airline lessees. From Asia-Pacific, the Chinese airlines dominate the lessee space. China Southern leads with 195 aircraft on lease, followed by Air China with 168 aircraft, Garuda Indonesia with 158 aircraft, China Eastern with 157 aircraft, and lastly, Jet Airways from India.

Top lessee by carriers/airlines (Jan 2016)

88

91

92

92

96

97

102

104

105

108

122

131

157

158

159

168

195

271

282

430

0 50 100 150 200 250 300 350 400 450 500

Delta

Jet Airways

Azul Linhas Aereas

GOL

Transaero

LATAM

Air Berlin

Air Canada

Alitalia

TUI AG

Emirates

United Airlines

China Eastern

Garuda Indonesia

Aeroflot

Air China

China Southern

IAG

Air France-KLM

American Airlines

North America

Europe

Asia-Pacific

Middle-East

Latin America

C.I.S

Source: Air Finance, DBS Bank

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Aircraft Leasing


Strategies commonly employed by top lessors Narrow-bodies generally preferred. Based on CAPA’s fleet database, we infer that nearly 60% of the global in-service passenger fleet owned by lessors as at February 7, 2017 are narrow-bodies. Offering better cost-efficiency and route-flexibility relative to wide-body aircraft, narrow-bodies are highly sought-after by airlines, particularly in Asia where LCCs have been rapidly gaining market share as they continue to drive regional connectivity through fleet expansion and the launch of new short–to-mid-haul routes. Given the above, it is unsurprising that narrow-bodies are able to tap a bigger market– and are thus generally more liquid, which helps support secondary market values – and are often easier placed out than wide-body types. But evolution of wide-body jets could help lift proportion of wide-bodies from 13% currently. Helped by technological shifts, new-generation wide-body aircraft, such as Boeing’s 787 Dreamliner as well as Airbus’ A350 and A330 neo, offer improved cost economics, performance, and operational flexibility than previous generations’ (such as the Boeing 747 and Airbus A340) – and at a fraction of the cost. With the ability to conform to a wide range of carriers’ business models, these new-generation wide-body types could play a bigger role in lessors’ portfolios going forward. % of global in-service leased passenger fleet are narrow bodies*

* as at 7 Feb 2017

Source: CAPA, DBS Bank GECAS and AerCap dominate both the narrow-body… We estimate that the top 10 players hold well over 40% of the global leased narrow-body fleet. Among the top 10, data from CAPA as at February 7, 2017 also suggests that the narrow-

body space is mostly dominated by long-standing industry leaders, GECAS and AerCap. With a fleet of 905 and 730 narrow-body aircraft in their respective portfolios, GECAS and AerCap’s current scale in the narrow-body leasing market significantly eclipses that of their next closest rivals. Top 10 lessors for narrow bodies by fleet size (as at 7 February 2017)*

Source: CAPA, DBS Bank; *excludes Avolon/CIT merger data … and wide-body leasing space. Similar to trends in the global narrow-body leasing market, both AerCap and GECAS also appear to dominate the wide-body leasing market, with estimated market share of 14.9% and 5.9%, respectively. Meanwhile the top 10 players jointly hold about 40% of the global leased wide-body fleet, with Aercap having a larger proportion of wide body aircraft in their portfolio relative to other top tier lessors. Top 10 lessors for wide bodies by fleet size (as at 7 February 2017)*

Source: CAPA, DBS Bank; *excludes Avolon/CIT merger data

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Industry Focus

Aircraft Leasing


Lessors acquire their fleet either from the manufacturers directly or from the secondary market. Aircraft lessors generally acquire aircraft through a) ordering and purchasing new aircraft directly from manufacturers, b) purchase and lease-back transactions with its airline customers, or c) acquiring aircraft from other lessors or even the entire portfolio/platform. Top 10 lessors have an average fleet age of 7.4 years. Based on data from CAPA, we estimate that the average fleet age of the top 10 aircraft lessors’ (by in-service narrow- and wide-body fleet size as at February 7 2017) is approximately 7.4 years. Average fleet age of top 10 aircraft lessors (as at 7 Feb 2017) *

* includes in-service narrow body and wide body fleet only Source: CAPA, DBS Bank

Managing fleet age against risks. Lessors with older planes tend to enjoy higher yields, and vice versa. In the event of overcrowding in the secondary market, however, lessors with an ageing fleet could be faced with higher residual-value risks, which may put pressure on their credit rating and financing costs. As such, a strong risk-management framework is necessary to help balance the benefits of an older fleet against possible longer-term risks. No two leasing businesses the same. While the actual operating model pursued tends to differ among the tier-1 lessors, their underlying business strategy may be broadly classified under either of the following categories: - (1) Young fleet: Under this strategy, lessors typically manage newer aircraft that are still in the first aircraft life-cycle and are thus less subject to residual value risk and substantial maintenance capex needs. Lessors employing this strategy include ICBC Leasing, Avolon, BOC Aviation, and Air Lease, which have average fleet ages between 3.8 and 5.1 years. (2) Yield-focused: Lessors such as Aircastle and AWAS operate in a niche space which is more agnostic (on a relative basis) to fleet age and instead, is focused on extracting yield and further value from their fleet. (3) All-rounders: Armed with specialty knowledge and extensive technical expertise, lessors such as GECAS and AerCap are well able to manage aircraft across ages and life-cycles. Their higher fleet ages of 11.3 years and 11.6 years, respectively, are reflective of this strategy.

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Industry Focus

Aircraft Leasing


Key metric comparison between selected aircraft leasing companies

As at end 2015 (US$m) AerCap Air Lease Air Castle FLY Leasing CALC

BOCA

Total assets 43,914 12,355 6,570 3,417 3,090 12,474

Aircraft net book value 32,219 10,813 5,867 2,663 311 9,476

ROE (%) 13.8% 11.0% 6.9% 13.0% 19.5% 15.1%

Owned fleet 1109 240 162 80 63 227

Aircraft on order 447 389 35 n.a 129 241

Weighted average age (years) 7.7 3.6 7.5 6.6 3.5 3.3

Average lease remaining (years) 5.9 7.2 5.9 6.5 10

7.4

Cost of debt funding (%) 3.70% 3.70% 5.20% 5.40% 4.10% 2.00%

Debt to equity (x) 3.5 2.6 2.3 3.7 9.5 3.7

Number of Aircraft Lessees 218 89 61 65 11 62

Number of Countries 90 50 37 36 3 30

Manufacturer Bias Airbus (53%) Airbus (40%) Boeing (56%) Boeing (57%) Airbus (92%) Airbus (51%) (existing fleet)

Geographic concentration (by NBV)

Europe (35%),AP (32%)

Asia (47%), Europe (34%)

Asia (42%), Europe(28%)

Europe (41%), Asia (31%)

Asia (100%) Asia (54%), Europe (23%)

Largest 3 customers

American Airlines (11%),

Diversified client base

S. African Airways (~7%)

Diversified client base

China Eastern (17%)

Cathay Pacific (~7%)

Aeroflot Russian Airlines (~7%)

Thai Airways (~7%)

Chengdu Airlines (15%)

Iberia (~6%)

Virgin Atlantic Airways (~6%)

Martinair (~6%)

China Southern

(14%)

Qantas(~6%)

Source: Company filings

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Industry Focus

Aircraft Leasing


The emergence and growth of aircraft lessors in Asia Inorganic growth a key driver. While aircraft leasing has traditionally been dominated by American or European firms, Asian lessors have been catching up in a big way – beginning with the founding of Changjiang Leasing and ORIX Aviation in 2000. Today, five of the twelve largest aircraft lessors hail from Asia, and a sixth is from Australia. Most of these have prominently grown through the acquisition of another leasing company, sometimes two. Less than a year after HNA Group completed the acquisition of Avolon and merged it with its own aircraft-leasing arm Hong Kong Aviation Capital, it sealed a deal in October 2016 to acquire CIT’s aircraft-leasing arm – forming the world’s third-largest lessor. In 2012, SMBC Aviation was acquired from Royal Bank of Scotland, and BOC Aviation was acquired from Singapore Airlines (and other investors) in 2006. Organic growth has also helped. Meanwhile, Asian lessors have also grown organically from deliveries from OEM manufacturers, primarily Airbus and Boeing. As it stands, Avolon/CIT, SMBC, CDB Leasing, BOC Aviation, and ICBC Leasing all have order books of over 100 aircraft, which should help drive double-digit growth in their portfolios in the coming

years. And this does not take into account the purchase and leasebacks of aircraft they will enter into. All this implies that the largest Asian lessors will continue to grow at a pace that is above industry average.

Top global aircraft lessors (>100 seats) – November 2016

Lessor In-service On order Total

AerCap 1,127 408 1,535 GECAS 1,203 256 1,459 HNA/Avolon/CIT 593 262 855 Air Lease Corp 276 373 649 SMBC Aviation Capital 389 201 590 BOC Aviation 272 216 488 ICBC Leasing 279 133 412 CDB Leasing* 184 214 398 BBAM LLC 389 0 389 Aviation Capital Group 248 101 349 AWAS 233 15 248 Macquarie AirFinance 198 40 238

Source: Bloomberg Intelligence, DBS Bank; *As at June 2016

Timeline: The emergence of the Asian players

ccb financ Source: AirFinance, CALC, DBS Bank

Founded in 2000

BOCA acquired Singapore Aircraft Leasing Enterprise

Founded in 2006

Founded in 2007

Founded in 2007

CDB leasing acquired Shenzhen Financial Leasing co.

Founded in 2008

HKAC founded in 2010 via the acquisition of Allco

Founded in 2010

Founded in 2009

SMBC acquired RBS Aviation Capital

Bohai acquires Avolon and CIT

Mitsubishi officially takes over Jackson Square Aviation

JV between CIT and Century Tokyo

JV between MCAP and Li-Ka Shing’s Cheung Kong

Founded in 1969 and acquired by Shinsei Bank in 2005

Founded in 1991

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Industry Focus

Aircraft Leasing


Chinese lessors to the fore Post-2007: Chinese banks enter the foray after deregulation. After the China Banking Regulatory Commission (CBRC) relaxed regulations on aircraft leasing in 2007, many financial institutions, led by China’s big banks such as ICBC, CCB, CDB, Minsheng, CMB, and Bank of Communications, started building up their aircraft-leasing arms and developing their own capabilities and scale in this segment. Top China aircraft lessors (In no particular order)

CDB Leasing

ICBC Financial Leasing

BOC Aviation

CALC

Minsheng Financial Leasing

CMB Financial Leasing

Bank of Communications Financial Leasing

CCB Financial Leasing

ABC Financial Leasing

AVIC Leasing

Avolon/CIT (HNA Group)

Source: Airfinance, DBS Bank China’s fast-growing domestic aviation pie. According to Boeing, China will take delivery of nearly 6,000 new jets worth US$780 billion between 2015 and 2035, as its domestic market is projected to be the world’s largest by 2030. Chinese lessors have been growing their share of the domestic aircraft-leasing business aggressively through acquisitions from other aircraft leasing companies as well as through purchases and leasebacks from Chinese airlines. By 2018, according to industry consultant Ascend, Chinese lessors will capture 55% of the aircraft-leasing market, from 38% in 2013, and nearly zero a decade ago. It is estimated that Chinese lessors now handle 80% or more of new domestic leasing transactions in China.

Going international. In 2013, China’s central government had spoken of their desire for local lessors to expand outside their domestic market, given the huge potential growth in aviation traffic in the next decades. Prior to this, only a handful of Chinese lessors, namely BOC Aviation, CDB Leasing, ICBC Leasing, and Hong Kong Aviation Capital had significant operations outside China. We have since then seen Chinese lessors participate more actively in the international markets, and many of them are now actively linked to transactions outside China.

Bank-backed aircraft lessors in China. The large majority of China’s top aircraft lessors are supported by the country’s top banks. Examples of these are:

China Development Bank (“CDB”) Leasing

(Listed in the Hong Kong Stock Exchange in July 2016)

Industrial and Commercial Bank of China (“ICBC”) Financial Leasing

Minsheng Financial Leasing

China Merchants Bank (“CMB”) Financial Leasing

Bank of Communication Financial Leasing

China Construction Bank (“CCB”) Financial Leasing

Bank of China (“BOC”) Aviation (Listed in the Hong Kong Stock Exchange in June 2016)

Agricultural Bank of China (“ABC”) Leasing

Here, we profile some of China’s top, and up-and-coming aircraft lessors. HNA Group making a big splash as the world’s third-largest aircraft lessor through the acquisition of CIT. In January 2016, HNA Group, via its subsidiary Bohai Leasing, completed the acquisition of Avolon – then a top 10 aircraft lessor globally – and merged its existing aircraft-leasing arm Hong Kong Aviation Capital under Avolon to form a top 8 aircraft lessor.

This was sensationally followed by an agreement reached in October 2016 by Avolon to acquire the aircraft-leasing business of CIT Group for US$10 billion – which will form a combined business that will have an owned, managed and committed fleet of 910 aircraft valued at over US$43 billion, – placing the combined entity well ahead of SMBC Aviation and Air Lease as the third-largest aircraft leasing business in the world.

We expect that Avalon, having achieved its ‘medium-term target’ in less than a year after it was bought by Bohai Leasing, will continue to be active in acquisitions and transactions as it seeks to narrow the gap between itself and the two big boys, GECAS and AerCap, and to perhaps one day even surpass them.

Page 19

Industry Focus

Aircraft Leasing


BOC Aviation – taking SALE to the next level after acquisition. Bank of China acquired Singapore Aircraft Leasing Enterprise (SALE) from Singapore Airlines and other shareholders in 2006, and subsequently became known as BOC Aviation. Since then, BOC Aviation with Bank of China’s support, has grown to be among the top aircraft leasing companies globally and was a top-5 player globally when it successfully completed its IPO in HK in Jun 2016. Having been nudged out of the top 5 by Avolon’s acquisition of CIT, prospects for BOC Aviation remains bright as it is looking to leverage on new equity raised from its IPO to more aggressively growth its business. ICBC Leasing – a top three aircraft lessor in China. The leasing arm of China’s ICBC Bank, ICBC Leasing is one of China’s largest aircraft lessors with an owned, managed and committed aircraft portfolio of over 400 aircraft. The portfolio is primarily made up of Boeing and Airbus aircraft, with a spattering of Embraer and Bombardier planes. According to its website, ICBC Leasing has 48 airline customers in South America, Europe, Africa, the Middle East and Asia. With over 100 aircraft on order, ICBC Leasing is well positioned to continue growing and remain one of the country’s and world’s top lessors. CDB Leasing – China’s largest diversified lessor. The leasing arm of the China Development Bank, CDBFL focuses on aircraft and infrastructure leasing mainly in China. As at end June 2016, CDB Leasing had a portfolio of 184 owned aircraft, 11 managed aircraft and 214 committed aircraft. This consisted mainly of narrow body aircraft, such as the A320 family and B737-800, and wide-body aircraft including the A330 and B777. CDB Leasing had 41 airline clients in 22 countries. With committed aircraft that is well over its current owned portfolio, CDB Leasing is positioned to grow firmly in the years ahead. CALC – a growing independent lessor in China. Established in 2006, CALC had grown its fleet to 81 aircraft by end 2016, leased to 16 airline customers in Asia and Europe. With a firm order book for 92 aircraft from Airbus and potential for more from pop-ups and purchase & lease-backs, CALC is well poised to grow its fleet to at least 173 by 2022. CALC has also been growing its earnings through the sale of its finance lease receivables to recycle its capital and grow its business, and also has a 49% stake in an aircraft disassembly business based in Harbin that is slated for commencement in 2017. This could help push CALC to become a true full value chain aircraft solutions provider.

Ping An International Financial Leasing. Ping An International Financial leasing company was founded in 2012 is a wholly owned subsidiary of Ping An Insurance Group – which is China’s largest non-state owned company. It has made sizeable orders and has been active in the secondary markets for purchase-and-leaseback deals to build up its portfolio, and has also been linked with M&A deals in the sector. Selected Chinese aircraft lessor activities: 2015 -2016

Timeline Activities

Feb 2015 Commencement of trading for Rongzhong

International Financial leasing

Jul 2015

China Aircraft Leasing Group (CALC) US$94m

Hong Kong IPO - Asia’s first publicly traded

aircraft lessor

Jul 2015 Newly set up Ping An International Financial

Leasing aviation business

July 2015

Two new lessors entered the market

Hong Kong Financial Group Bridge Partners

opened an aviation division

Astro Aircraft Leasing launched

Sep 2015

Bohai Leasing; a subsidiary of HNA Group

acquired Avolon (the world’s third largest aircraft

lessor at the point of time)

June 2016

BOC Aviation, an arm of Bank of China debut on

the Hong Kong Stock Exchange with a US$1.1bn

IPO.

Jul 2016 China Development Bank Leasing (CDB) Hong

Kong US$800m IPO

Oct 2016 Avolon agrees to acquire CIT’s aircraft leasing

business for US$10bn Source: Company filings, DBS Bank

Page 20

Industry Focus

Aircraft Leasing


Japanese lessors: Re-emerging once more Pioneers in aviation financing. The Japanese were one of the earliest players in aircraft leasing, with the establishment of Showa Leasing in 1969. In the 1980s, the Japanese were a major source of aviation financing. Re-emergence. While Japanese banks have always figured strongly in domestic aviation financing, they have re-emerged in recent years in the global aviation market, as they seek higher returns and lower risk than traditional corporate lending. With the purchase of RBS Aviation Capital by Sumitomo Mitsui Financial Group (SMBC Aviation) and Mitsubishi UFJ’s acquisition of Jackson Square Aviation, Japanese lessors have once more returned to the fore. A Japanese financing structure: JOL or JOLCO (tax leases) The Japanese have been prominent in aircraft leasing since the 2000s, helped by their very own Japanese operating lease with call option (“JOLCO”) or Japanese operating lease (“JOLs“). A JOLCO is an operating lease fully or partially funded by a Japanese-domiciled source of funds. Under this structure, Japanese investors would plough back profit into financing aircraft purchases in exchange for tax benefits and depreciation-allowances claims It typically takes the form of an SPV with equity provided by Japanese equity investors (typically 20%-30%) and the remainder financed by debt. has helped Japanese lessors become significant players in the aircraft-leasing space. JOLs or JOLCOs are essentially like conventional operating or finance leases but the depreciation benefits that allow Japanese investors to decrease the taxable part of their funds end up being shared by lessor and lessee (in the form of lower lease rates). Since JOLs or JOLCOs are also available to foreign lessees, the availability and benefits offered by JOLs and JOLCOs have helped Japanese lessors become significant players in the aircraft-leasing space. Top Japanese lessors

Top Japanese Lessors

SMBC Aviation Capital

ORIX Aviation

Jackson Square Aviation

MC Aviation Partners

Century Tokyo Leasing Corporation

Showa Leasing

Mitsui Busaan Aerospace

Source: Airfinance Journal, DBS Bank

Selected profile of top aircraft lessors in Japan SMBC Aviation Capital (“SMBC”) was established as a

result of a US$7.3-billion acquisition of Royal Bank of Scotland’s aircraft-leasing business by leading Japanese institution Sumitomo Mitsui Banking Corporation. SMBC Aviation Capital is based in Dublin, Ireland. It is today among the world’s top 5 aircraft-leasing companies, with 669 owned, managed, and committed aircraft in its portfolio as at the end of September, 2016.

ORIX Aviation was founded in 1991 as part of ORIX Corporation. a Japanese financial conglomerate with businesses in asset lending rentals, property leasing, insurance, and investment management. It has presence in 30+ countries, with 60+ lessees.

Jackson Square Aviation is a San Francisco-based lessor which was acquired for about US$1.3 billiion in 2013 by Mitsubishi UFJ Lease & Finance (“MUL”), one of the largest leasing companies in Japan by assets.

MC Aviation Partners (“MCAP”) was founded in 2008 as the wholly-owned leasing-and-trading arm of Mitsubishi Corporation, and currently owns and manages a fleet of over 100 aircraft.

Century Tokyo Leasing Corporation (“TC Lease”) Century Tokyo Leasing Corporation was established in 2009 via a mergerof Century Leasing System, Inc. and Tokyo Leasing Co., Ltd.

Showa Leasing is a pioneer in the aircraft leasing space; Founded in Tokyo in 1969 as a general leasing company, Showa is Asia’s first aircraft leasing firm. It was subsequently acquired by the Shinsei Bank Group in 2005 and is now the financial and operating leasing arm of Shinsei Bank.

Page 21

Industry Focus

Aircraft Leasing


Other non-traditional lessors Airline Lessors. The first airline-lessor was run by the now-defunct Ansett Australia, which established its leasing arm Ansett Worldwide Aviation Services in 1985. It was later sold to Morgan Stanley Dean Witter in 2000 for US$600 million and rebrandedin 2004 as AWAS – one of the top 10 aviation lessors by fleet size. Similarly, Singapore Airlines also set up a leasing arm known as Singapore Aircraft Leasing Enterprise (SALE) – jointly with Boullioun Aviation Service (in 1993) – which was sold to Bank of China in 2006 for US$965 million; SALE has become one of the world’s largest aircraft-leasing companies. The rationale for airlines to set up a leasing business We’ve seen in recent years a number of airlines setting up their own leasing arms which, in addition to leasing to their own affiliated airlines, also lease to third-party airlines. The more prominent names include Indonesia’s Lion Air, Malaysia’s AirAsia, and Norway’s Norwegian Air Shuttle. We believe there are three main reasons for this phenomenon. 1.) Seeking a higher, stable and more diversified income stream. The airline business is cyclical, highly dependent on oil prices and global GDP growth, and hence on passenger demand. The leasing business enables airlines to build a new, more stable, and diversifiedrevenue stream which also hedges against volatility in the US dollar. To quote Norwegian Air Shuttle’s chief executive Bjorn Kjos, “They (aircraft lessors) have a fantastic bottom-line. They earn all the money the airlines should have earned.” 2) Bulk discount. It’s an open secret that the more planes you order from the OEMs e.g. Airbus and Boeing, the larger the discount. Having a leasing arm to place the planes helps an airline place larger orders and hence obtain a larger discount, which ultimately boosts profits. 3) Redistribute surplus aircraft. Having a leasing arm could also help an airline place out surplus aircraft in times of lower demand, though this would be less true in the event of a downturn in global air travel demand. Challenges facing airline-lessors 1) Given their association to particular airlines, airline-lessors are generally less successful in diversifying their customer concentration as compared to non-airline lessors (i.e. independent or bank-backed leasing companies), and thus face greater difficulty in accessing maintenance and other relevant records pertaining to the leasing business. 2) The business of aircraft-leasing requires highly technical skills that are different from running an airline and which carriers do not typically possess; they include building infrastructure that

supports remarketing and sales, contracting, configuration, and strong technical management of the assets toextract the most value from the aircraft. 3) Airline-lessors may not have the cost-of-funding advantage that many large or bank-backed lessors have. Below, we briefly profile three prominent airline-lessors that collectively have over 1,000 aircraft committed for delivery. AirAsia’s wholly owned Asia Aviation Capital (AAC). Asia Aviation Capital based in Labuan, Malaysia was primarily set up as a wholly-owned subsidiary with the objective of providing aircraft-leasing services to low-cost carrier, AirAsia Group. AAC is responsible for acquiring, financing, leasing, remarketing, and selling aircraft for and on behalf of AirAsia Group’s affiliates outside Malaysia. Recently, AirAsia said that an undisclosed firm had made a US$1-billion offer for AAC and the group has appointed bankers to explore the sale of a stake in AAC. Lion Air’s Transportation Partners (TP). Transportation Partners was set up in 2011 in Singapore as a company primarily involved in the leasing of aircraft and related services to Lion and Lion-affiliated airlines, as well as to external customers. Its first inroad into external aircraft-leasing was in 2014, when it signed a deal to lease three B737s to China’s 9 Air (subsidiary of Juneyao Airlines). In 2014, Indonesia’s largest privately-owned airline had a backlog order of 500 aircraft worth over US$20 billion, with deliveries over ten years. Focusing on both growth markets (China, India) and developed aviation markets such as USA and Japan, Lion Air hopes to further expand its scale in third-party aircraft leasing beyond its fleet of six aircraft as at 2015. Norwegian Air Shuttle. The Oslo-based carrier set up a leasing arm based in Ireland, and in 2012, placed orders for more than 200 planes to be delivered by 2020. It has already leased 12 aircraft to Hong Kong-based HK Express, among others. As with other airline-lessors, Norwegian’s leasing entity will develop its own fleet by selling or leasing surplus aircraft to third parties while renewing the fleet and enabling high utilisation via their leasing operations. The subsidiary in part would also enable Air Shuttle to manage its currency-mismatch exposure: loans denominated in the US dollar and aircraft balance-sheet values which are translated into the Norwegian krone. In February 2016, it was reported that Norwegian Air Shuttle will look into spinning off this business, including the possibility of listing it or selling a stake.

Page 22

Industry Focus

Aircraft Leasing


Hong Kong’s tycoons join the party Li Ka-shing’s Accipter and Vermillion Aviation. The wholly-owned aircraft-leasing arm of CK Hutchison Holdings, Accipter, was established in 2014 and reportedly bought 18 planes from units of GE Capital Aviation Services for around US$714.8 million in the same year to kick-start its business. Accipter currently owns 43 planes. Cheung Kong Holdings was also reported in 2014 to have formed a joint venture, Vermillion Aviation, with Mitsubishi Corp’s MC Aviation Partners to buy planes with a combined appraisal value of US$800 million; they have plans to grow the venture’s assets to US$5 billion within a few years. In December 2016, Cheung Kong Holdings announced it would be buying Accipter (CK Capital) from CK Hutchison for HK$7.6 billion. This is probably to consolidate the aircraft-leasing business under Cheung Kong Holdings. Dato Dr. Cheng Yu-tung’s two aircraft leasing joint-ventures. Chow Tai Fook Enterprises invested in its first aircraft-leasing joint venture Goshawk Aviation in 2013 with Investec and the Cheung Kong Group. Joint venture #1: Goshwak Aviation. After further restructuring, Chow Tai Fook Enterprises and NWS Holdings (both owned by Cheng Yu-tung) now own 50% each of Goshawk. Goshawk focuses on younger, narrow-body commercial aircraft for leasing to international airlines. As at January 30 2015, Goshawk’s portfolio consists of 27 aircraft. Joint venture #2: Bauhinia Aviation Capital. In 2016, Chow Tai Fook Enterprises and New World Development started their second aviation concern by forming a three-way joint venture with Aviation Capital Group. Chow Tai Fook and New World will each own 40 % of the aircraft-leasing investment company, Bauhinia Aviation Capital, while Aviation Capital will have the remaining 20%. Bauhinia Aviation seeks to expand its aircraft portfolio to 50 narrow-bodies with an initial capital commitment of US$600 million from the shareholders.

Potential transactions in the aviation leasing space We are likely to see more deals and transaction in the aircraft leasing segment globally, with Asian lessors in the mix.

1. AirAsia’s leasing arm - Asia Aviation Capital. Bloomberg

reported in Dec 2016 that AirAsia had received a dozen bids for its aircraft leasing unit, mostly from Chinese leasing firms, which included the leasing arms of China Merchants Bank and Ping An Insurance. According to the report, AirAsia is seeking buyers for a majority stake in Asia Aviation Capital, which it has valued at about US$1bn.

2. Asian lessors interest in AWAS. It was reported by Bloomberg in December 2016 that Dublin-based AWAS has been put up for sale by its private equity owner Terra Firma, that could value the transaction, including debt, at US$7bn. According the report, interested parties include Li Ka-Shing, Ping An Insurance, as well as other Asian lessors, mostly Chinese. In March 2016, it was reported by Reuters that Terra Firma had rejected two bids from HNA Group for AWAS, and in 2015, AWAS had already sold a portfolio of 90 planes to Macquarie Group.

3. Potential listing of Aviation Capital Group (“ACG”).

Privately held ACG which is a wholly owned subsidiary of Pacific Life Insurance Company announced that it was considering an IPO back in December 2015 which would allow the aviation leasing arm to gain access to additional capital in order to pursue its growth and expansion strategy.

4. Minsheng Financial Leasing Co. IPO. Minsheng Financial Leasing Co. Ltd which controlled by China’s Minsheng Bank has publically stated that it could look to go public in Hong Kong and/or Shanghai by 2018.

5. Listing of other Asian lessors. Following CALC, BOC Aviation and CDB Financial Leasing, we believe that there are other Asian lessors, besides those mentioned above, that could look to list their business to tap for new equity to fund their growth.

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Industry Focus

Aircraft Leasing


The attractiveness of aircraft leasing

Indexing aircraft leasing returns. Ascend created the Ascend Aircraft Investment Index (AAII) that simulates the way an aircraft operating leasing portfolio functions and its respective unlevered returns over the period of measurement. The underlying model’s inputs are based on Ascend’s historical Current Market Values and Current Market Lease Rates (“CMLR”) to mirror past circumstances. When calculating the monthly returns from the portfolio, the model includes factors such as asset appreciation/depreciation, lease cash flow, lessor fees, capital expenditure for new acquisitions and capital gains from asset disposals (if any).

Firm returns (unlevered) with relatively low volatility. The AAII demonstrates achievable annual core unlevered returns of 6.4% for the 1991-2015 period, with a return volatility of 5.5%. The remarkably smooth shape of the AAII curve contrasts with the more volatile lines for the other benchmarks. The dips in the AAII curve after the recessions of 2001 and 2008 are small compared with the steep falls for other indices, while the growth for the rest of the period is noticeably stable and devoid of any sudden rises, which suggests a low volatility of returns provided by the underlying aircraft operating lease portfolio in our view.

Stable and predictable cash flows; US$ play. The business of aircraft operating leasing offers investors predictable and stable cash flows, given that leases typically have a very long tenure (10-12 years for new aircraft) at a predictable rate (either fixed or floating with reference to LIBOR). With aircraft usually placed

out 12-18 months in advance, this further enhances earnings and earnings growth visibility for lessors.

Higher and more consistent profitability. For investors who crack the high barriers of entry of capital and technical expertise needed to manage an aircraft leasing business well over a sustained period, it has been shown to offer a higher and more consistent ROE than running an airline business (well).

Singapore Airlines’ ROE vs BOC Aviation ROE (10-year)

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

18.0%

BOCA SIA*

Source: DBS Bank; *FYE Mar

Ascend Aircraft Investment Index (AAII) return performance

Source: Ascend research

* The following aircraft types are included in this AAII sample portfolio: the Airbus A320 and Boeing 737 Classic and NG families, Airbus A330 family, Boeing 757-200, Boeing 767-300ER and Boeing 777-300ER

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Industry Focus

Aircraft Leasing


Valuations and Equity picks PE Valuations

Listed aircraft lessors in the US and HK are trading at an average of 9.7x current earnings, declining to 8.6x forward earnings, with the range being fairly tight for the 7 companies in the peer group. In HK, BOC Aviation is the cheapest in terms of PE, trading at 8.5x current PE, declining to 7.5x PE – substantially below the peer average. Meanwhile, CDB Financial Leasing is the most expensive of the trio in HK – at 10.6x current PE, declining to 9.3x forward PE. PB Valuations

Other than CALC, which is trading at 2.2x current P/B, against a projected current ROE of 22.6%, the rest of the aircraft lessors are generally trading at around 1x to 1.1x current P/B. In terms of P/B vs ROE, BOC Aviation seems to offer more value, as it is trading at similar P/B to other lessors Financial Leasing despite generating higher ROE. Dividend Yields

While on average the sector only offers a dividend yield of 2.1%, there are 2 names that offer a decent yield. Based on consensus estimates, CALC is offering a prospective yield of 3.9%, which is fairly decent in our view.

Current P/B vs Current ROE for aircraft lessors (9 Feb 2017)

AerCap

Air Lease

Air Castle

FLY

CALC

BOCA

CDB Leasing

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

0.00 0.50 1.00 1.50 2.00 2.50

Source: ThomsonReuters, DBS Bank

Aircraft Lessors in US and HK (Prices as of 9 Feb 2017)

9 Feb 2017 Mkt Cap --------- PER ---------- Price-to-Book ROE Crnt Company Last Px US$m Hist Crnt Forw Hist Crnt Hist Crnt Yield AerCap Holdings NV USD 45.94 9,204 7.3 7.3 7.5 1.10 0.99 15.0% 13.5% 1.4% Air Lease Corp USD 37.86 3,894 13.8 11.1 10.2 1.31 1.17 9.5% 10.6% 0.5% Aircastle Ltd USD 22.78 1,791 14.1 13.0 10.1 1.03 0.98 7.3% 7.6% 4.3% FLY Leasing Ltd USD 13.91 451 6.6 8.2 7.2 0.73 0.65 11.0% 8.0% 0.0% CALC HKD 9.23 797 13.1 9.5 8.1 2.64 2.17 20.2% 22.8% 3.9% BOC Aviation HKD 40.60 3,631 8.5 7.5 1.08 12.8% 2.4% CDB Financial Leasing HKD 1.92 3,128 10.6 9.3 0.99 9.4% 2.5%

Average 11.0 9.7 8.6 1.36 1.15 12.6% 12.1% 2.1% Source: ThomsonReuters (Consensus estimates)

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Industry Focus

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BOCA is our top pick (BUY, TP HK$48.40)

BOCA offers investors a firm alternative to airlines to the continued growth of air travel globally and in particular Asia, as the region’s largest listed player. BOCA’s earnings and cash flows are highly stable and predictable, and the group also possesses strong competitive advantages such as low cost of funding, strong track record (22 years of continuous profit), and an experienced management team. We like BOC Aviation (BOCA) for 1) its size and scale (top 5 aircraft lessor by fleet size, including order book, globally), 2) attractive portfolio characteristics (well-diversified customer base, average fleet age of just 3.2 years with average remaining lease of 7.3 years), 3) firm earnings outlook (12.5% EPS CAGR over 2015-2018F) backed by a large order book of 232 aircraft (at end-1Q16) to be delivered over the next few years. At 8.5x FY16F PE, declining to 7.5x FY17F PE, and trading at just over 1x FY16F P/BV with 13.8% ROE, which is set to improve as the group increases its leverage post-IPO, current valuations are attractive. Initiate coverage on CALC with a BUY, TP HK$11.60

Established in 2006, CALC has grown its fleet to 81 aircraft by end 2016, leased to 16 airline customers in Asia and Europe. With a firm order book for 92 aircraft from Airbus and potential for more from pop-ups and purchase & lease-backs, CALC is well poised to grow its fleet to at least 173 by 2022. Hence, CALC’s lease income is projected to grow steadily over the next few years, which is further supplemented by gains from the sale of its finance lease receivables. CALC also has a 49% stake in an aircraft disassembly business based in Harbin that is slated for commencement in 2H17 and targets to disassemble up to 20 aircraft per annum in 2018. If successfully executed, this could provide further earnings and share price upside. We value CALC based on a blend of 10 FY18 P/E and 2x FY18 P/B to derive a 12-month target price of HK$11.60. The higher than peer average target P/B multiple of 2x reflects the Group’s industry-leading ROE of over 19%. CDB Financial Leasing – China’s largest diversified lessor

The leasing arm of the China Development Bank, CDBFL focuses on aircraft and infrastructure leasing mainly in China. The company experienced significant impairment losses in 2015 as a result of the economic slowdown but managed to stay profitable nonetheless. With the focus on filtering of risker clients, and on the aircraft leasing and infrastructure segments, profitability should improve ahead. With profitability set to improve for 2016 and in 2017 on lower impairment losses, we see the stock’s fair value at 1x P/B, or HK$2.01, against a projected ROE of 10.3% for 2016E and 9.8% for 2017F.

Price Relative charts

BOCA

73

93

113

133

153

173

193

213

233

33.3

35.3

37.3

39.3

41.3

43.3

45.3

47.3

May-16 Aug-16 Nov-16

Relative IndexHK$

BOC Aviation Ltd (LHS) Relative HSI (RHS)

CALC

77

97

117

137

157

177

197

217

237

4.5

6.5

8.5

10.5

12.5

14.5

Jul-14 Jan-15 Jul-15 Jan-16 Jul-16 Jan-17

Relative IndexHK$

China Aircraft Leasing Group (LHS) Relative HSI (RHS)

CDB Financial Leasing

74

84

94

104

114

124

134

144

1.6

1.7

1.8

1.9

2.0

2.1

2.2

Jul-16 Oct-16 Jan-17

Relative IndexHK$

China Development Bank Financial Leasing (LHS) Relative HSI (RHS)

Source: DBS Bank, Bloomberg Finance L.P.

Page 26

Industry Focus

Aircraft Leasing


Key Risk Factors

In our view, the key factor that drives returns in aircraft leasing, in both the short term and long term, is the aircraft supply-demand dynamics. Airbus and Boeing duopoly. The most widely and commonly used aircraft types that carry the vast majority of today’s air traffic are mainly produced by Airbus and Boeing. According to CAPA, nearly 89% of the seats in the global fleet in service today are attributed to Boeing and Airbus. The market for aircraft (passenger and freighter equivalent of 100 seats or more has gradually evolved into a duopoly of Europe’s Airbus Group and US-based Boeing. Several smaller players (Fokker, British Aerospace, and Lockheed Martin) have exited the market over the years, and Boeing took over long-time rival McDonnell-Douglas (MDC) in 1997.Airbus and Boeing today account for 98% of deliveries in the market for 100+-seat passenger jets and freighter variants. While Embraer and Bombardier have a small share of this market, they pose a challenge only to the smaller players. Meanwhile, COMAC of China and Irkut in Russia are developing new 150-seater single-aisle programmes, the C919 and MC-21, respectively, that may challenge this duopoly to some extent. However, the success of these programmes, in terms of both development and acceptance by the market, remains to be seen. Airbus and Boeing duopoly in aircraft of >100 seats

Source: Flightglobal Fleet Analyzer

Oversupply worries. The most common concern for investors seems to be that of aircraft oversupply. Keen competition among airlines and strong order-books at OEMs Airbus and Boeing, along with news that both manufacturers are ramping up production, worry investors. Our view is that given the OEM duopoly in aircraft supply, aircraft supply-demand should be balanced in the long-term as it is in the OEM’s interest to promote a balanced situation. A stable supply-demand picture helps aircraft retain value, which is positive for airlines, lessors as well as the OEMs themselves. In the short term, we also see the aircraft supply-demand environment as relatively benign as 1) global load factors are near historic highs, 2) the growth rate of OEM production matches growth of expected demand, 3) order-books are strong, and 4) storage/retirement is already at low rates. Interest rate exposure. A key feature or driver of an aircraft lessors’ earnings is the net spread (the difference between average yield on aircraft portfolio and average cost of debt) that a lessor earns. This means that aircraft lessors have interest-rate risk. In an environment of rising interest rates, investors may have reason to fret. Generally speaking, aircraft lessors are well aware of this risk and manage it via 1) natural hedging where fixed-rate leases are funded by fixed-rate debt, and floating-rate leases have floating-rate debt, 2) active interest-rate hedging using derivatives such as caps and swaps, and 3) trading (sale) of aircraft in the portfolio with interest-rate exposure. Furthermore, with demand for popular aircraft types being robust and the backlog for such aircraft being large – along with healthy airline profits generally – lessors should have some pricing power in terms of lease rates for new aircraft. As a result, we believe that lessors’ earnings should not be impacted much by rising interest rates, unless the pace is sudden and/or the quantum of the hike is large. Overpaying for aircraft in the secondary market. We believe that lessors without a substantial order-book to drive its organic growth could face lower returns if it can only look to grow via acquisition of aircraft from other lessors or through purchase and leasebacks from airlines. This is given the intensifying competition from new entrants into the aircraft-leasing space. Paying a premium for such assets would result in lower returns for the lessor.

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Industry Focus

Aircraft Leasing


Low fuel prices: a double-edged sword. We are currently in a period of low fuel prices. While BrentBrent crude has rebounded from a low of less than US$40 a barrel a year ago, it remains relatively cheap currently. This has helped boost airline profitability, and in this buoyant environment for airlines, demand for leasing of aircraft (new or used) as well as lease rates have remained firm. Low oil prices haveIt has also reduced the risk of airlines defaulting on their lease payments. On the other hand, the low- fuel-price environment means that older, less fuel-efficient aircraft are now more attractive or viable to operate. With aircraft being brought out of storage and a lower rate of aircraft retirement, demand for new aircraft may be affected. However, we do observe that orders for new aircraft and OEM order-books, especially the variants with newer technology and aremore fuel-efficient, remain robust and most lessors have also generally placed out their new aircraft 12 months or more in advance. Cyclical Industry. A lessor business is almost entirely dependent on the willingness as well as the ability of airline customers to enter into new aircraft operating leases and to pay and perform their obligation leases. During a downturn, the lessee may find it difficult to honour cashflow commitments, leading to delays in payments, and in the worst case, could face bankruptcy. Geopolitical risks, war, acts of terrorism, epidemics, and natural disasters could also impair the lessees’ ability to honour their lease terms. Increasing competition in the leasing space, high fuel costs, and worsening labour conditions are some other factors. Downgrade in ratings may lead to higher cost of debt and/or refinancing risk. A lessor’s efficiency in obtaining funds is crucial to its operating business model. Its ability to borrow and the cost of funds hinge strongly on its balance-sheet strength and credit ratings; should a lessor’s credit rating be downgraded for whatever reason, there could be some serious consequences on its cost of funding and/or ability to borrow and refinance its loans as well as ability to compete. Lessees may fail in maintenance obligations. The key value-generating asset is the aircraft itself. Under each lease agreement, the lessee is primarily responsible for maintaining the aircraft and complying with all regulations on aviation safety and airworthiness. If the lessee fails to properly maintain the aircraft, this could impact the sale value or re-lease value of the aircraft at the expiry of a lease, which imparts residual risk and could affect its overall fleet portfolio values.

Delays in delivery or failure of deliveries. For most traditional lessors who place their orders directly with the OEMs, the manufacturers’ ability to deliver the aircraft on time is of utmost importance. Failure to deliver or a delay – which are commonplace for aircraft with new technology – could result in lost or delayed revenues and brand equity with airline customers. Newer technology aircraft may impact aircraft values and returns of older aircraft. The introduction of new technology could affect the values of older aircraft in the long term, which would impact returns. The impact varies for different aircraft types, and is largely dependent on operator base, fleet size, production run and order backlog. The larger the operator base, existing fleet size, production run, and order backlog, the better the mitigation. A good example of this would be the next-generation A320neo and Boeing 737 MAX aircraft that have recently entered (in the case of the neo) or are soon to enter (the MAX) the market. It will take many years of strong production of these two latest models to challenge the existing fleet size of their predecessors. According to CAPA, there are currently over 6,700 of the A320 family of the aircraft in service and over 6,800 of the B737 family of the aircraft in service. Aircraft lessors manage this risk by 1) mainly focusing on popular in-demand aircraft types with a large operator base, 2) ordering new generation aircraft and 3) trading and selling of aircraft. Liquidity shock. Aircraft lessors’ success hinges highly on access to debt and capital markets and liquidity. A market shock with the magnitude of the 2008-2009 global financial crisis, which led to the drought of liquidity, could paralyse the capital-intensive and high-gearing business model of aircraft lessors. IFRS 16 ‘Leases’. Come January 2019, IFRS 16 ‘Leases’ will be rolled out and it will bring most leases on lessess’ balance sheets. For airlines, this means that operating leases will have to be recognised on the balance sheet and will have an impact on gearing ratios, asset return metrics, and also potentially impact reported net profits. While IFRS 16 should not result in substantial changes in accounting for lessors, there could be an impact on theirbusiness models and how the leases are structured, given the significant accounting impact that IFRS 16 would have on the lessees (airlines). For example, we could see lease periods being shortened.

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Industry Focus

Aircraft Leasing


Appendix

Page 29

Industry Focus

Aircraft Leasing


Aircraft leasing 101

Operating vs finance lease. Leasing is a form of asset financing often used by businesses, which allows the lessee to make periodic payments in exchange for the right to use an asset over a contracted period, instead of incurring the full cost of asset-ownership upfront. Leases are typically classified as finance or operating leases, depending on the degree to which all the risks and rewards of ownership are transferred to the lessee: In an aircraft-operating lease, the risks and rewards of aircraft ownership sit with the operating lessor but risks and rewards of operations remain with the lessee (the airline). The lessee is obliged to make regular rental payments in exchange for the right to operate the aircraft over an agreed fixed term. Meanwhile, the lessor retains the right and discretion to sell the given aircraft with the attached lease. Similarly, under a finance lease, the lessee also makes periodic payments to the lessor over a defined period, but has typically (1) has the added option to purchase, or (2) is automatically granted ownership of the given aircraft at the end of the lease term. As such, residual value risks are borne by the lessee under finance leases. Key difference between aircraft and real estate operating leases The rights and obligations that accrue to lessors and lessees in aircraft-operating leases are largely similar to that of property rental contracts.

The key differences between the two, however, lie in currency denomination and tenure. While real estate contracts are often denominated in their respective local currencies, aircraft-operating leases are largely denominated in the US dollar. Aircraft-operating leases also carry longer contractual terms, of 6-12 years on average, compared to about two years for real estate leases. In addition, terms for asset mobility and maintenance payment also often differ. Aircraft-leasing popular among airlines. A variety of funding sources are available to airlines for growing their fleet, depending on their business models, operating environment, and financial status. Operating leases have been increasingly popular over the last five decades as they offer airlines fleet flexibility and financial flexibility as well as shorten the lead time for direct purchases or equity-raising. They also reduce residual value risks for airlines. According to Flightglobal’s Fleets Analyzer, smaller airlines (with a fleet of less than 20 aircraft) were estimated to have leased 48% of their fleet while larger airlines (with a fleet of at least 20 aircraft) had approximately 39% of their fleet on operating leases in December 2015. Meanwhile, operating lessors are estimated to have placed approximately 81% of their total fleet with these larger airlines.

Percentage of Aircraft Fleets on Operating Lease by Airline Fleet Size (as at December 2015)

Airlines with >= 20 aircraft in fleet Airlines with <20 aircraft in fleet

39%

61%

Operating lease Non operating lease

48%52%

Operating lease Non operating lease

Source: Ascend Flightglobal Fleets Analyzer Source: Ascend Flightglobal Fleets Analyzer

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Industry Focus

Aircraft Leasing


How aircraft leasing works. There are three main channels for aircraft acquisitions, namely (1) direct orders from OEMs such as Airbus and Boeing, (2) purchase and leasebacks from airline customers, and (3) purchase of aircraft from the secondary market, which is further discussed in a later segment. In general, lessors will first place an order for aircraft directly with OEMs before sourcing for potential lessees (airline customers). Once identified, both the lessor and lessee would proceed to negotiate terms for the lease, including periodic lease obligations, tenure, maintenance obligations, and remarketing.

The lessor usually finances the asset purchase with a mix of debt and equity (cash). Prior to delivery, lessors typically collect a security deposit (between 1-6 months of rent) and ensures that the new aircraft and lease agreement are adequately insured. After taking delivery of the new aircraft (noting delivery lead time of about four years, on average), the lessor proceeds to lease the asset to its airline customer, in exchange for periodic lease payments over the contracted lease term. In the event that the lessee defaults, the operating lessor will repossess and remarket the aircraft. The lessor also has the option to dispose of the asset - with and without the attached lease – in the secondary market.

Illustration of a typical aircraft operating leasing model

Source: Aircraft Financing, 4th Edition

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Industry Focus

Aircraft Leasing


What’s driving the popularity of aircraft leasing? Why airlines lease. While there are a myraid of factors contributing to the attractiveness of aircraft leasing as a means of asset financing from an airline’s perspective, we focus on seven key drivers as highlighted by commercial aviation finance solutions provider, Investec: (1) Financial flexibility: Leasing allows carriers to optimise

the use of its capital and focus on operations rather than fleet management.

(2) Avoid large upfront investments: Upon making an order, the buyer has to make large upfront payments for the aircraft. Through leasing, lessees avoid significant capital outlay.

(3) Fleet flexibility: Leasing, as opposed to ownership,

allows carriers to better adapt to changes in aviation market conditions.

(4) Reduced delivery lead time for new planes: For narrow-

bodies and aircraft with newer technology, delivery slots are often limited, with long delivery lead times. Leasing provides airlines with reduced order lead time compared to direct orders with OEMs.

(5) Preservation of capital: Smaller airlines with higher

costs of funding can leverage on lessors’ oftensuperior access to capital through leasing.

(6) Mitigate residual value risk: With leasing, residial

value risks are borne by lessors rather than airlines.

(7) Asset light model – particularly for LCCs: With the proliferation of LCCs, leasing lowers the barrier to entry and mitigate as much as possible the significant capital commitments and hence better allow the LLCs to capture market share.

Why airlines choose to lease

Source: Investec, DBS Bank

Attractive Delivery

SlotsFinancial Flexibility

Fleet Flexibility

Avoid Pre-delivery Payment

Growth in LCCs

Residual Value Risk

Availability of Capital

Aircraft Leasing

Leasing requires less upfront investment, and allows airlines to focus their capital on operations rather than on fleet management

Carriers are better able to manage fleet plans under a leased vs ownership model

Through leasing, airlines are able to avoid large upfront investments for aircraft

Leasing is especially popular among LCCs and start-up airlines as it allows them to quickly grow and capture market share without significant capital commitments

Smallar airlines with higher cost of funding can preserve capital by leveraging on lessors’ often superior access to capital through leasing.

Delivery lead time for new aircraft is generally shorter through leasing

Which is borne by lessors

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Industry Focus

Aircraft Leasing


Critical success factors for aircraft lessors What makes an aircraft operating lessor successful? Focused on investing, managing, and trading their fleet, aircraft lessors are fundamentally viewed as financial-service providers. Often bearing the cost of borrowing, related expenses, and risks pertaining to the ownership of aircraft, the individual lessor’s success lies in the extent to which it is able to deliver on the following: (1) Lower cost-to-value ratio for aircraft purchases Primary sources of aircraft for lessors. The three key channels from which lessors typically acquire aircraft are:

(a) Direct from original equipment manufacturers (“OEMs”): Direct orders from OEMs typically require pre-delivery payment financing (PDP) two years prior to delivery. Meanwhile, operating lessors seek to place out aircraft 12-18 months prior to delivery, on average.

(b) Purchase-leaseback (“PLB”). Under PLB, operating lessors purchase new or existing aircraft from airlines, which are subsequently leased back to the respective airlines.

(c) Secondary market. Lessors also have the option to acquire a single – or a portfolio of – aircraft from other lessors or financier-owners.

Access to in-demand technologies and models, which often hold better investment value. Aircraft orders with OEMs are typically placed up to four years in advance for aircraft with the latest technologies. Lessors typically place orders periodically with OEMs to ensure steady access to newer aircraft technologies, which are more efficient than previous generations of aircraft. Examples include the next-gen Boeing -737 MAX and Boeing -787 Dreamliner, which are approximately 20% more fuel-efficient than older models, and are thus highly sought after. Extracting better investment value through bulk discounts. Another interesting aspect of direct bulk purchases lie in the substantial 10-30% discount concession (on average) off catalogue/list prices, effectively lowering lessors’ all-in aircraft purchase costs.

Catalogue prices of selected commercial aircraft

Source: Airbus, Boeing, DBS Bank (2) Access to cheaper funding Key funding soures. Capital markets provide aircraft leasing companies with depth and lower cost of funds via:

(a) Loan products. Faced with higher costs of financing following the introduction of the OECD’s 2011 Aircraft Sector Understanding (ASU), the role of export credit agencies (ECAs) in aircraft financing has gradually diminished over the years. As such, only 11% of aircraft deliveries in 2016 are expected to have been financed via EX-IM banks or ECAs. Meanwhile, nearly 20% of aircraft purchases are financed by commercial bank debt, particularly in Japan and China. (b) Debt capital markets. Boeing estimates that about 45% of aircraft lessor’s funding requirements are sourced from debt capital market products, including asset-backed securities, as well as secured and unsecured notes/bonds.

Key benefits offered by debt capital markets. The leading role played by debt capital markets as a primary source of funding for aircraft lessors can be mainly attributed to:

(a) Better access to capital. Lessors are able to reach a wider investment audience who are often more sophisticated and thus receptive to varying debt structures. (b) Liquidity and pricing. Active trading in the secondary markets could provide debt instruments (issued by aircraft lessors, in this case) with improved liquidity and pricing support.

Aircraft Model Type List Price US$, million

Airbus 2016 average list prices

A320-neo Narrow-body $107.3m

A321-neo Narrow-body $125.7m

A330-200 Wide-body $231.5m

A350-800 Wide-body $272.4m

A380-800 Wide-body $432.6m

Boeing 2015 average list prices

B737-Max 8 Narrow-body $112.9m

B737-Max 9 Narrow-body $116.6m

B747-800 Wide-body $378.5m

B777-300ER Wide-body $339.6m

B787-8 Wide-body $224.6m

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Industry Focus

Aircraft Leasing


(c) Longer tenor. Unlike traditional bank financing, users of capital markets generally have to option to take on longer loan tenors. This provides capital-intensive businesses, such as aircraft-leasing companies, with greater financial flexibility and ability to manage cashflow.

Credit rating plays a pivotal role in funding costs. Lessors’ funding costs are largely dependent on their respective financial strengths. Aircraft lessors with higher credit ratings are thus able to raise debt more cheaply. Meanwhile, issuers with weaker credit ratings may be subject to higher risk premiums and typically commit to higher yields – thus incurring higher funding costs relative to higher-rated issuers. Therefore, a higher credit rating could serve as a significant advantage in the capital-intensive aviation industry. Long-term credit ratings for selected tier 1 lessors*

*as at 26 July 2016 Source: Fitch, DBS Bank Enhancing returns through financial leverage. An aircraft-leasing company typically borrows up to 75% of an aircraft’s base value while funding the remaining with equity (cash) – which is sizeable considering that an aircraft can cost north of US$100 million. By financing its aircraft purchases with debt and subsequently servicing its loan obligations through aircraft lease payments collected from its lessees, aircraft lessors with access to cheap funding are therefore well-positioned to deliver enhanced returns. (3) Securing higher aircraft lease rates Factors driving lease rates. Lease rates are often largely driven by market forces. Apart from economic conditions, other factors that come into play when forecasting lease rates include:

(a) Residual value: Difference between the expected and actual residual value of the aircraft at the end of the lease term.

(b) Credit worthiness of the lessee: Lessee (airlines) with lower credit quality are usually subject to higher lease rates.

(c) Acquisition price: The higher the cost of the aircraft, the higher the expected lease payment.

(d) Aircraft age: All else being equal, a younger aircraft with lower maintenance needs (which are borne by lessees) should command a premium in lease rates.

(e) Level of technology and aircraft type: Helped by technological improvements, newer aircraft types tend to be more cost-efficient (better fuel efficiency, better resistance to corrosion, etc.) and should thus command a premium.

(f) Other variables that may affect lease rates include:

- Interest rates: Often incorporated into the lease rate formula

- Relevant taxes: Which differs across jurisdictions

- Tenor and lease terms: Such as return conditions, maintenance and maintenance reserve requirements

Snapshot of historical lease rates. Due to higher aircraft purchase costs, wide bodies tend to have higher lease rates. Depending on model and demand, lease rates for newer aircraft have on occasion risen above US$1m a month. According to data provided by IBA and Capital Aviation Research, lease rates for narrow-bodies have historically ranged between US$150,000 to US$400,000 per month. Lease rates for wide-body aircraft (in US$100k) vs 12 mths libor

Source: IBA, Capital Aviation Research, DBS Bank

Aircraft Lessor Fitch Ratings

AerCap BBB-

Aviation PLC B+

Aviation Capital Group BBB

BOC Avaiation A-

SMBC Aviation Capital BBB+

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Industry Focus

Aircraft Leasing


Lease rates for narrow-bodies (in US$100k) vs 12mths libor

Source: IBA, Capital Aviation Research, DBS Bank Key terms in the lease agreement. Underlying conditions for and responsibilities of both the lessor and lessee in aircraft-leasing transactions can be found in the lease agreement, and typically include:

(a) Lease tenor: Lease terms typically vary with aircraft type and region, and are usually shorter for narrow-body aircraft (3-7 years on average) than wide-bodies. At the end of the lease, the lessee is obliged to return the aircraft to the lessor in good order, and may have the option to either renew the lease or purchase the underlying aircraft at fair market value.

Aircraft lease ROE for first, second and third lease

0%

2%

4%

6%

8%

10%

12%

14%

16%

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25

First lease Second lease Third lease

ROE

Years Source: Ascent Advisory

(b) Useful life: The useful life can further be broken down into three key phases - each with a different ROE, which affects lease rates:

Young Phase Due to customised cabins, the first phase for new aircraft typically lasts 10-15 years. Given higher demand and lower maintenance costs, lessors tend to enjoy higher lease rates and returns during this phase.

Mid-life Phase

The second phase is usually shorter, and lasts 3-8 years. Mid-life aircraft are often marketed to 2nd- or 3rd-tier carriers at lower lease rates.

End-of-life Phase

This phase is typically the shortest, with the lowest lease rates compared to the first and second phases.

(c) Lease extension: On average, 15% to 30% of expiring leases are extended between 20 to 40 months. (d) Other important terms found in lease agreements include: - Commitment fees: Before the commencement of the lease, a commitment fee (similar to that of deposits) is paid by the lessee to the lessor. - Security deposit: To mitigate potential losses (in the form of foregone lease payments and additional remarketing expenses) for lessors in the event of default by the lessee, the latter is expected to maintain a cash deposit or letter of credit with the lessor prior to delivery. - Insurance: As the lessee usually assumes the operating risk, they are required to be adequately insured:

Hull insurance Hull insurance and insurance designed to protect the lessor’s aircraft assets and coves all potential loss in the event of an accident or physical damage, including the cost of the aircraft restoration or placement.

Liability insurance According to Article 50 of the Montreal Convention 1999, the leasee is required to have adequate liability insurance coverage for potential third party liabilities. Premiums paid are typically a function of the maximum take-off weight and passenger carriage capacity.

- Maintenance reserve: Lessees are generally responsible for the maintenance of leased aircraft, and may be liable for periodic supplemental maintenance rent payments. Maintenance rents are calculated based on the utilisation of the airframe, engine, and other essential components required to keep the aircraft in service. Once the qualifying maintenance has been undertaken, the lessee is usually reimbursed for maintenance rent paid.

Page 35

Industry Focus

Aircraft Leasing


For leases that do not entail maintenance rent payments, apart from normal wear and tear, lessees are still obliged to return the aircraft in good order.

Different maintenance reserve events and cost structures

Cost Fixed interval Variable interval

Fixed cost Engine LLPs

Variable cost

Airframe maintenance Check

Landing gear overhaul

APU overhaul Engine

performance restoration and overhaul

*LLPs: Life limited parts, *APU: Auxiliary power units Source: IATA, DBS Bank Maintenance reserve trends

8

12

16

20

Mill

ions

APU D-checkEngine 1 & 4 Engine 3 Engine 2

Source: IATA, DBS Bank Unutilised reserves could help bolster gains on the sale of assets. In the case when aircraft are sold, accumulated maintenance reserves previously held for future maintenance needs can often help lift trading profits from the sale of aircraft. Remarketing aircraft. Approximately 12-24 months prior to lease expiry, aircraft leasing companies will begin to remarket the given aircraft to other potential carriers. To reduce time spent on remarketing, aircraft in the young phase are usually marketed to 2nd- or 3rd-tier carriers at lower lease rates.

(4) Maximising returns through disposals Realisation of residual value. The residual value of aircraft is only realised when the lessor or owner disposes of an aircraft from its current portfolio in the secondary market, and pays off all outstanding debt related to the given asset. Influenced by a host of factors, fluctuation in aircraft values may affect the resale value of aircraft. All else being equal, however, lessors are often able to register gains on disposal if the amortisation of debt outpaces the asset’s rate of depreciation. The current low-oil-price environment, coupled with airlines’ capacity constraints (as evidenced by the firm order backlog for newer aircraft). has made it more viable for airlines to boost capacity by operating older aircraft, lifting demand and secondary valuations for used aircraft in the process. Conversely, events detrimental to the demand for certain aircraft types (due to operational and safety concerns) or the broader air travel industry (in the case of an economic downturn, for instance) can weigh on the market value of these assets, and may result in potential impairment. Appraisers play an outsized role in valuing aircraft. As most aircraft transactions are not publicly disclosed, the determination of aircraft value is largely left to professional aircraft appraisers. A blend of both art and science, the valuation of aircraft is hinged upon the appraisers’ technical expertise, forecasts, and assessment of the aircraft market. Rule-of-thumb estimation of aircraft value. Passenger aircraft are often depreciated against an economic life of 25 years but in reality, may be able to extend their useful life through freighter conversions. Further value may also be extracted through the sale of parts. According to Investec, the impact of depreciation on an aircraft’s base value can be anywhere between 3% and 9% p.a., and accelerates as the aircraft ages. While most aircraft values are determined via appraisal, a useful rule-of-thumb estimation we can use to gauge aircraft value over time is as follows:

Aircraft age Approximate aircraft value More than 5 years 70% of initial value

More than 10 years 50% of initial value More than 15 years 35% of initial value More than 25 years 25% of initial value

Source: Investec, DBS Bank

Page 36

Industry Focus

Aircraft Leasing


Drivers of aircraft value A number of factors play a pivotal role in determining the value of an aircraft. They can be more simplistically categorised into: (1) Market drivers, (2) Aircraft factors, (3) Economic drivers

Deterministic factors of aircraft value

Source: Airline Monitor, Jackson Square Aviation, Airfinance, DBS Bank (1) Market drivers that affects aircraft value

Product life-cycle: Aircraft with a longer production run tend to retain value better and hence have higher residual values, as aircraft with longer production runs typically are more numerous, and hence have better liquidity, wider operator base, and a higher market share within fleets. Stages within the production cycle too have an impact on aircraft values.

• Early stage production aircraft typically do not have good value as they tend to have higher operating weight and thus higher operating cost as well as other issues associated with early production. OEMs therefore may thus price them more competitively.

• Mid-stage production aircraft will have most, if not all, production issues ironed out and units tend to have much more stable aircraft values and depreciate at a more balanced and predictable rate over time.

• Late production units are often subject to larger decline in value given they are competing against new offerings which tend to offer better efficiencies. These however are compensated by large discounts typically offered by the manufacturers. For instance, United Airlines in early 2016 turned down aircraft with new technology such as the Bombardier C-series in favour of 25 additional late-stage B737-700s that will be soon be discontinued. This was likely driven by

a huge discount Boeing gave for the order – said to be more than 50% off catalogue prices of US$80.6 million, according to Airway News senior business analyst Vinay Bhaskara.

Stages within the aircraft production cycle

Source: Airline Monitor, Jackson Square Aviation, Airfinance, DBS Bank

Drivers of aircraft values

(1) Market drivers (2) Aircraft factors

Aircraft type and specs

(3) Economic drivers

Aircraft technology

Supply & demand

Product life-cycle

Market liquidity

Secondary market

Fuel prices

Economic cycle N

o. o

f ai

rcra

ft

man

ufac

ture

d

Early Stable Late

Time for production run

Page 37

Industry Focus

Aircraft Leasing


Supply and demand: The number of stored aircraft is often used to gauge the health of the airline industry. A high number of stored aircraft implies weak market demand, pushing down valuations, and vice versa.

For any particular type of aircraft, it’s important to know if the aircraft is being stored because of technical or economic obsolescence, in which case these aircraft are likely to remain parked forever; if it is being stored due to the cyclical nature of the airline business, that would imply an oversupply of the aircraft. An example for the first scenario would be out-of-production aircraft types such as the MD-80, and an example for the second scenario would be a 747 freighter.

Market liquidity: Further de-composed by 2 key factors:

(a) Order books: An aircraft’s orderbook reflects the number of firm orders for an aircraft type, broken down into the number of deliveries and the number on firm backlog. It provides clarity on the market share (and popularity) an aircraft type has achieved, and is one of the most important drivers of aircraft value and its retention.

(b) Market Penetration: The market penetration an aircraft type has achieved is another important driver of its value. The higher the customer (operator) base and the wider the geographical base, the better the aircraft value.

Secondary markets: If there is sufficient market liquidity as addressed by all the other factors above, the aircraft asset can be easily disposed of in the secondary market, which helps it achieve the highest possible value in a secondary sale. Secondary markets tend to be strong in up-tick economic cycles with many sources of financing available. Passenger-to-freighter conversion and the suitability of an aircraft type to do so also helps with the secondary value of an aircraft.

Aircraft value cycle largely driven by market cycle The aircraft value cycle may be understood by considering the relationship between Current Market Value (“CMV” - the spot trading value) and Base Value (“BV” - underlying long term economic value). The chart below illustrates the previous and current aircraft value cycle, demonstrating the cumulative proportion of installed fleet compared to CMV / BV. It shows that the trough of the prior (2001 — 2008) cycle in July 2002 and the trough of the current cycle are quite similar. We also note that the peak of the prior cycle in July 2008 lies considerably to the right of the current position in the cycle. By February 2016, aircraft market values have only improved by about half as much as they did in the prior cycle, indicating potentially further upside since.

Aircraft value cycle (Feb 2016)

Source: Ascend value from Flightglobal, DBS Bank

Page 38

Industry Focus

Aircraft Leasing


(2) Aircraft factors

Aircraft type. An aircraft type (or family) in particular has a strong influence on its value. This is largely due to the difference in the rate of market value depreciation versus book value deprecation. Lessors tend to favor aircraft with low depreciation as there is higher residual value and hence, it provides more certainty in terms of the aircraft value as and when the planes are traded in the secondary markets. Furthermore, there exists differences even within aircraft of the same family,

Aircraft value matrix (most desirable aircraft)

Low High

High

Mark

et V

alu

e D

epre

ciation

Book Value Depreciation

A320-200A330-300

E190777-300ER

737-800c

A330-200

A380-800

CRJ200

777-200LR

737-300767-300ER MD-80

747-400

717-200

Ideal quadrant for lessors and banks

Source: Investec, Ascend Advisory, DBS Bank

Aircraft specifications. Production aircraft are usually offered with various specifications in 1) engines and configuration, 2) operating weights, and 3) cabin builds and Buyer Furnished Equipment (BFE) options. Differences in these specifications will impact the value of an aircraft and in the case of cabin builds and BFE options, highly standardized aircraft tend to have a higher resale value.

Technology. The latest variant of aircrafts such as the Boeing’s B787 Dreamliner features newer technology and composite material construction which is lighter and less susceptible to corrosion.; a switch to major electric architecture instead of the bleed valve system creates strong reliability and reduces more weight, given the smaller need for all the pneumatic-piping wrapping around the aircraft. New aircraft also have more accommodative features, for instance, lower cabin altitude which increases overall passenger cabin comfort– something that carriers like to have as part of their service offering. All these new technologies help reduce operating costs and maintenance effort while potentially increasing loads – which make the Dreamliner an attractive asset to operate for any carrier.

Page 39

Industry Focus

Aircraft Leasing


(3) Economic drivers Fuel prices. The cost of fuel often makes up between 30%

(for full service carriers) to 50% (for LCCs) of an airline’s operating cost. The fuel efficiency of an aircraft therefore has a huge influence on the profitability of its operator. A low fuel price environment tends to help support the value of the older aircraft types while the reverse holds true when fuel prices are high. It has also been argued that high fuel prices would help the value of new, fuel-efficient aircraft and that low fuel prices would diminish the attractiveness and thus value of the newer aircraft types.

Economic cycle. The economic cycle also play a role in determining aircraft value namely on 1) demand – aircraft values tend to be firmer when demand for air travel and thus aircraft is high, and 2) liquidity – aircraft asset values tend to be stronger when there is ample financing to fund aircraft acquisitions in the primary and secondary markets.

Aviation (Economic) Cycle

Source: Avolon, DBS Bank

Time: 8-10 years

Indu

stry

cyc

le

Peak

Trough

Cycle weakening

Slowing global economy Airline profits decline Lease rates at base level Tightening liquidity Asset trading slow

Cycle recovery

Economies improving Airlines still loss-making but

restructuring and reducing cost Lease rates recovery Slow return to market for banks

Cycle peak

Strong global economy Airlines profitable Lease rates above base level Excess liquidity Active asset trading market

Cycle Trough

Economic slowdown Airline industry heavily loss-

making Lease rates fall below base No liquidity

Page 40

Industry Focus

Aircraft Leasing


Stock Profiles

Page 41

ASIAN INSIGHTS VICKERS SECURITIESed-TH / sa- AL

BUY

Last Traded Price: HK$38.10 (HSI : 22,821) Price Target 12-mth: HK$48.40 (27% upside) Potential Catalyst: Earnings delivery and accretive aircraft acquisitions Where we differ: In line with consensus Analyst Paul YONG CFA +65 6682 3712 [email protected]

What’s New Net profit rose 24% y-o-y to US$212m, ahead of

expectations, on higher average lease rate factor Well positioned to grow for many years with firm

delivery order book and strong balance shee Interim dividend of US 6.1cts Maintain BUY and TP of HK$48.40

Price Relative

Forecasts and Valuation FY Dec (US$ m) 2015A 2016F 2017F 2018FTurnover 1,091 1,172 1,452 1,789 EBITDA 971 1,088 1,351 1,666 Pre-tax Profit 402 462 564 673 Net Profit 344 395 482 576 Net Pft (Pre Ex) 343 395 482 576 Net Profit Gth (Pre-ex) (%)

11.1 15.0 22.1 19.4

EPS (US$) 0.58 0.61 0.69 0.83 EPS (HK$) 4.52 4.71 5.39 6.43 EPS Gth (%) 10.9 4.2 14.5 19.4 Diluted EPS (HK$) 4.51 4.71 5.39 6.43 DPS (HK$) 0.00 1.32 1.62 1.93 BV Per Share (HK$) 32.07 36.47 40.24 44.74 PE (X) 8.4 8.1 7.1 5.9 P/Cash Flow (X) 3.1 3.0 3.0 2.6 P/Free CF (X) nm nm nm nm EV/EBITDA (X) 11.1 11.2 10.9 10.1 Net Div Yield (%) 0.0 3.5 4.2 5.1 P/Book Value (X) 1.2 1.0 0.9 0.9 Net Debt/Equity (X) 3.2 2.8 3.1 3.4 ROAE (%) 15.1 13.8 14.0 15.1

Earnings Rev (%): Nil Nil Consensus EPS (US$) 0.56 0.64 Other Broker Recs: B: 5 S: 0 H: 3

Source of all data on this page: Company, DBSV, Thomson Reuters, HKEX

Firm Earnings Growth Trajectory Recommend BUY on BOC Aviation with a TP of HK$48.4. We like BOC Aviation (BOCA) for 1) its size and scale (top 5 aircraft lessor by fleet size, including order book, globally), 2) attractive portfolio characteristics (well-diversified customer base, average fleet age of just 3.2 years with average remaining lease of 7.3 years), 3) firm earnings outlook (12.5% EPS CAGR over 2015-2018F) backed by a large order book of 232 aircraft (at end-1Q16) to be delivered over the next few years. At 8.1x FY16F PE, declining to 7.1x FY17F PE, and trading at just over 1x FY16F P/BV with 13.8% ROE, which is set to improve as the group increases its leverage post-IPO, current valuations are attractive. Outstanding proxy for burgeoning air travel growth. BOCA offers investors a firm alternative to airlines to the continued growth of air travel globally and in particular Asia, as the region’s largest player. BOCA’s earnings and cash flows are highly stable and predictable, and the group also possesses strong competitive advantages such as low cost of funding, strong track record (22 years of continuous profit), and an experienced management team. Continual aircraft acquisitions to drive 19% profit CAGR. We project BOCA’s net profit to grow 15% y-o-y from US$343m to US$395m in 2016F, 22% to US$482m in 2017F and 19% to US$576m in 2018F. Lease revenue is projected to grow at 19.2% CAGR to US$1.6bn by end-2018F as the net book value of aircraft grows from US$9.5bn as at end-2015 to US$17.1bn at end-2018F. Valuation: Target price of HK$48.4 based on 1.32x FY16 P/BV. Taking into account the quality of its aircraft portfolio against its peers, we believe that BOCA should have an implied cost of equity of 10.5% and hence be valued based on 1.32x P/BV against its projected 13.8% ROE. We see BOCA’s share price re-rating as the group consistently delivers firm earnings growth. The stock also offers a decent prospective dividend yield of 3.5%. Key Risks to Our View:

Key risks, in our view, include a) intense competition for aircraft investments, b) a spike in interest rates, and c) unfavourable demand-supply dynamics.

At A Glance Issued Capital (m shrs) 694 Mkt. Cap (HK$m/US$m) 26,439 / 3,409

Major Shareholders Bank of China Group (%) 70.0 China Investment Corporation 2.7

Free Float (%) 27.3 3m Avg. Daily Val. (US$m) 10.2 ICB Industry : Industrials / Industrial Transportation

DBS Group Research . Equity 30 August 2016

China / Hong Kong Company Guide

BOC Aviation Ltd Version 2 | Bloomberg: 2588 HK Equity | Reuters: 2588.HK

Refer to important disclosures at the end of this report


Company Guide

BOC Aviation Ltd

WHAT’S NEW

Strong interim (1H16) earnings reported

BOC Aviation reported 1H16 earnings that were above expectations, with net profit growing 23.8% y-o-y to US$212.2m, against our full-year net profit growth forecast of 15% y-o-y, as total revenue rose by 8.2% y-o-y to US$579.2m.

Lease rental income rose by 5.7% y-o-y despite a 0.7% y-o-y decrease in plant and equipment and assets held for sale to US$11.86bn. This was because BOC Aviation enjoyed a higher average lease rate factor due to a y-o-y increase in USD LIBOR for the Group’s floating rate leases and more new leases contracted at higher fixed rate rentals. Interest and fee income rose by 62.4% y-o-y to US$25.5m due to an increase in fees for advancing aircraft progress payments and higher managed aircraft fees following the sale of a portfolio of 24 aircraft in October 2015 for which BOCA continues to provide management services. BOCA also saw higher trading gains on sale of aircraft (+35.3% y-o-y to US$37.2m).

Meanwhile, operating costs declined 6.2% y-o-y led by lower depreciation charges as older aircraft incurring accelerated depreciation have all been disposed while there was also no aircraft impairment charges compared to a year ago (US$13.6m). 1H16 costs also included c. US$3m in IPO-

related expenses. Finance costs rose by 23.8% y-o-y to US$101m on higher USD Libor costs as well as having a higher proportion of fixed debt. However, we do note that the Group’s lease rental income spread over its cost of debt has actually increased y-o-y. As such, pre-tax earnings rose 20.3% y-o-y to US$239.5m.

BOCA declares an interim dividend of US 6.1cts, representing c. 20% payout.

Looking ahead, BOCA is well positioned to continue its firm growth trajectory as it has placed 100% of the aircraft to be delivered the rest of 2016 (35 aircraft in 2H16) and 67% of those to be delivered in 2017 (54 aircraft in total in 2017). Furthermore, with its balance sheet boosted by IPO proceeds, BOCA is looking to make more aircraft acquisitions to further bolster its growth. BOCA’s net gearing stood at c. 2.9x at the end of 1H16 and we would look for the Group to progressively gear up over the next two years towards its long-term target of 3.5–4x to enhance its profitability and ROE.

Maintain BUY, TP HK$48.40

Interim Income Statement (US$m)

% Chg FYE Dec US$m 1H15 2H15 1H16 y-o-y

Lease rental Income 487.9 487.6 515.9 5.7% Interest and fee income 15.7 24.1 25.5 62.4% Other income:

- Net gain on sale of aircraft 27.5 42.6 37.2 35.3% - Other income 3.9 1.3 0.5 -86.9%

Total revenue and other income 535.1 555.7 579.2 8.2% Depreciation of plant and equipment 193.5 188.5 186.3 -3.7% Finance expenses 81.9 86.8 101.4 23.8% Staff costs 28.2 30.5 31.9 13.1% Other operating costs and expenses 18.7 17.2 20.1 7.3% Impairment of aircraft 13.6 30.3 0.0 -100.0% Total costs and expenses 335.9 353.4 339.6 1.1%

Profit before income tax 199.1 202.3 239.5 20.3% Income tax expenses (27.7) (30.5) (27.3) -1.2%

Profit for the period 171.5 171.8 212.2 23.8%

EBITDA 474.5 477.6 527.2 11.1% Pretax margin 37.2% 36.4% 41.4%

Tax rate 13.9% 15.1% 11.4%

Source of all data: Company, DBS Vickers estimates


Company Guide

BOC Aviation Ltd

CRITICAL DATA POINTS TO WATCH

Earnings Drivers:

Growth in lease rental income to be mainly driven by expanding aircraft portfolio. With a significant number of deliveries of aircraft from its firm order book, which should be further bolstered by purchase and leaseback transactions, we project BOCA’s aircraft portfolio to grow from a net book value of US$9.5bn as at end-2015 to US$11.4bn in 2016F, US$14.3bn in 2017F, and US$17.1bn by end-2018F.

IPO net proceeds of US$547m to fund aircraft acquisitions, including pre-delivery payments and purchase and lease-backs. BOCA successfully concluded its public listing in June to raise net proceeds of US$547m, and we have also assumed that BOCA will continue to fund aircraft acquisitions using a debt-to-equity ratio of 3.5-4 :1 in the long run.

We also project that the lease rate factor will increase (assuming a 50-bp rate hike per annum from mid-2016 through to mid-2018, and this will be adjusted on 60% of leases that are on floating rates) from 9.92% in 2015 to 10.05% in 2016F, 10.3% in 2017F and 10.55% in 2018F. Coupled with the expected growth in BOCA’s aircraft portfolio, we project the company's lease rental income to grow by 7.4% y-o-y to US$1,047m in 2016F, 26.1% y-o-y to US$1,321m in 2017F, and 25.2% y-o-y to US$1,654m in 2018F.

Stable gains on aircraft disposal assumed. We have assumed that BOCA will dispose c. US$1.5bn net book value worth of aircraft between 2016F and 2018F, with a margin on net book value of 5%. This translates to gains on sale of aircraft of c. US$75m per annum between 2016F and 2018F.

Stable depreciation costs and operating leverage... As a percentage of total revenue, we project depreciation costs to be steady at around 33.2-35% of total revenue (our assumption for depreciation is c. 3.4% of average gross book value of aircraft). Meanwhile, as percentage of total revenue, we project SG&A expenses, which include staff costs, travelling and marketing expenses, as well as other operating expenses, to decline marginally over time, from 7.1% of total revenue in 2016F down to 7% in 2017F and 6.9% in 2018F.

…offset by higher finance expenses. As we expect LIBOR to move up (we have assumed a 50-bp increase per annum starting from mid-2016 to mid-2018), finance expenses as a percentage of revenue is projected to increase from 17.1% in 2015 to 18.4% in 2016F, 20.1% in 2017F and 22.2% in 2018F. We have assumed an average cost of debt of 2.1% in 2016F, 2.45% in 2017F and 2.8% in 2018F.

Net book value of aircraft (US$ m)

Lease rate factor (%)

Sale of aircraft at net book value (US$ m)

Trading gain margin (%)

Cost of Debt (%)

Source: Company, DBS Vickers


Company Guide

BOC Aviation Ltd

Balance Sheet:

96-97% of total assets between 2016F-2018F are in aircraft andaircraft progress payments, of which 82-87% are in aircraftassets. The bulk of the remaining 3-4% of assets are largely cash,including restricted cash. Debt ratio should increase through to2018F following an assumed equity injection in 2016F. Whilewe project BOCA’s debt-to-equity ratio to fall to 2.9x by end-2016F after raising net IPO proceeds of US$547m, it is expectedto increase to c. 3.5x by end-2018F as the group continues tobuy aircraft and fund them using a targeted debt-to-equity ratioof 3.5-4 : 1

Share Price Drivers:

Recommend BUY with TP of HK$48.4. Taking into account P/BV vs ROE for BOCA’s peers in aircraft leasing as well as other Asian lessors, plus BOCA’s own qualities versus its aircraft leasing peers, we believe that BOCA’s cost of equity should be 10.5%, translating into a target of 1.32x P/BV, against a projected ROE of 13.8% for 2016F. Hence, we derive a TP of HK$48.4 for BOCA and this translates to FYE Dec’16 PE of 10.2x, against projected EPS CAGR of 12.5% over 2015-2018F. We believe BOCA's share price will re-rate as the company delivers on consistent earnings growth, and executes on its growth plans both organically (aircraft deliveries) and inorganically (purchase and lease-backs). Dividend payout of 30% assumed. We have assumed that BOCA will pay dividends equal to 30% of its profits going forward, compared to 27% of earnings paid out in total between 2013 and 2015, and 41% and 45% payouts for 2013 and 2014 respectively.

Key Risks:

Key Risks. 1) Highly competitive environment for aircraft investments could impact BOCA’s ability to acquire sufficient aircraft or at a value adequate to reach its targeted returns; 2) A rapidly increasing interest rate environment would lower BOCA’s earnings.

Company Background:

BOC Aviation (BOCA) is the largest Asia-headquartered aircraft operating lessor, as measured by the value of owned aircraft. Founded in 1993, BOCA today has total assets of US$12.5bn, and has recorded 22 consecutive years of profit with US$2.1bn in cumulative profits. The company is also among the world’s top 5 operating lessors by fleet size (including firm order backlog).

Leverage & Asset Turnover (x)

Capital Expenditure

ROE

Forward PE Band

PB Band



Company Guide

BOC Aviation Ltd

Key Assumptions

FY Dec 2014A 2015A 2016F 2017F 2018F Net book value of aircraft (US$ m)

9,923.4 9,475.7 11,367.2 14,273.8 17,079.7

Lease rate factor (%) 9.8 9.9 10.1 10.3 10.6 Sale of aircraft at net book value (US$ m) 1,319.5 1,753.9 1,500.0 1,500.0 1,500.0

Trading gain margin (%) 2.3 4.0 5.0 5.0 5.0 Cost of Debt (%) 1.9 2.0 2.1 2.5 2.8 Source: Company, DBS Vickers

Segmental Breakdown (US$ m)

FY Dec 2014A 2015A 2016F 2017F 2018F Revenues (US$ m) Lease Rental Income 937 975 1,047 1,321 1,654 Interest and Fee Income 12 40 43 48 50 Net gain on sale of aircraft

30 70 75 75 75

Others 10 5 6 8 10 Total 988 1,091 1,172 1,452 1,789


Income Statement (US$ m)

FY Dec 2014A 2015A 2016F 2017F 2018F Revenue 988 1,091 1,172 1,452 1,789 Cost of Goods Sold (381) (382) (411) (496) (596) Gross Profit 607 708 761 956 1,193 Other Opng (Exp)/Inc (88) (120) (83) (101) (123) Operating Profit 519 588 678 855 1,070 Other Non Opg (Exp)/Inc 0 0 0 0 0 Associates & JV Inc 0 0 0 0 0 Net Interest (Exp)/Inc (165) (187) (216) (291) (396) Dividend Income 0 0 0 0 0 Exceptional Gain/(Loss) 1 0 0 0 0 Pre-tax Profit 354 402 462 564 673 Tax (44) (58) (67) (82) (98) Minority Interest 0 0 0 0 0 Preference Dividend 0 0 0 0 0 Net Profit 310 344 395 482 576 Net Profit before Except. 309 343 395 482 576 EBITDA 900 971 1,088 1,351 1,666 Growth Revenue Gth (%) 7.6 10.3 7.4 23.9 23.2 EBITDA Gth (%) 12.8 7.9 12.1 24.1 23.3 Opg Profit Gth (%) 12.4 13.5 15.1 26.2 25.1 Net Profit Gth (%) 11.7 10.9 14.9 22.1 19.4 Margins & Ratio Gross Margins (%) 61.4 65.0 64.9 65.9 66.7 Opg Profit Margin (%) 52.5 54.0 57.8 58.9 59.8 Net Profit Margin (%) 31.3 31.5 33.7 33.2 32.2 ROAE (%) 15.4 15.1 13.8 14.0 15.1 ROA (%) 2.9 2.9 2.9 3.0 3.1

ROCE (%) 4.3 4.3 4.4 4.7 4.9 Div Payout Ratio (%) 44.9 0.0 30.0 30.0 30.0 Net Interest Cover (x) 3.1 3.1 3.1 2.9 2.7 Source: Company, DBS Vickers


Company Guide

BOC Aviation Ltd

Interim Income Statement (US$ m)

FY Dec 1H2015 2H2015 1H2016

Revenue 535 556 579 Cost of Goods Sold (193) (188) (186) Gross Profit 342 367 393 Other Oper. (Exp)/Inc (61) (78) (52) Operating Profit 281 289 341 Other Non Opg (Exp)/Inc 0 0 0 Associates & JV Inc N/A N/A N/A Net Interest (Exp)/Inc (82) (87) (101) Exceptional Gain/(Loss) 0 0 0 Pre-tax Profit 199 202 240 Tax (28) (30) (27) Minority Interest N/A N/A N/A Net Profit 171 172 212 Net profit bef Except. 171 172 212

Growth Revenue Gth (%) N/A N/A 8.2 Opg Profit Gth (%) N/A N/A 21.3 Net Profit Gth (%) N/A N/A 23.8 Margins Gross Margins (%) 63.8 66.1 67.8 Opg Profit Margins (%) 52.5 52.0 58.9 Net Profit Margins (%) 32.0 30.9 36.6 Source: Company, DBS Vickers

Balance Sheet (US$ m)

FY Dec 2014A 2015A 2016F 2017F 2018F

Net Fixed Assets 11,015 11,717 13,909 16,816 19,622 Invts in Associates & JVs 0 0 0 0 0 Other LT Assets 2 3 3 3 3 Cash & ST Invts 367 729 496 477 538 Inventory 0 0 0 0 0 Debtors 16 23 23 23 23 Other Current Assets 2 2 2 2 2

Total Assets 11,403 12,474 14,432 17,321 20,188

ST Debt

889 963 963 963 963 Creditors 77 115 123 150 183 Other Current Liab 78 137 100 100 100 LT Debt 7,272 7,649 8,549 10,849 13,049 Other LT Liabilities 990 1,170 1,434 1,658 1,889 Shareholder’s Equity 2,096 2,440 3,263 3,601 4,004 Minority Interests 0 0 0 0 0 Total Cap. & Liab. 11,403 12,474 14,432 17,321 20,188

Non-Cash Wkg. Capital (137) (227) (199) (226) (259) Net Cash/(Debt) (7,794) (7,883) (9,016) (11,335) (13,473) Debtors Turn (avg days) 5.4 6.6 7.2 5.8 4.7

Creditors Turn (avg days) n.m. n.m. n.m. n.m. n.m.

Inventory Turn (avg days) N/A N/A N/A N/A N/AAsset Turnover (x) 0.1 0.1 0.1 0.1 0.1Current Ratio (x) 0.4 0.6 0.4 0.4 0.5Quick Ratio (x) 0.4 0.6 0.4 0.4 0.5Net Debt/Equity (X) 3.7 3.2 2.8 3.1 3.4Net Debt/Equity ex MI (X) 3.7 3.2 2.8 3.1 3.4Capex to Debt (%) 22.4 15.3 26.6 28.2 23.7Z-Score (X) NA NA NA NA NASource: Company, DBS Vickers


Company Guide

BOC Aviation Ltd

Cash Flow Statement (US$ m)

FY Dec 2014A 2015A 2016F 2017F 2018F

Pre-Tax Profit 353 401 462 564 673 Dep. & Amort. 396 400 431 520 625 Tax Paid 0 0 (1) (1) (1) Assoc. & JV Inc/(loss) 0 0 0 0 0 (Pft)/ Loss on disposal of FAs 0 0 0 0 0 Chg in Wkg.Cap. 55 161 194 27 33 Other Operating CF (6) (42) (17) 17 3

Net Operating CF 797 921 1,069 1,128 1,333 Capital Exp.(net) (1,827) (1,318) (2,527) (3,327) (3,327) Other Invts.(net) 0 0 0 0 0 Invts in Assoc. & JV 0 0 0 0 0 Div from Assoc & JV 0 0 0 0 0 Other Investing CF 0 0 0 0 0 Net Investing CF (1,827) (1,318) (2,527) (3,327) (3,327) Div Paid (139) 0 0 (118) (145)Chg in Gross Debt 998 536 900 2,300 2,200 Capital Issues 0 0 547 0 0 Other Financing CF (98) 0 (30) (30) (30) Net Financing CF 761 536 1,417 2,152 2,025 Currency Adjustments 0 0 0 0 0 Chg in Cash (269) 139 (41) (48) 31 Opg CFPS (US$) 1.26 1.29 1.35 1.59 1.87 Free CFPS (US$) (1.75) (0.67) (2.24) (3.17) (2.87)


Target Price & Ratings History

Source: DBS Vickers

Analyst: Paul YONG CFA

12

36.0

37.0

38.0

39.0

40.0

41.0

42.0

43.0

Jun-

16

Jul-1

6

Aug

-16

HK$S.No. Date Closing 12-mth Rat ing

Price TargetPrice

1: 7-Jul-16 HK$39.95 HK$48.4 Buy2: 27-Jul-16 HK$37.75 HK$48.40 Buy

ed-JS / sa- AH

BUY (Initiating coverage)

Last Traded Price ( 9 Feb 2017):HK$9.23 (HSI : 23,525) Price Target 12-mth: HK$11.60 (26% upside)

Potential Catalyst: Better than expected performance from a) sale of finance lease receivables and/or b) aircraft disassembly business Where we differ: We have more conservative earnings forecasts than consensus on less aggressive realisation gain assumptions

Analyst Paul YONG CFA +65 6682 3712 [email protected]

Price Relative

Forecasts and Valuation FY Dec (HK$ m) 2015A 2016F 2017F 2018FTurnover 1,549 2,239 2,584 2,851 EBITDA 1,325 1,936 2,256 2,498 Pre-tax Profit 480 845 943 1,036 Net Profit 380 659 736 808 EPS (HK$) 0.63 0.96 1.06 1.16 EPS Gth (%) 21.4 52.6 10.8 9.8 Diluted EPS (HK$) 0.52 0.91 1.02 1.12 DPS (HK$) 0.22 0.34 0.37 0.41 BV Per Share (HK$) 3.61 4.49 5.20 5.95 PE (X) 14.7 9.6 8.7 7.9 P/Cash Flow (X) nm nm 14.5 5.4 P/Free CF (X) nm nm nm nm EV/EBITDA (X) 15.5 12.2 10.9 10.3 Net Div Yield (%) 2.4 3.6 4.0 4.4 P/Book Value (X) 2.6 2.1 1.8 1.6 Net Debt/Equity (X) 6.8 5.6 5.1 4.7 ROAE (%) 19.3 25.0 22.0 20.9

Earnings Rev (%): New New New Consensus EPS (HK$) 0.97 1.14 1.27 Other Broker Recs: B: 7 S: 0 H: 1

ICB Industry: Industrials ICB Sector: Industrial Transportation

Principal Business: CALC is a leading independent aircraft leasing company in China Source of all data on this page: Company, DBSV, Thomson Reuters, HKEX

Punching above its weight • China Aircraft Leasing Group (CALC) is a leading

independent aircraft lessor in China, with an order book

to grow its fleet from 81 to 173 aircraft by 2022

• Firm earnings growth propelled by growing lease

income and disposal of finance lease receivables

• Aircraft disassembly business could provide further

upside to earnings and share price

• Initiating coverage with BUY and TP of HK$11.60

Leading independent aircraft lessor in China. Established in 2006, CALC has grown its fleet to 81 aircraft as at end of 2016, leased to 16 airline customers in Asia and Europe. With a firm order book for 92 aircraft from Airbus and potential for more from pop-ups and purchase & lease-backs, CALC is well poised to grow its fleet to at least 173 by 2022.

Growing lease income supplemented by sale of finance lease receivables. Underpinned by its growing fleet, CALC’s lease income is projected to grow steadily over the next few years, further supplemented by gains from the sale of its finance lease receivables. CALC also receives strong support from the Chinese government, as evidenced by the growing subsidies it receives.

Foray into aircraft disassembly business could set CALC apart from the competition. CALC has a 49% stake in an aircraft disassembly business based in Harbin that is slated to commence operations in 2H17 and targets to disassemble up to 20 aircraft per annum from 2018. If successfully executed, this could provide a further lift to earnings and share price.

Valuation

We value CALC based on a blended valuation of 10x FY18F PE and 2x FY18F P/B to derive a 12-month target price of HK$11.60. The higher than peer average target P/B multiple of 2x reflects the Group’s industry-leading ROE of over 19%.

Key Risks to Our View:

CALC derives a substantial portion of its revenues from government subsidies and gains from sale of finance lease receivables and should these fall short, it would significantly impact the Group’s earnings.

At A Glance

Issued Capital (m shrs) 616 Mkt. Cap (HK$m/US$m) 5,685 / 733 Major Shareholders

China Everbright Ltd (%) 32.3 Friedmann Pacific A.M. (%) 27.3

Free Float (%) 40.4 3m Avg. Daily Val. (US$m) 0.8

77

97

117

137

157

177

197

217

237

4.5

6.5

8.5

10.5

12.5

14.5

Jul-14 Jan-15 Jul-15 Jan-16 Jul-16 Jan-17

Relative IndexHK$

China Aircraft Leasing Group (LHS) Relative HSI (RHS)

DBS Group Research . Equity 10 Feb 2017

China / Hong Kong Company Focus

China Aircraft Leasing Group Bloomberg: 1848 HK Equity | Reuters: 1848.HK Refer to important disclosures at the end of this report

Company Focus

China Aircraft Leasing Group

Page 2

INVESTMENT THESIS

Profile Rationale

Established in 2006, China Aircraft Leasing Group (CALC) is a leading independent aircraft lessor in China, and also provides customers with aircraft full-life solutions - covering fleet planning consultation, structured financing, fleet replacement package deal and third party aircraft resale. The group has also made a recent foray into the aircraft disassembly business, which is slated for commencement in 2H17.

Firmed earnings growth supported by a young and growing fleet. Underpinned by a growth in owned fleet from 63 aircraft at end-2015 to 125 by end FY18F, as well as higher gains from disposal of finance lease receivables, we expect net profit to grow substantially from HK$380m in FY15 to HK$808m by FY18F.

Foray into aircraft disassembly business could set CALC apart from competition. CALC has a 49% stake in an aircraft disassembly business based in Harbin that is slated for commencement in 2H17, and targets to disassemble up to 20 aircraft p.a. in 2018. While we have yet to factor contributions from this business into our forecasts, if successfully executed, this could provide further earnings and share price upside.

Valuation Risks

12-month TP of HK$11.60. We value CALC based on a blendof 10x FY18F PE and 2x FY18F PB to derive a 12-monthtarget price of HK$11.60. The higher than peer averagetarget multiple of 2x reflects the Group's industry-leadingROE of over 19%.

Reliance on government subsidies and gains from sale of finance lease receivables. CALC derives a substantial portion of its revenues from government subsidies and gains from sale of finance lease receivables and should these fall short, it would significantly impact the group's earnings.

Source: DBS Vickers

Company Focus


Page 3

BUSINESS MODEL

Leading independent aircraft lessor in China. Established in 2006 and having completed its first purchase and leaseback transaction with China Southern Airlines in 2007, China Aircraft Leasing Group (CALC) has today grown to become a leading independent aircraft lessor in China. As at end-2016, CALC has a fleet of 81 aircraft with 92 on order with Airbus, with total assets of over US$4bn. CALC was listed on the Hong Kong Exchange in July 2014, becoming the first aircraft lessor to be listed in Asia.

2015 Revenue Breakdown: HK$1,549m

Source: Company, DBS Bank estimates

Strong top and bottom line growth. Fueled by a rapidly growing fleet, CALC’s revenue has grown from HK$223m in 2011 to HK$1.5bn in 2015, while net profit has grown from HK$51m to HK$380m over the same period.

Revenue and profit track record (HK$m)


Current portfolio of 81 aircraft with an average age of c. 4 years. CALC’s aircraft portfolio stands at 81 at the end of 2016, with an average age of c. 4 years. This is made up of 72 A319/320/321 series of aircraft and four A330 series of aircraft, and five B737 NGs. The portfolio has an average remaining lease of over nine years. Furthermore, CALC has 92 A320s on order with Airbus.

Fleet breakdown by aircraft type


80% of revenue from aircraft leasing income. The bulk of CALC’s revenue is derived from the leasing of aircraft. In 2015, 80% of the Group’s total revenue was from aircraft leasing, of which 82% was classified as being from financial lease income and the remaining from operating lease income. Meanwhile, 16% of the Group’s revenue in 2015 was from government subsidies and 3% from gains from disposal of financial lease receivables.

Operating lease vs Finance lease. While a large proportion of the Group’s leases have been classified as finance leases, CALC regards itself as an operating lessor as it keeps the title of the aircraft in its hands at the end of the lease and generally its lessees have no option to acquire the leased aircraft at a nominal value. However, because these leases have a longer rental period (e.g. 12 years), hence they have been classified as finance leases.

Government subsidies. CALC receives grants and subsidies mainly from the Management Committee of Tianjin Dongjiang Free Trade Port Zone. These are incentives provided by the government to support the development of the aircraft leasing industry. The amount of government subsidies received by CALC has been growing in tandem with the number of aircraft in CALC’s portfolio that are registered in China.

Disposal of financial lease receivables. To augment its earnings and cash flow, CALC consistently disposes of its finance lease receivables to investors such as banks and insurance companies

Financial lease

income66%

Operating lease

income14%

Gain from disposal of

finance lease receivables

3%

Government subsidy16%

Others1%

223 448

687

1,145

1,549

51 95 173 303 380

0

200

400

600

800

1,000

1,200

1,400

1,600

1,800

2011 2012 2013 2014 2015

Total Revenue Net Profit

54

72

Boeing 737 NG Airbus 330 series Airbus 319/A320/A321 series

Company Focus


Page 4

for gains. This helps the Group to realise the unearned finance income for profit and also helps to improve capital recycling for CALC.

Aircraft delivery schedule. CALC is poised to take delivery of 17 A320s from Airbus in 2017, and a further 15-20 per year in 2018 and 2019, which provides the Group with a steady pipeline for growth.

Diversified customer portfolio. CALC has a well diversified customer base, with a bias towards Chinese carriers. Of the 81

aircraft in the portfolio as at end 2016, 15 are leased to overseas airlines, which includes Air Macau, Air India, Pegasus Airlines and Jetstar Pacific. The remainder are leased to various Chinese carriers.

CALC’s Customer Portfolio as at end 2016

Source: Company

Company Focus


Page 5

2015 Operating Costs Breakdown: HK$1,068m


Interest and depreciation make up the bulk of operating costs. As expected of an aircraft lessor, the bulk of operating costs for CALC consists of depreciation and interest costs, which made up 79% of the Group’s total operating costs in 2015. Meanwhile, employee compensation and benefits made up 6% of total operating costs, while the remaining can be attributed to other costs such as business tax & surcharges, professional service expenses, and overheads.

Interest expense

71%

Depreciation8%

Employee compensation

& benefits6%

Others15%

Company Focus


Page 6

INDUSTRY OVERVIEW: Demand outlook for aircraft and operating leasing remains rosy

Sustainable increasing trend in demand for air travel. Facilitated by rapid economic growth, there has been increasing demand for air travel since 1990. The air travel industry has weathered various major external shocks over the years to register 5.1% CAGR in the 25 years until 2015, compared to 3.6% average global GDP growth rate in the same period.

There were only three short periods of negative growth – the first in 1991 following the first Gulf War, then following the September 11 terrorist attacks and lastly, after the global financial crisis of 2008-09. Global passenger traffic in 2015 was almost 3.5 times greater than that seen in 1990, exceeding global GDP growth by 2.5 times.

Global GDP and passenger traffic growth

Source: Ascend Flightglobal Fleet Forecast

Global passenger traffic is forecast to grow by 5.0% per annum between 2015 to 2035. Barring such unprecedented shocks, air traffic growth should remain on a long-term steady growth trend. Going forward, rising per capita income, increasing affordability and propensity to travel will continue to propel traffic growth, especially in emerging markets and drive the need for more aircraft. According to most industry experts, this trend is likely to continue for the next two decades with 5% p.a. growth for passengers, driven mainly by emerging markets. This implies 2.6 times the current revenue passenger kilometres (RPKs) will be flown by 2035. Traffic growth is expected to remain around 1.5 to 2.0 times the rate of underlying GDP growth, depending on the region.

IATA expects emerging markets to be the most dynamic region in terms of passenger traffic growth by 2035. Breaking down into regions, traffic growth should be increasingly driven by emerging markets; Western Europe and North America are considered mature markets, with growth expectations of only 2.9-3.5% per annum while many markets in Asia, the Middle East, Africa and Latin America are forecast to grow at rates well above 4.5% per annum according to Airbus.

This is underpinned by increasing disposable income and rapidly growing middle class populations. The number of Asia’s middle class households is expected to grow by 2x to 249m by end 2020 from 89m at end 2010 and may double during 2020-2030 to 508m, underpinning air traffic growth. In particular, China and India hold significant, long term growth potential.

Company Focus


Page 7

The market is also stimulated by expansion of low cost carriers in short haul markets, most recently in the Asia-Pacific region, and increasing connectivity by Gulf ‘hub carriers’ in long haul markets between Europe, Africa, the Americas and Asia-Pacific. Technology is a key driver of air travel growth as new aircraft technologies generate operational and cost efficiencies which are passed on to passengers.

Revenue passenger kilometre (RPK) traffic by domicile

Regions % of

2015

World’s

RPK

% of

2035

World’s

RPK

20-year

CAGR

Asia-Pacific 30% 36% 5.7%

Europe 25% 22% 3.5%

North

America

24% 19% 2.9%

Middle East 9% 11% 5.7%

Latin

America

5% 5% 4.8%

CIS 4% 4% 4.1%

Africa 3% 3% 4.5%

Global Average 4.5%

Source: Airbus, DBS

Nearly 40,000 new aircraft will be needed over the next 20 years. Boeing expects approximately 39,620 new aircraft (or close to US$3 trillion worth of new aircraft deliveries) to be delivered into 2035. This is also largely in line with latest fleet forecasts provided by Airbus. Over 39,620 aircraft by 2035 translates into annual increase of 3.6%, less than the forecast rate of traffic growth (5%) with the balance (difference between 5.0% and 3.6%) made up from improved asset and labour productivity, increased seat densities, deployment of larger aircraft, and other operational efficiencies.

Meanwhile, aviation consultant Ascend estimates that 33,540 new aircraft will be delivered over the next twenty years, approximately 19,930 of which are likely required to fulfil new demand generated by passenger traffic growth, whilst almost another 13,610 new aircraft are forecast replace aircraft presently in service that will be retired from passenger service in the next ten years due to fuel efficiency, retirement and freight conversion. Approximately 5,550 of the fleet currently in service today are expected to remain in service in 2035.

Aircraft fleet growth forecasts

Source: Ascend

Asia Pacific will lead on delivery value, in line with faster air traffic growth according to Boeing. On a regional basis, the Asia-Pacific region (including China) is forecast to account for 40% of deliveries by value in the 20-year period. The mature markets of North America and Europe will have shares of 19% and 17% respectively. Middle Eastern carriers may only account for 8% of aircraft deliveries but their 13% share of value reflects the many large twin-aisle aircraft the Gulf hub carriers have ordered. Fleet growth forecast by region

Source: Ascend

Replacement needs and tighter regulation to drive demand. Travel demand aside, replacement needs and emergence of new regulations may also drive demand for newer aircraft. As compared to older models, newer aircraft offer the advantages of: (i) Lower operating costs, especially improved fuel burn (the best way to hedge fuel cost exposure) and lower maintenance costs; (ii) Improved payload and range capability (important for opening new markets) and despatch reliability; (iii) Advanced cockpits and cabins (weight savings either reduce costs or offer greater revenue

19,160

5,550

13,610

19,930

‐

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

45,000

2015 2035

Base fleet Replacement demand Growth demand

AP (excl. China), $638bn, 24%

China, $427bn, 16%

Europe, $414bn, 16%

Latin America, $176bn, 7%

Middle East, $359bn, 14%

North America, $443bn, 17%

Russia & CIS, $68bn, 3% Africa, $73bn, 3%

Company Focus


Page 8

potential from increased seat density. Often, older aircraft are uneconomic to refurbish); and (iv) Availability (the option to upgrade an older aircraft is driven by available supply of new aircraft).

The airline industry is also subject to regulations, particularly on the safety and operational axes. The latter may impact fleet strategy and aircraft values. Another form of regulation which can potentially impact aircraft liquidity is aircraft importation age restrictions, which are used in certain countries to prevent the import of aircraft older than a certain age (typically 10, 15 or 20 years). According to Ascend, such regulations can be found in approximately 44 countries today, but only half of these are currently in effect.

Airlines have typically used a variety of avenues to finance new aircraft deliveries worth more than US$100bn annually. Demand for new commercial airliners is presently strong and annual financing for new deliveries now exceeds US$100bn, excluding spare parts and services which airlines buy direct from aircraft manufacturers. Over 2016 to 2020, Ascend estimates the value of deliveries of new 100+ seater passenger jets and their freighter versions will be around US$662bn in total. According to Boeing, annual aircraft financing required for new deliveries alone willl likely reach US$172bn by 2020, which represents CAGR of 5.9% between 2015 and 2020.

Aircraft financing needs to grow at 5.9% CAGR into 2020

Source: Boeing, DBS

Major aircraft funders include export credit agencies (ECA), commercial banks, operating lessors, public debt/capital markets, private equity / hedge funds, cash / equity and manufacturer finance (both airframe and engine OEMs). Recently, many new investors have recognised the investment potential offered by aircraft and a number of new players have entered the field.

122 127 130142

161172

0

20

40

60

80

100

120

140

160

180

200

2015 2016F 2017F 2018F 2019F 2020F

Company Focus


Page 9

Aircraft Manufacturer Supply

Aircraft deliveries showed strong resilience even during GFC. Commercial jet airline deliveries have been growing constantly over the past 10 years despite small hiccups in 2008-2010 during the GFC. However, during the last economic downturn (i.e. 2008 - 2009), there was not a significant decline in production, as Airbus and Boeing, the two key OEMs today, made concerted efforts to manage their production rates more efficiently than in previous cycles. In addition, during this period, the OEMs benefited from the rise of new markets and strong oil economies that absorbed deliveries which were deferred by airlines in many developed markets. Production is expected to increase over the next three years, in line with estimates for increasing demand for new aircraft. This is driven particularly through increasing the output of single-aisle aircraft at both Airbus and Boeing.

Narrow body aircraft will continue to be the workhorse of the industry. Around 21,300 of the forecast deliveries are predicted to be single-aisle aircraft, 6,900 will be twin-aisle aircraft and 4,000 will be regional jets. The Middle East and Asia-Pacific will require relatively more twin-aisle aircraft, with the former rapidly developing as a key hub region for long-haul services between the west and east, and the latter seeing significant growth in long-haul services and that twin-aisle aircraft are required for denser intra-Asia-Pacific routes, which are already operated using twin-aisle aircraft.

Commercial jet airline delivery trend


Airbus and Boeing duopoly. The single-aisle and twin-aisle aircraft manufacturing landscape has gradually evolved into a duopoly between the European Airbus Group and US-based Boeing. Several smaller players (Fokker, British Aerospace, Lockheed) have exited the market over the years, and Boeing took over long-time rival McDonnell-Douglas (MDC) in 1997. Airbus and Boeing today account for 98%of deliveries in the 100+ seat passenger jet and freightervariant market. Embraer and Bombardier have a small shareof the 100-seat sector. COMAC of China and Irkut in Russiaare developing new 150-seater single-aisle programmes, theC919 and MC-21 respectively, for the end of the decade.The timing of these aircraft is indicative of the long-lead timeinherent in new aircraft development programmes.

Airbus and Boeing duopoly in OEM


Company Focus


Page 10

Aircraft Lease Market Dynamics and Peers comparison

Asia Pacific and Europe are core markets for aircraft leasing. As at 31 January 2016, the commercial aviation industry comprised 780 airlines in about 160 countries operating almost 20,000 passenger jets of 100+ seats and their freighter versions. The global airline fleet is currently dominated by the Asia-Pacific region with a 32% market share, of which China alone has 13%. North America follows with 26% and Europe with 25%. The fleet of aircraft on operating lease has a similar share in Asia-Pacific

(34%) with a higher share in China (41%) and in Europe (32%), and a lower share in North America (16%). The table below indicates that the core aircraft operating lease markets are in Asia-Pacific and Europe. The tax regime in North America encourages profitable airlines to own aircraft on their balance sheets. An aircraft operating lessor will achieve the greatest efficiencies by focusing on larger airlines, where multiple aircraft deals are possible.

Airline fleet and operating lease fleet by region (Jan 2016)

Source: Ascend, DBS Vickers

Lessors retain some advantage in fund-raising owing to their diversified portfolios and consistent financial performance through the cycle, which renders them more attractive options for sources of finance that still remain available.

Operating lessors are expected to continue to grow their portfolio through the next few years but they must still access debt to finance new deliveries, and the retreat of commercial banks from the sector will potentially impact their ability to grow. Lessors will thus be expected to seek new sources of capital to support their growth, which represents investment opportunities for new capital funds.

Operating lease market penetration should continue to increase. The aircraft fleet is expected to continue its consistent long-term growth trend, with the global fleet predicted to exceed 30,000 aircraft by 2024. As explained earlier, operating leases offer advantages of ownership for

some airlines over alternative forms of finance, as well as providing operational advantages. Consequently, the fleet of aircraft owned by operating lessors is expected to grow in line with the global expanding aircraft fleet.

Since the mid-1960s, the percentage of the global fleet of commercial passenger and cargo jets owned or managed by operating lessors has grown from zero to more than 40% of the total fleet of 100+ seat passenger jets and their freighter versions at end 2015. In early 2016, there were around 7,900 aircraft in service which were owned by aircraft operating lessors, representing 11% CAGR over the past 30 years or double the rate of growth of the commercial jet airliner fleet in service. This trend should continue in our view given the benefits of operating lease such as financial and fleet flexibility. Key driver of this faster growth is that lessors can access capital much more easily than airlines, as we have explained earlier.

As ia P acific(inc l. China)

EuropeNorth

AmericaL atin

AmericaMiddle

E as tAfrica

Airline operators (100+ seat aircraft) 234 235 68 89 54 100

Operators with >20 aircraft 58 52 18 16 15 7

Dedicated cargo operators 31 24 33 7 25 9

In service fleet 6,308 4,874 5,177 1,433 1,194 646

Aircraft on operating lease 2,674 2,478 1,346 756 422 196

Average fleet age (yrs) 7.5 11 14.2 10.1 9.5 13.4

Average age of operating lease fleet 6.5 10.3 12.5 9.3 8 11.6

5yr delivery total 2,934 1,310 943 567 489 166

20 yr forecast delivery total 13,908 6,490 6,484 3,002 2,757 903

2015 Operating revenues (US$bn) 202 198 204 31 59 18

2015 EBIT margin 6.60% 5.30% 14.30% 1.30% 2.90% -1.70%

2015 Net margin 2.90% 3.50% 9.50% -1.00% 2.40% -1.70%

Company Focus


Page 11

Operating lease as percentage of aircraft fleet

Source: Ascend

Europe and Asia-Pacific are the leading regions of customer placement for aircraft operating lessors and the top ten Asian lessors have significant placements in each of these regions. China is the most significant market for the Asian top 10 lessors, unsurprising given the initial Chinese lessee-

focus of many of the new Chinese based lessors, while they have less exposure to the overseas market.

Operating Lessor Fleet & Backlog by Airline Lessee Region

Source: Flightglobal Fleets Analyzer — as at 31 Dec 2015

Company Focus


Page 12

KEY RISK FACTORS

Exposed to the performance of the aviation industry. CALC’s business is almost entirely dependent on the willingness as well as the ability of airline customers to enter into new aircraft operating leases and to pay and perform their obligation leases. During a downturn, CALC’s airline customers may find it difficult to honour cash flow commitments, leading to delays in payments, and in the worst case, could face bankruptcy. Geopolitical risks, war, acts of terrorism, epidemics and natural disasters could also impair the lessees’ ability to honour their lease terms. Increasing competition, high fuel costs, worsening labour conditions are some other factors

Supply-demand dynamics will affect lease rates and aircraft values. The aviation industry is cyclical in nature, leading to periods of oversupply and undersupply in the aircraft leasing and sales industry. The oversupply of a specific type of aircraft will of course lead to depressed market values and lease rates in future.

Re-leasing terms may not be favourable. As the existing leases expire, CALC would need to renegotiate leases with prospective lessors and depending on the economic cycle, re-lease terms may be lower than currently estimated. In the event that no favourable terms can be found, the company may have to bear off-lease time and/(or) unfavourable financial results of operations.

Lessees may fail in maintenance obligations. Under each lease agreement, the lessee is primarily responsible for maintaining the aircraft and complying with all aviation safety and airworthiness regulations. If the lessee fails to properly maintain the aircraft, this could impact the sale value or re-lease value of the aircraft at the expiry of current lease.

Competition may impede CALC’s ability to grow. CALC operates in a highly competitive market for investment opportunities in aircraft. The business of acquisition, leasing and sale of commercial aircraft is highly competitive, and CALC competes with airlines, other lessors, aircraft investors as well as other new potential market entrants for such opportunities. Intensifying competition could impede CALC’s growth and/or lower the returns for this business.

Delays in delivery or failure of deliveries may adversely impact CALC. CALC’s growth depends mainly on the manufacturers’ ability to deliver the ordered aircraft timely. A failure to deliver by the manufacturer or a delay in delivery, commonplace for new aircraft types, could result in lost or delayed revenues for CALC.

Interest rate impact. CALC is partially vulnerable to higher interest rates as it has not perfectly matched or hedged its leases with its loan. A sharp increase in interest rates could substantially impact CALC’s earnings. In the longer term, CALC could also be vulnerable to interest rate volatility if it cannot balance fixed and floating rate debt to match its own fixed and floating rate aircraft leases.

Reliance on government subsidies. CALC derives a substantial portion of its revenues from government subsidies and gains from sale of finance lease receivables and should these fall short, it would significantly impact the Group’s earnings.

Company Focus


Page 13

MANAGEMENT & STRATEGY

Experienced and diversified management team. CALC is led by a highly-experienced management team with decades of collective experience in the global aviation and finance sectors.

Key Management Team

Name and Title Responsibilities Credentials

Mr. Chen Shuang Responsible for reviewing the Group’s overall strategic planning and managing overall business operations

Mr. Chen is an Executive Director and Deputy General Manager of China Everbright Holdings, a leading SOE. Also an Executive Director and CEO of HK-listed China Everbright Limited

Executive Director and Chairman

Mr. Poon Ho Man Responsible for formulating and reviewing the Group's overall strategic planning and managing overall business operations

A founder of CALC, Mr. Poon has over 20 years of experience in direct investment, structured finance and aviation financing, with over 10 years of focus in aircraft leasing and airport investment.

Mr. Barry Mok Chung Tat Responsible for the Group's overall strategic planning and implementation. Also oversees the accounting and risk management, and other corporate functions

Has over 30 years of extensive corporate and banking experience and has arranged c. HK$500bn debt capital market facilities. Previously the Chief Executive of BOCI Capital

Deputy CEO and Chief Financial Officer

Ms. Winnie Liu Wanting Responsible for the Group's overall strategic planning and implementation, as well as managing commercial operations.

Joined CALC in 2006 and has lead the team to place over 60 new and used aircraft to over 10 airlines in the Greater China region. Closed over US$2bn worth of multiple aviation financing projects and the first securitisation in China.

Executive Director, Deputy CEO and Chief Commercial Officer

Mr. Pitney Tang Yu Ping Oversees all aspects of transaction-related functions

Has held senior financial positions in various companies listed in Hong Kong, and has over 20 years of experience in corporate development, and financial management

Chief Operating Officer

Mr. Jens Dunker In charge of aircraft asset trading and global marketing

Has over 20 years of experience in the aircraft industry with a focus on aircraft purchasing and financing SVP, Aircraft Trading and

Global Marketing

Mr. Duan Xiaoge Responsible for technical and asset management

Has over 27 years of experience in the aircraft industry, focusing on aircraft maintenance and engineering, project consultancy and planning

SVP, Technical and Asset Management

Mr. Christian McCormick Covers international financing initiatives, with primary focus on capital market initiatives on the international markets

Leading expert in aircraft financing solutions with 30 years of experience in the financial services industry. Ex-CEO of Natixis Transport Finance

Managing Director Finance

Source: Company, DBS Bank

Company Focus


Page 14

Aiming to be a full value chain aircraft solutions provider. CALC aims to become a one-stop aircraft solutions provider, and to capture the full value-chain of an aircraft life cycle. This includes a) the purchase of new aircraft, b) structured finance, c) lease negotiaitons, d) asset management, e) fleetreplacement package deals, f) sale and leaseback of usedaircraft, and e) aircraft disassembly. While CALC’s existingbusiness focuses on new aircraft leasing, its investment inAircraft Recycling International Ltd (ARI) would focus on mid-aged aircraft leasing as well as the disassembly of retiredaircraft (more on this below).

Fleet expansion plan – to grow to at least 173 aircraft by 2022F. With a firm order book of 92 aircraft to be delivered by 2022, CALC is poised to more than double its aircraft portfolio, currently at 81, which will provide it with strong organic growth in revenue and earnings. In addition to the current order book with Airbus, CALC will also look to expand its fleet through the purchase of aircraft in the secondary market, and also through pop-up orders from Airbus or Boeing.

Realisation of lease receivables for gains. CALC sells the remaining rental receivables for aircraft leases to investors to augment its cashflow and earnings. In March 2015 and January 2016, CALC signed a framework agreement with the Bank of Communications Company Limited and the Shanghai Branch of China Construction Bank for the realisation of lease receivables for 20 aircraft and 15 aircraft respectively. Underpined by these agreements and given firm demand for such products in China, CALC targets to realise 15 aircraft or more annually from 2017 onwards.

Diversified and flexible financing channels. To fund the business and its growth, CALC has utilised and accessed a wide variety of financing channels. This includes 1) realisation of lease receivables as explained above; 2) bank borrowings, which have been one of the Group’s key sources to finance aircraft acquisitions; 3) covertible bonds, such as the US$115m convertible bonds issued in March 2015 (US$75m of which was repurchased in July 2016 to lower interest costs); 4) Medium Term Notes and USD Bonds – CALC hadsuccessfully issued both Medium Term Notes and USD Bondsin 2015 and 2016; 5) ECA financing and credit support – thisis an alternative source of financing for CALC. In fact, theGroup has financing for three aircraft backed by a guaranteeissued by UK Export Finance; 6) JOLCO – CALC closed its firstJapanese Operating Lease with a Call Option financing to twonew A320s delivered to Pegasus Airlines in June 2017; 7)placement of new shares – CALC placed out 40m new sharesto independent shareholders in August 2016 at HK$8 pershare.

Globalisation – to grow the business beyond China. As CALC’s aircraft portfolio grows, the Group aims to lease more aircraft to overseas airlines to diversify its client base and widen its aviation expertise. The number of aircraft leased to overseas airlines has grown from 0 in 2014 to 15 in 2016. This globalisation strategy also includes CALC seeking potential overseas M&A opportunities to speed up its growth.

Downstream expansion into aircraft disassembly business could reap future rewards. CALC has a 48% stake in ARI, which is building Asia’s largest aircraft disassembly centre near Harbin Taiping International Airport, covering an area of 300,000 square metres. Slated to commence operations in the second half of 2017, ARI aims to reach a dismantlling capacity of 20 aircraft per annum in 2018, and could contribute significantly to CALC’s bottomline from 2018 onwards.

Other shareholders in ARI include Sky Cheer with 20%, FPAM (CALC’s major shareholder) with 18%, and China Everbright (CALC’s largest shareholder) with 14%.

With c. 12,000 aircraft to be retired in the next 20 years, a growing number of which are in China, ARI is well positioned to benefit from this. We have yet to factor in the contribution of ARI to CALC’s forecast.

China Aircraft Global Venture (CAG) Fund. CALC is seeking to build up a new platform (China Aircraft Global Venture) to capture demand for aircraft leasing and management solutions. CAG will be a composite fund comprising of shares, junior debt, and senior debt with a target equity size of US$500m – US$1bn, and it will be focused on aircraft leasing and transactions incidental to leasing, trading and financing of aircraft. If successful, CAG would be an additional source of income for CALC as an asset manager and help to reduce the gearing ratio of CALC, while strengthening CALC’s position with OEM manufacturers for aircraft purchases.

Sound and active risk management. To achieve the right balance between risk and return, CALC actively monitors and manages all aspects of the Group’s business risks, including 1) counterparty risk, 2) asset risk, 3) business operation risk, 4) corporate and compliance risk, and 5) financial market risk.

CALC manages interest risk via 1) matching fixed rate leases with fixed rate debt (22 out of 70 aircraft in 1H16), hedging fixed rate leases with floating rate debt (15 of 70 aircraft in 1H16), matching floating rate leases with floating rate debt (3 out of 70 aircraft in 1H16), realisation of finance lease reiceivables (11 of 70 aircraft in 1H16). This means that only a small proportion of the Group’s leases are exposed to rising interest rates.

Company Focus


Page 15

FORECASTS & FINANCIALS

23% CAGR in revenues from 2015 – 2018F, driven by growth in lease income ... Underpinned by growth in its owned fleet from 63 as at end 2015 to 125 by end 2018F, which is backed by the Group’s order book with Airbus as well as through other forms of aircraft acquisitions, we project CALC’s lease income to grow from a total of HK$1.24bn in 2015 to HK$2.06bn by 2018F.

… as well as higher gains from disposal of finance lease receivables. At the same time, CALC is expected to increase the number of aircraft finance lease receivables it realises to 14 in 2016E and at least 15 per annum in 2017F and 2018F, thereby growing income from disposal of finance lease receivables substantially from HK$54m in 2015, to HK$540m by 2018F.

Government subsidies to be steady. We assume that government subsidies will continue to be steady for CALC as it grows its fleet and expand its China business, coming in at between HK$200m to HK$242m per year between 2016 to 2018.

29% CAGR in operating profit from 2015 – 2018F. Driven by the firm growth in revenues, and coupled with operating leverage, we project the Group’s operating earnings to grow at 29% CAGR from 2015 to 2018F, from HK$481m in 2015, to HK$1,036m by 2018F.

Contribution from aircraft disassembly yet to be factored in. As ARI, CALC’s aircraft disasembly business in Harbin, is only expected to commence operations in 2H17, we await further clarity on the potential revenue and margins of this business before factoring this investment in our financial forecasts for CALC.

Key Forecasts and Assumptions

FYE Dec HK$m 2014 2015 2016F 2017F 2018F

Financial lease income 714.7 1015.4 1246.4 1339.8 1373.1 Operating lease income 182.1 223.9 359.2 531.3 683.1 Other income 248.1 310.0 633.0 713.0 795.0

Gain from disposal of finance lease receivables 111.5 54.1 420.0 480.0 540.0 Government subsidy 133.9 242.6 200.0 220.0 242.0 Others 2.7 13.3 13.0 13.0 13.0

Total Revenue 1145.0 1549.3 2238.7 2584.1 2851.2

Interest expense 520.5 753.7 941.4 1090.4 1176.2 Depreciation 71.31 91.30 150.22 222.18 285.66 Other operating expenses 199.9 223.3 302.2 328.2 353.6

Total operating costs 791.7 1068.2 1393.9 1640.8 1815.4

Operating Profit 353.2 481.1 844.8 943.3 1035.8

Aircraft on Finance Lease 40 57 69 87 105 Less total finance lease receivables sold 5 7 14 30 48 Net Finance lease 35 50 55 57 57 Operating Lease 4 6 12 16 20

Total 44 63 81 103 125

Number of aircraft lease receivable realisations 4 2 14 16 18


Company Focus


Page 16

Income Statement

Net profit CAGR of 29% over 2015-2018F to HK$808m by 2018. Backed by its growing fleet, CALC’s lease income is projected to grow steadily over the next few years, supplemented by gains from the sale of its finance lease receivables. This should help drive the projected growth in the Group’s net profit, from HK$380m in 2015 to HK$808m by 2018F.

Tax rate of 22% assumed. CALC has had a simple average tax rate of just over 21% in the last four years, and we have assumed a tax rate of 22% for the Group going forward.

Income Statement (HK$ m)

Margins Trend

FY Dec 2013A 2014A 2015A 2016F 2017F 2018F

Revenue 687 1,145 1,549 2,239 2,584 2,851 Cost of Goods Sold (54) (71) (91) (150) (222) (286) Gross Profit 633 1,074 1,458 2,088 2,362 2,566 Other Opng (Exp)/Inc (91) (200) (223) (302) (328) (354) Operating Profit 541 874 1,235 1,786 2,034 2,212 Other Non Opg (Exp)/Inc (2) 27 (1) 0 0 0 Associates & JV Inc 0 0 0 0 0 0 Net Interest (Exp)/Inc (330) (521) (754) (941) (1,090) (1,176) Exceptional Gain/(Loss) 0 0 0 0 0 0 Pre-tax Profit 210 381 480 845 943 1,036 Tax (37) (78) (100) (186) (208) (228) Minority Interest 0 0 0 0 0 0 Preference Dividend 0 0 0 0 0 0 Net Profit 173 303 380 659 736 808 Net Profit before Except. 173 303 380 659 736 808 EBITDA 594 973 1,325 1,936 2,256 2,498 Growth Revenue Gth (%) 53.4 66.7 35.3 44.5 15.4 10.3 EBITDA Gth (%) 45.1 63.7 36.3 46.1 16.5 10.7 Opg Profit Gth (%) 43.5 61.4 41.3 44.7 13.9 8.8 Net Profit Gth (%) 81.3 75.5 25.6 73.3 11.7 9.8 Margins & Ratio Gross Margins (%) 92.1 93.8 94.1 93.3 91.4 90.0 Opg Profit Margin (%) 78.8 76.3 79.7 79.8 78.7 77.6 Net Profit Margin (%) 25.1 26.4 24.5 29.4 28.5 28.3 ROAE (%) 21.1 22.4 19.3 25.0 22.0 20.9 ROA (%) 1.7 1.9 1.8 2.5 2.5 2.5

ROCE (%) 4.5 4.5 4.6 5.3 5.3 5.4

Div Payout Ratio (%) 70.7 31.3 35.3 35.0 35.0 35.0

Net Interest Cover (x) 1.6 1.7 1.6 1.9 1.9 1.9 Source: Company, DBS Vickers

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Operating Margin % Net Income Margin %

Company Focus


Page 18

1H16 earnings more than doubled y-o-y, lifted by increased leasing income and higher gains on disposal of finance lease receivables. CALC’s net profit rose by 106% y-o-y to HK$240m, on higher revenue of 61% to HK$1,027m. Revenue jumped substantially due to higher leasing revenue from a larger aircraft fleet, as well as from higher gains from disposal of finance lease receviables. The Group’s fleet rose from 50 aircraft as at end 1H15 to 70 by end 1H16, a growth of 40% or 20 aircraft.

Interim Income Statement (HK$ m) Margins Trend FY Dec 2H2013 1H2014 2H2014 1H2015 2H2015 1H2016

Revenue 422 432 713 636 914 1,027 Cost of Goods Sold (27) (28) (44) (45) (47) (70) Gross Profit 395 405 669 591 867 957 Other Oper. (Exp)/Inc (59) (96) (104) (96) (128) (138) Operating Profit 336 309 565 496 739 819 Other Non Opg (1) 15 12 0 0 (8)

Associates & JV Inc 0 0 0 0 0 0

Net Interest (Exp)/Inc (190) (238) (283) (337) (416) (475) Exceptional Gain/(Loss) N/A N/A N/A N/A N/A N/A Pre-tax Profit 145 86 294 158 322 335 Tax (17) (23) (55) (41) (59) (95) Minority Interest 0 0 0 0 0 0 Net Profit 128 63 240 117 263 240 Net profit bef Except. 128 63 240 117 263 240 Growth Revenue Gth (%) N/A 63.5 68.7 47.0 28.2 61.5 Opg Profit Gth (%) N/A 50.5 68.0 60.5 30.8 65.3 Net Profit Gth (%) N/A 42.5 86.8 85.7 9.8 105.7 Margins Gross Margins (%) 93.6 93.6 93.9 93.0 94.9 93.2 Opg Profit Margins (%) 79.6 71.4 79.3 77.9 80.9 79.8 Net Profit Margins (%) 30.4 14.5 33.7 18.4 28.8 23.4 Source: Company, DBS Vickers

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Page 18

Balance Sheet

Gearing to improve as CALC continues with disposal of finance lease receivables, and as equity base grows from on-going profitability. CALC’s net gearing is projected to improve from 6.8x as at end 2015 to 4.7x by end 2018F. This is mainly due to 1) CALC ramping up and maintaining the number of aircraft realisations at 14-18 per year from 2016E to 2018F and 2) the Group’s equity base growing from HK$2.2bn in 2015 to HK$4.1bn by end 2018F, which would be mainly from higher retained earnings as CALC remains highly profitable.

Balance Sheet (HK$ m) Asset Breakdown

FY Dec 2013A 2014A 2015A 2016F 2017F 2018F

Net Fixed Assets 1,487 1,707 2,413 4,160 5,540 6,920 Invts in Associates & JVs 0 0 0 0 0 0 Other LT Assets 7,679 11,443 16,473 18,150 18,810 18,810 Cash & ST Invts 3,653 5,148 5,042 6,216 6,831 7,277 Inventory 0 0 0 0 0 0 Debtors 0 0 0 0 0 0 Other Current Assets 14 15 19 19 19 19 Total Assets 12,833 18,313 23,947 28,545 31,201 33,027 ST Debt

2,821 4,690 3,412 4,000 4,500 5,000 Creditors 0 0 0 0 0 0 Other Current Liab 9 22 38 50 93 104 LT Debt 8,771 11,295 16,558 19,558 20,558 21,558 Other LT Liabilities 275 526 1,731 1,845 2,445 2,235 Shareholder’s Equity 939 1,761 2,189 3,092 3,605 4,130 Minority Interests 20 19 19 0 0 0 Total Cap. & Liab. 12,833 18,313 23,947 28,545 31,201 33,027 Non-Cash Wkg. Capital 5 (7) (18) (31) (73) (84) Net Cash/(Debt) (7,938) (10,837) (14,928) (17,342) (18,227) (19,281) Debtors Turn (avg days) N/A N/A N/A N/A N/A N/A Creditors Turn (avg days) N/A N/A N/A N/A N/A N/A Inventory Turn (avg days) N/A N/A N/A N/A N/A N/A Asset Turnover (x) 0.1 0.1 0.1 0.1 0.1 0.1 Current Ratio (x) 1.3 1.1 1.5 1.5 1.5 1.4 Quick Ratio (x) 1.3 1.1 1.5 1.5 1.5 1.4 Net Debt/Equity (X) 8.3 6.1 6.8 5.6 5.1 4.7 Net Debt/Equity ex MI (X) 8.5 6.2 6.8 5.6 5.1 4.7 Capex to Debt (%) 11.8 9.2 3.5 8.1 6.4 6.3 Z-Score (X) NA NA NA NA NA NA Source: Company, DBS Vickers

Net Fixed Assets -70.1%

Assocs'/JVs -0.0%

Bank, Cash and Liquid

Assets -29.9%

Inventory -0.0%

Debtors -0.0%

Company Focus


Page 19

Cash Flows

Improved operating cash flows on higher disposal of finance lease receivables. We project CALC’s operating cash flow to improve from a net outflow of over HK$4bn in 2015 to an outflow of less than HK$800m in 2016E, a net inflow of HK$440m in 2017F, and inflow of HK$1.2bn in 2018F on higher pretax earnings, and more critically, as we project CALC to realise 14, 16, and 18 finance lease receivables in 2016F, 2017F, and 2018F respectively.

Dividend payout ratio of 35% assumed, with potential upside. CALC paid out between 30%-35% of its earnings in the last two years, and we have assumed a 35% payout ratio in the years ahead. Given the Group’s fast improving balance sheet and stronger cash flows from gains from the disposal of finance lease receivables, there is potential for CALC to increase its payout ratio.

Cash Flow Statement (HK$ m) Capital Expenditure

FY Dec 2013A 2014A 2015A 2016F 2017F 2018F

Pre-Tax Profit 210 381 480 845 943 1,036 Dep. & Amort. 54 71 91 150 222 286 Tax Paid (37) (78) (100) (186) (208) (228) Assoc. & JV Inc/(loss) 0 0 0 0 0 0 (Pft)/ Loss on disposal of FAs 0 0 0 0 0 0 Chg in Wkg.Cap. (3,134) (3,732) (4,553) (1,565) (517) 111 Other Operating CF (2) (1) 20 (33) 1 (14) Net Operating CF (2,909) (3,359) (4,062) (788) 442 1,191 Capital Exp.(net) (1,364) (1,473) (700) (1,898) (1,602) (1,666) Other Invts.(net) 0 0 0 0 0 0 Invts in Assoc. & JV 0 0 0 0 0 0 Div from Assoc & JV 0 0 0 0 0 0 Other Investing CF 0 1 2 (19) 0 0 Net Investing CF (1,364) (1,472) (698) (1,917) (1,602) (1,666) Div Paid (23) (69) (119) (198) (259) (269) Chg in Gross Debt 5,516 4,269 3,990 3,102 1,500 1,190 Capital Issues 109 621 908 475 34 0 Other Financing CF (38) 78 (40) (292) 0 0 Net Financing CF 5,564 4,899 4,740 3,088 1,275 921 Currency Adjustments 2 (9) (16) 0 0 0 Chg in Cash 1,294 58 (36) 382 115 446 Opg CFPS (HK$) 0.48 0.64 0.81 1.13 1.38 1.56 Free CFPS (HK$) (9.11) (8.25) (7.86) (3.90) (1.67) (0.68) Source: Company, DBS Vickers

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Page 20

VALUATION

Trading below -1 SD to its historical PE band and at -1 SD P/B band. CALC is currently trading at 8.7x FY17F PE, which is below -1 SD of 10.4x PE, and well below the average of 14.7x PE.Meanwhile, the stock is trading at 1.85x FY17F P/B, which is at -1 SD of its average valuation of 2.6x P/B.

Relative to its peer group, CALC offers good value, particularly given its 3.9% dividend yield. At 9.5x FY16E PE, declining to 8.2x FY17F PE, CALC is trading cheaper in terms of PE compared to peer average of 9.7x FY16E PE and 8.6x FY17F PE based on consensus estimates. However, while CALC is trading at a higher 1.9x FY17F P/B, its ROE at >19% is substantially higher than its peer average of 12.1%. CALC’s prospective dividend yield of 4.2% is also more attractive than its peer average of 2.1%.

12-month TP of HK$11.60. We value CALC based on a blended valuation of 10x FY18F P/E and 2x FY18F P/B to derive our 12-month target price of HK$11.60. We applied a higher than average PE multiple to reflect the Group’s faster than industry earnings growth pace while the higher than peer average target P/B multiple of 2x reflects the Group’s industry-leading ROE of over 19% (22.7% based on consensus).

CALC’s 12-month Target Price Calculation

Methodology Multiple Year TP HK$

Target P/BV 2.00 FY18 11.91 Target PE 10.0 FY18 11.20 Blended TP 11.60

Source: DBS Bank estimates

PE band chart

PB band chart

Source: Thomson Reuters, DBS Vickers Source: Bloomberg, DBS Vickers

Peer valuations – Consensus Estimates (9 Feb 2017)

Mkt Cap --------- PER ---------- Price-to-Book ROE Crnt Company Last Px US$m Hist Crnt Forw Hist Crnt Hist Crnt Yield AerCap Holdings NV USD 45.94 9,204 7.3 7.3 7.5 1.10 0.99 15.0% 13.5% 1.4% Air Lease Corp USD 37.86 3,894 13.8 11.1 10.2 1.31 1.17 9.5% 10.6% 0.5% Aircastle Ltd USD 22.78 1,791 14.1 13.0 10.1 1.03 0.98 7.3% 7.6% 4.3% FLY Leasing Ltd USD 13.91 451 6.6 8.2 7.2 0.73 0.65 11.0% 8.0% 0.0% CALC HKD 9.23 797 13.1 9.5 8.1 2.64 2.17 20.2% 22.8% 3.9% BOC Aviation HKD 40.60 3,631 8.5 7.5 1.08 12.8% 2.4% CDB Financial Leasing HKD 1.92 3,128 10.6 9.3 0.99 9.4% 2.5%

Average 11.0 9.7 8.6 1.36 1.15 12.6% 12.1% 2.1%


Avg: 14.7x

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*This Equity Explorer report represents a preliminary assessment of the subject company, and does not represent initiation into DBSV’s coverage universe. As such DBSV does not commit to regular updates on an ongoing basis. The rating system is distinct from stocks in our regular coverage universe and is explained further on the back page of this report.

ed: JS / sa: AH, PY

NOT RATED HK$1.94 HSI : 23,525.14 Closing price as of 10 Jan 2017 Return *: 2 Risk: Moderate Fair Value : 12-Month HK$ 2.01 Analyst Paul YONG CFA +65 6682 3712 [email protected]

Price Relative

Forecasts and Valuation FY Dec (RMBm) 2015A 2016F 2017F 2018FRevenue 10,641 11,273 11,978 12,841EBITDA 8,327 9,594 10,506 11,367Pre-tax Profit 1,300 2,373 2,854 3,350Net Profit 1,053 1,922 2,312 2,713Net Pft (Pre Ex.) 1,139 1,922 2,312 2,713EPS (HK cts) 12.5 19.6 20.6 24.2EPS Pre Ex. (HK cts) 13.5 19.6 20.6 24.2EPS Gth (%) (45) 57 5 17EPS Gth Pre Ex (%) (40) 45 5 17Diluted EPS (HK cts) 13.5 19.6 20.6 24.2Net DPS (HK cts) 1.78 0.0 0.0 0.0BV Per Share (HK cts) 178 200 220 245PE (X) 15.6 10.0 9.5 8.1EV/EBITDA (X) 16.2 14.8 13.6 12.4Net Div Yield (%) 0.9 0.0 0.0 0.0P/Book Value (X) 1.1 1.0 0.9 0.8Net Debt/Equity (X) 7.9 5.5 4.9 4.3ROAE (%) 7.3 10.3 9.8 10.4 Consensus EPS (HK cts): 18.0 20.5 24.1Other Broker Recs: B: 2 S: 0 H: 4 ICB Industry : Industrial ICB Sector: Industrial Transportation Principal Business: China Development Bank Financial Leasing Co., Ltd. provides leasing services to customers in industries including aviation, infrastructure, shipping, commercial vehicle and construction machinery.

China’s largest diversified lessor • Improved outlook for China’s largest leasing

company after huge impairment losses in 2015

• Higher profitability from reducing exposure to

riskier clients • Renewed focus on more profitable aircraft and

infrastructure segments to drive future growth

• Rebound in profitability to c. 10% ROE should support 1x P/B valuation, translating to a fair value of HK$2.01

The Business Profitability to improve in 2016. The leasing arm of the China Development Bank, CDB Financial Leasing (CDBFL) focuses on aircraft and infrastructure leasing mainly in China. The company recognised significant impairment losses in 2015 as a result of the economic slowdown but was profitable nonetheless. With a focus on filtering out riskier clients, and on the more profitable aircraft and infrastructure leasing segments, profitability ahead should improve. Demand for leasing is growing in China. With state support, internationalisation of RMB and ever growing demand for customised leasing products, demand for leasing is on a growth trajectory in China. In particular, aircraft and infrastructure leasing is on the rise backed by strong demand for air travel and leasing solutions for infrastructure funding. The Stock Fair value of HK$2.01, based on 1x P/B. With improving profitability in 2016E and 2017F on lower impairment losses, we peg the stock’s fair value at 1x P/B against a projected ROE of 10.3% for 2016E and 9.8% for 2017F. Stronger than expected rebound in profitability could rerate share price further. If CDBFL can manage impairment losses or improve margins to a level that are better than expected, the resultant higher earnings should be a share price catalyst. Key risk. The group’s profitability would be affected if it cannot manage asset quality – leading to substantial impairment losses.

At A Glance

Issued Capital (m shrs) 12,642Mkt. Cap (HK$m/US$m) 23,273 / 3,129Major Shareholders (%) China Development Bank 64.7Three Gorges Capital 10.4HNA Group 6.3

Free Float (%) 18.73m Avg. Daily Val (US$m) 0.22

Source of all data on this page: Company, DBS Bank, Bloomberg Finance L.P

DBS Group Research . Equity 10 Feb 2017

Hong Kong Equity Explorer

CDB Financial Leasing Bloomberg: 1606 HK | Reuters: 1606.HK Refer to important disclosures at the end of this report

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China Development Bank Financial Leasing (LHS)

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Equity Explorer


Page 2

REVENUE DRIVERS

CDB’s leasing platform. As the sole leasing arm of China Development Bank (CDB), one of the three policy banks in the PRC, CDBFL has the unique opportunity to build strategic relationships with industry-leading enterprises which have business ties with CDB. In addition, CDBFL also enjoys balance sheet and risk management support from CDB, and a quasi-sovereign credit rating while maintaining an independent decision making system. CDBFL has four leasing segments : 1) aircraft, 2) infrastructure, 3) ship, commercial vehicle and construction machinery (SCVC), and 4) others, which includes leasing of commercial property and manufacturing equipment to entities including SMEs. It should be noted that CDBFL used to focus on leasing aircraft and infrastructure to medium and large enterprises before 2012, before expanding to other segments in 2012 (also to SMEs in aircraft and infrastructure). With the slowdown in the PRC, the new segments have fallen on hard times. Therefore, CDBFL is in the process of reducing exposure to riskier customers in these two segments and plans to renew its focus on aircraft and infrastructure segments which have continued to perform well amid the slowdown.

Well-known brand with a dominant position... CDBFL plans to leverage upon its position as the largest lessor in the PRC (by total revenue according to Frost & Sullivan) and well-respected brand name enhanced by its strategic partnership with CDB to continue to grow its high quality asset base. … in a robust leasing market. PRC’s leasing industry is on a growth trajectory driven by ongoing market-oriented reforms (e.g. in Sep-15, State Council published national strategy to encourage leasing in segments such as aircraft and infrastructure), internationalisation of RMB, and increasing demand for customised leasing products and services. Therefore, we expect leasing’s penetration rate in the PRC (leased assets to total fixed asset investment), currently at 5%, to rise towards the level of developed countries (e.g. above 20% in the USA and UK).

COST STRUCTURE

Impairment costs the main variable as other costs are largely stable. CDBFL’s main costs are interest cost and depreciation & amortisation, which usually are relatively stable with less volatility. However, impairment costs rose 152% to RMB2bn in 2015, due to i) an increase in non-performing assets, especially in the ‘other’ segment, ii) limitations in CDBFL’s risk management process, and iii) increase in allowance for impairment losses.

Chart 1 : Breakdown of 2015 revenue (RMB 10.6bn)

Chart 2: Operating Cost Breakdown

Chart 3: CDBFL’s owned aircraft fleet as at 31-12-2015

*Includes aircraft under both financial and operating lease

Source: Company , DBS Bank

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90%

100%

2013 2014 2015 1H16

Interest expense Depreciation & Amortisation Impairment losses Others

Equity Explorer


Page 3

KEY OPERATING ASSETS

Young aircraft fleet, mostly popular models. The key operating assets of CDBFL are the owned aircraft fleet that are leased out on operating leases. In addition to possessing aircraft that are in high demand such as A320, A330 and Boeing 737, the average age of its fleet was only 4.5 years as at the end of 2015. Finance lease receivables account for over half of total assets. At the end of 2015, finance lease receivables totalled c. RMB81bn, forming 52% of the group’s total assets. This represented the bulk of the group’s finance leases in the infrastructure, ship, commercial vehicle and construction machinery, as well as ‘Others’ segments.

GROWTH PROSPECTS

Demand for aircraft is robust. Driven by rising air passenger travel (measured by Revenue Passenger Kilometre or RPK), demand for aircraft is expected to remain solid; global RPKs are expected to rise at a CAGR of 5.1%, and at a much higher rate of 11.3% in the PRC from 2014 to 2019. As CDBFL’s fleet and order book are made up of aircraft models that are in high demand, the demand for air travel should translate into strong demand for CDBFL’s aircraft. Infrastructure leasing on the rise in PRC. With the economic reforms in PRC and rising urbanisation, leasing is seen as a more attractive proposition to local governments and construction firms in the PRC in terms of efficient use of funds and flexibility in lease terms. Backed by its leading position in the market and strategic relationship with CDB, CDBFL is expected to ride this growth wave. MANAGEMENT & STRATEGY

Well experienced and closely tied with CDB. Among the well experienced Board of Directors, Chairman - Mr. Wang Xuedong- and Vice Chairman and President - Mr. Fan Xun -stand out with their past experience in CDB , which has helped CDBFL to maintain a cordial relationship with CDB. It should be noted that out of the four Executive Directors, Mr. Geng Tiejun is also a CDB affiliated director. Leadership is market oriented. CDBFL’s management has the mandate to be market oriented and is open to growth through acquisitions in addition to organic growth.

Table 1: Largest lessors in China

Revenue (RMB bn)

Market share

CDB Leasing 11.7 6.1%

ICBC Financial Leasing 10.5 5.5%

Far East Horizon Limited 10.1 5.3%

Minsheng Financial Leasing 9.1 4.8%

Bohai Leasing 6.9 3.6%

Table 2: Key Management Team Wang Xuedong,Chairman/ Executive Director

• Prior to joining the company in Aug-2014, served various leadership roles in CDB for 20 years, latest as the President of the CDB Hunan Branch from Mar-2008 to Aug-2014.

• Graduate of Dalian College of Technology, completed a master’s degree in economics at Central University of Finance and Economics in Beijing.

Fan XunVice Chairman/ Board, Executive Director, President

• When Mr. Fan joined the company in Mar-2015, he had already served in CDB for close to 18 years. Most recent appointment was as Chairman of the board of supervisors of CDB Securities from Aug-2010 to Mar-2015.

• Alumni of Tianjin University and holds a master’s degree in economics from Tianjin College of Finance and Economics.

Geng TiejunExecutive Director/ Vice President

• Close to 11 years of leadership roles at CDB. • Graduate of Hunan University in Changsha

and holds postgraduate qualifications from the Party School of the Central Committee in Beijing and Stevens Institute of Technology in Hoboken.


Equity Explorer


Page 4

Key Assumptions

FY Dec 2014 2015A 2016F 2017F 2018F

Aircraft fleet 169 180 214 245 272 Asset growth in infrastructure leasing (12.8) 16.7 4.00 4.00 4.00 Asset yield on aircraft leasing (%) 10.0 9.30 9.10 9.10 9.10 Asset yield on infrastructure leasing (%) 7.20 6.10 6.00 5.90 5.80 Average cost of debt (%) 4.70 3.80 3.90 4.00 4.10

Segmental Breakdown FY Dec 2013A 2014A 2015A 2016F 2017F 2018F

Revenues (RMBm) Aircraft leasing 3,680 4,406 4,729 5,265 5,848 6,587 Infrastructure leasing 4,119 4,009 3,426 3,712 3,797 3,882 Ship, Commercial Vehicle 1,227 1,385 1,197 1,120 1,154 1,189 Other leasing 2,023 1,525 1,289 1,175 1,180 1,184Total 11,049 11,325 10,641 11,273 11,978 12,841

Income Statement (RMBm) FY Dec 2013A 2014A 2015A 2016F 2017F 2018F Revenue 11,049 11,325 10,641 11,273 11,978 12,841Cost of Goods Sold 0.0 0.0 0.0 0.0 0.0 0.0Gross Profit 0.0 0.0 0.0 0.0 0.0 0.0Other Opng (Exp)/Inc (3,478) (3,249) (4,626) (3,983) (4,023) (4,338)Operating Profit 7,572 8,075 6,014 7,290 7,955 8,503Other Non Opg (Exp)/Inc 376 155 278 0.0 0.0 0.0Associates & JV Inc 0.0 0.0 0.0 0.0 0.0 0.0Net Interest (Exp)/Inc (5,511) (5,854) (4,907) (4,917) (5,101) (5,153)Exceptional Gain/(Loss) 62.9 3.95 (86.3) 0.0 0.0 0.0Pre-tax Profit 2,499 2,380 1,300 2,373 2,854 3,350Tax (612) (464) (247) (451) (543) (637)Minority Interest 0.0 0.0 0.0 0.0 0.0 0.0Preference Dividend 0.0 0.0 0.0 0.0 0.0 0.0Net Profit 1,887 1,916 1,053 1,922 2,312 2,713Net Profit before Except. 1,824 1,912 1,139 1,922 2,312 2,713EBITDA 9,936 10,090 8,327 9,594 10,506 11,367Growth Revenue Gth (%) nm 2.5 (6.0) 5.9 6.3 7.2EBITDA Gth (%) nm 1.6 (17.5) 15.2 9.5 8.2Opg Profit Gth (%) nm 6.7 (25.5) 21.2 9.1 6.9Net Profit Gth (Pre-ex) (%) nm 4.8 (40.4) 68.8 20.3 17.4Margins & Ratio Gross Margins (%) 100.0 100.0 100.0 100.0 100.0 100.0Opg Profit Margin (%) 68.5 71.3 56.5 64.7 66.4 66.2Net Profit Margin (%) 17.1 16.9 9.9 17.1 19.3 21.1ROAE (%) N/A 14.7 7.3 10.3 9.8 10.4ROA (%) 1.3 1.4 0.7 1.1 1.4 1.6ROCE (%) 4.0 4.7 3.1 3.5 3.8 4.1Div Payout Ratio (%) 0.0 0.0 14.2 0.0 0.0 0.0Net Interest Cover (x) 1.4 1.4 1.2 1.5 1.6 1.7


Margins Trend

9.0%

19.0%

29.0%

39.0%

49.0%

59.0%

69.0%

2014A 2015A 2016F 2017F 2018F


Equity Explorer


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Balance Sheet (RMBm) FY Dec 2013A 2014A 2015A 2016F 2017F 2018F

Net Fixed Assets 32,237 36,598 42,625 46,319 46,228 46,694Invts in Associates & JVs 0.0 0.0 0.0 0.0 0.0 0.0Other LT Assets 57,059 63,625 64,999 70,570 70,433 71,137Cash & ST Invts 12,748 6,511 8,972 9,822 9,801 9,908Inventory 0.0 0.0 0.0 0.0 0.0 0.0Debtors 25,379 14,065 13,827 15,025 14,996 15,147Other Current Assets 14,956 19,569 25,272 27,451 27,397 27,673Total Assets 142,378 140,366 155,695 169,187 168,855 170,559 ST Debt 77,281 74,486 86,076 90,047 86,903 84,864Creditor 0.0 0.0 0.0 0.0 0.0 0.0Other Current Liab 646 734 711 921 1,012 1,106LT Debt 42,615 41,003 41,076 42,970 43,379 44,315Other LT Liabilities 9,708 10,132 12,839 12,839 12,839 12,839Shareholder’s Equity 12,129 14,010 14,993 22,410 24,722 27,435Minority Interests 0.0 0.0 0.0 0.0 0.0 0.0Total Cap. & Liab. 142,378 140,366 155,695 169,187 168,855 170,559 Non-Cash Wkg. Capital 39,689 32,899 38,388 41,556 41,381 41,713Net Cash/(Debt) (107,148) (108,979) (118,179) (123,195) (120,481) (119,270)Debtors Turn (avg days) N/A 635.6 478.4 467.1 457.4 428.4Creditors Turn (avg days) N/A N/A N/A N/A N/A N/AInventory Turn (avg days) N/A N/A N/A N/A N/A N/AAsset Turnover (x) NM 0.1 0.1 0.1 0.1 0.1Current Ratio (x) 0.7 0.5 0.6 0.6 0.6 0.6Quick Ratio (x) 0.5 0.3 0.3 0.3 0.3 0.3Net Debt/Equity (X) 8.8 7.8 7.9 5.5 4.9 4.3Net Debt/Equity ex MI (X) 8.8 7.8 7.9 5.5 4.9 4.3Capex to Debt (%) 4.3 7.5 7.0 9.4 2.4 3.7


Asset Breakdown (2016)

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Cash Flow Statement (RMBm)

FY Dec 2013A 2014A 2015A 2016F 2017F 2018F

Pre-Tax Profit 2,499 2,380 1,300 2,373 2,854 3,350Dep. & Amort. 1,988 1,860 2,035 2,304 2,551 2,864Tax Paid (533) (430) (512) (242) (451) (543)Assoc. & JV Inc/(loss) 0.0 0.0 0.0 0.0 0.0 0.0Chg in Wkg.Cap. 576 (5,703) 6,654 (3,377) 83.1 (427)Other Operating CF 740 1,088 2,365 1,000 750 700Net Operating CF 5,271 (804) 11,842 2,058 5,787 5,945Capital Exp.(net) (5,195) (8,711) (8,849) (12,569) (3,073) (4,734)Other Invts.(net) 359 (335) (1,500) 0.0 0.0 0.0Invts in Assoc. & JV 0.0 0.0 0.0 0.0 0.0 0.0Div from Assoc & JV 0.0 0.0 0.0 0.0 0.0 0.0Other Investing CF (1,609) 1,130 446 0.0 0.0 0.0Net Investing CF (6,444) (7,917) (9,904) (12,569) (3,073) (4,734)Div Paid 0.0 0.0 (150) 0.0 0.0 0.0Chg in Gross Debt 0.0 3,922 0.0 5,865 (2,735) (1,104)Capital Issues 0.0 0.0 0.0 5,495 0.0 0.0Other Financing CF (286) (309) (435) 0.0 0.0 0.0Net Financing CF (286) 3,613 (584) 11,361 (2,735) (1,104)Currency Adjustments 0.0 0.0 0.0 0.0 0.0 0.0Chg in Cash (1,460) (5,108) 1,354 849 (20.9) 107Opg CFPS (HK cts) 55.7 58.1 61.5 55.3 50.9 56.8Free CFPS (HK cts) 0.90 (113) 35.5 (107) 24.2 10.8


Capital Expenditure

VALUATIONS

Fair value of HK$2.01, based on 1x P/B. With reference to the

chart on the right, CDBFL is trading at a slight premium to aircraft

lessors in terms of P/B vs ROE, but taking into account that the

group’s earnings are in the midst of normalising, we see the stock’s

fair value at 1x P/B against a projected rebound in ROE from 7% to

10%. This translates to HK$2.01 on 1x FY16 P/B.

Risk Assessment: Moderate Category Risk Rating Wgt Wgtd Score

1 (Low) - 3 (High) Earnings 2 40% 0.8Financials 2 20% 0.4Shareholdings 2 40% 0.8Overall 2.0

Rebound in profitability the key to support or even re-rate

share price. The key support or catalyst for the share price would

be an improvement in earnings, which we opine will largely depend

on minimising impairment losses.

Low free float; China Development Bank holds nearly two-

thirds of the shares. CDBFL’s shares are tightly held, with the top

three shareholders holding over 81% of the stock. The parent

company retains nearly 65% of the company post IPO and is

unlikely to pare down its stake below 51%. The third largest

shareholder HNA Group, with 6.3% stake, has its own leasing arm

listed in China, and could possibly reduce its stake in the future.

Current P/B vs Current ROE for aircraft lessors

Table 6: Peers’ Comparisons


0.0

2,000.0

4,000.0

6,000.0

8,000.0

10,000.0

12,000.0

14,000.0

2014A 2015A 2016F 2017F 2018F

Capital Expenditure (-)

RMBm

AerCap

Air Lease

Air Castle

FLY

CALC

BOCA

CDB Leasing

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

0.00 0.50 1.00 1.50 2.00 2.50

Mkt Cap ROE CrntCompany US$m Crnt F orw Hist Crnt Crnt Y ieldAerCap Holdings USD 45.94 9,204 7.3 7.5 1.1 0.99 13.5% 1.4%Air Lease Corp USD 37.86 3,894 11.1 10.2 1.31 1.17 10.6% 0.5%Aircastle Ltd USD 22.78 1,791 13 10.1 1.03 0.98 7.6% 4.3%FLY Leasing Ltd USD 13.91 451 8.2 7.2 0.73 0.65 8.0% 0.0%CALC HKD 9.23 797 9.5 8.1 2.64 2.17 22.8% 3.9%BOC Aviation HKD 40.6 3,631 8.5 7.5 1.08 12.8% 2.4%CDB F in Leasing HKD 1.92 3,128 10.6 9.3 0.99 9.4% 2.5%

A v erage 9.7 8.6 1.36 1.15 12.1% 2.1%

9-F eb-17 - - PE - - Price- to-BookLast Px

Industry Focus

Aircraft Leasing

ASIAN INSIGHTS VICKERS SECURITIES Page 42

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Industry Focus

Aircraft Leasing


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Industry Focus

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Industry Focus

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