China Aviation Oil Singapore Corp Ltd (SI:CNAO): Q3 results reflected the combined impact on gross margin of the core trading operation due to a return to a backwardation situation in product markets, as well as supply disruptions. More positively, SPIA and the other associates made a stronger contribution. With adverse trading conditions expected to persist for a period of time, management’s strategy to reduce volatility is being tested. The key growth drivers of increasing air traffic and an expanding geographic footprint continue to increase trading volumes and augur well for the future. Maintenance of profitability at a lower margin level while backwardation conditions persist should be offset by stronger growth from SPIA next year, but we now assume a more subdued expansion of the core business. The balance sheet remains supportive of further strategic M&A to facilitate growth. Our fair value falls to S$1.88 from S$2.11.
A robust performance in challenging markets
In Q3 the company traded the physical supply of oil products against a backdrop of markets for jet fuel and other oil products that moved into backwardation, impinging margin optimisation strategies and raising operational costs. These were exacerbated by weather related effects and a fire at a jet fuel supplier’s refinery, which also squeezed gross margin in Q3. Some margin recovery should be achievable in Q4 assuming no further non-recurring disruptions to supply. Nevertheless, the more difficult trading conditions for the core supply activity, where volume is growing strongly, is likely to mean a more depressed gross margin until a contango situation is re-established. Meanwhile the associates continue to increase contributions to earnings and cash as expected, generating more than half of the healthy net cash flow. As a result of more prudent core margin assumptions, we have reduced our net income forecast by 7% this year and 10% in 2018.
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