Position: Buy Target: HK$10.55

Shares Out: 473.2M Market Cap: HK$ 2,806.15 FYE: Dec

Concept:1. Monopoly business trading at 6.31x consensus 2012 FCF and 1.1x TBV2. Privileged business model with best-in-breed operating margins3. Increased passenger traffic should add meaningfully to earnings4. Current dividend yield of 6.2% provides downside protection5. Merger with HNA Airport is a catalyst – should result in meaningful rerating

Summary: Hainan Meilan International Airport Company Limited (HMIA) is a leading airport operator in the People’s Republic of China (PRC). HMIA currently trades at ~ 6x trailing EBITDA and a 35-60% discount to peers Beijing Capital International Airport Co. Ltd. (SEHK: 694) and Shanghai International Airport Co., Ltd. (SHSE: 600009). The stock is cheap because Hainan is a leisure island reliant on inbound domestic tourists and Haikou is currently regarded as a secondary city. In addition, HMIA has been losing market share to Sanya Phoenix Airport (Sanya), especially after the competitor completed its expansion in 2007. Sanya is located on the southern tip of Hainan Island and is closer to tourist hotspots.

In 2010, HMIA announced it was buying out Sanya. I believe the acquisition is accretive and would do a great deal to integrate the two networks and smooth out competition issues. Post-acquisition, HMIA will monopolize air traffic in and out of Hainan Island, giving the company significant pricing power in terms of negotiating landing and franchise fees. Both the Haikou Meilan and Sanya are controlled by the same entity, Hainan Airlines Group Co. Ltd, which also owns a number of smaller regional airports. As the company is the sole listing platform for the group’s airport interests, I believe that the probability that other related assets may be injected into the listed company, including Sanya, is extremely high. Additionally, the acquisition of HNA Airport can result in a meaningful rerating of the stock as HMIA comes to be viewed as a regional airport company, rather than a secondary destination.

I also see a meaningful increase in tourist volumes to the island. In 2010, the State Council announced that Hainan Province would be developed into an International Tourism Island. The measures introduced as a result encompass providing tax rebates for Chinese citizens, instituting more generous visitor visa policies, and the opening up of international air routes. The consensus analyst projection for annual traffic growth to Hainan following the introduction of these measures is 9%, while passenger throughput and cargo tonnage for the Chinese market is forecast to grow at a rate of 7.4% per year over the next 20 years1. My model assumes an average annual growth in passenger throughput from 2012 – 2017 of 7.9%. Airports are predominantly fixed-cost businesses. The majority of expenses link to the cost of operating and maintaining fixed assets, such as runways and terminals, rather than traffic volumes. Consequently, as traffic grows, I expect HMIA to demonstrate increases in productivity against its fixed-cost basis, resulting in improved EBITDA margins. I project an average 300-400 bp improvement in EBITDA margins between FY2012 and FY2016 from the FY2010 margin of 50.28%.

1 A forecast made by Boeing. http://www.boeing.com/companyoffices/aboutus/ boechina.html

Rec: Hainan Meilan International Airport Co. Ltd. (0357.HK HK$ 5.90)March 7, 2012

One of the key parts of my thesis is the ability of the company to increase revenues from non-aeronautical activities, which currently comprise only 32.4% of HMIA revenues. Establishment of the citizen tax exemption policy, which allows tourists to claim rebates on customs duties, excise taxes and business taxes, enjoying about 30 percent off regular prices is significant. As outlined in detail below, in CY2010, 50% of Chinese purchases of high-end luxury items were made overseas. The National Bureau of Statistics of China states that tax-free shopping could increase Hainan’s annual tourist traffic by 20%-25%, and consumption per person by 15%-20%. Following the announcement of the new tax regime, the island’s first airport duty-free mall opened in Meilan Airport in 2011 and average daily turnover is set to exceed RMB 6 million. As passenger throughput and revenues from non-aeronautical activities increase, HMIA’s sales should grow and its margins increase, at a minimum, to a level that would justify the purchase of HMIA shares at the current valuation.

HMIA is generating solid free cash flow. Actual per share FCF was RMB 0.28 in FY2010. Using a conservative estimate of RMB 57M for capex in FY2011 and 2012 (which takes into account the increased spending to expand capacity in international terminal and west-side passage at Meilan), I estimate FCF to be RMB0.23, RMB 0.43 and 0.52 in 2011, 2012 and 2013 respectively. Additionally, management is attacking operating margin “leaks” by reducing the size of its workforce through increased automation and franchising secondary activities such as advertising and parking. In 1H11 employee benefit costs were 19.65% lower versus 1H10 figures.

Historically, HMIA’s balance sheet has been fortress-like. While HMIA had net cash of RMB 935M as at end-2010, much of it was used to acquire a 24.5% stake in HNA Airport for RMB 989M. Total debt at end-1H11 was 467.9M, while total debt to trailing EBITDA stood at 1.5x versus a mean of 3.1x for a peer group of 25 global airport management companies. Currently, HMIA has $553.67M in cash and no borrowings under its lines of credit. However, I am concerned about deterioration in the quality of HMIA’s balance sheet post the HNA airport acquisition. Following the acquisition of the remaining 30% stake for RMB 1,211M via a proposed A-share listing in Shanghai, HMIA’s debt ratio, calculated as total liabilities over total assets, would increase to 43.90% versus a debt ratio of 6.16% as at end-2009. Considering that interest rates on borrowing in H1FY2011 ranged from 3.2% to 5.1%, HMIA is expected to generate healthy cash flows, and that given HMIA’s business model little or no capital is tied up in inventory, I believe the company can sustain such a debt level.

HMIA should benefit from several long-term trends. The cornerstone of the new 5-year plan introduced by the National People’s Congress is boosting consumer spending2. Social safety nets play a key role in consumption. I expect that as the government upgrades the provision of pension, health insurance, public education, and affordable housing (as occurred in Japan, Korea, and Taiwan in the latter half of the 20 th century), Chinese consumer spending will increase. McKinsey and Co. notes that China’s middle class (incomes of $8,000 - $30,000) is projected to rise from 135 million to over 200 million by 2015. As fixed investment in the mainland slows, domestic consumption, which is far less credit and resource intensive, will rise. This rise can be supported not only by liquidation of China’s huge stock of domestic savings (China’s household sector holds the equivalent of the combined GDP’s of Brazil, India and Russia in bank deposits) but also rapid productivity and personal income growth. Investing in companies that specifically serve domestic demand such as HMIA (97% of FY2011 arrivals were Chinese nationals) is an effective way to exploit this opportunity.

I recognize the significant near-term risk of a deceleration in Chinese GDP as plunging fixed income investment overwhelms less cyclical consumption. However, with the intensive liquidation of Chinese stocks in 2011 - the Shanghai SE Composite declined 20.2%, while the Hang Seng Composite Mid Cap Index fell 27% - I believe the market has priced in this risk. If investors are willing to look through the short –term risks, HMIA shares are inexpensive, trading at 6x consensus 2012 FCF, 5.4X EBITDA, and 1.15x TBV. The low valuation, combined with a dividend yield of 6.2%, should provide investors with considerable downside protection.

At HKD$5.90, the risk reward profile seems attractive. There are numerous ways in which HMIA investors could win: increasing traffic should lead to both higher earnings and a higher multiple. The accretive acquisition of HNA Airport could also meaningfully improve results and lead to a rerating of the stock as HMIA multiples mirror those of regional airport companies; and lastly, HMIA could generate substantial cash (and reduce debt) through the increases in non-aeronautical revenue largely due to the tax rebates

2 KPMG, China’s 12th Five-Year Plan, April 2011. China's 12th Five - Year Plan : Consumer Markets - April 2011

introduced in 2011.

As I detail in the report, we have used a DCF valuation to establish a target price of $10.55 for HMIA shares. Based on our 2013 estimates, our target price implies an EV/EBITDA multiple of 8x; a P/FCF multiple of 9.6x; and a P/TBV of 1.5x. These multiples are all below the average of HMIA’s competitors. Our price target implies potential upside of 78% in a 24-month period.

Following the acquisition of HNA Airport, I value the combined company at HK$ 11.60. While we do not have enough information on privately held HNA Airport to use a discounted cash flow approach, we can estimate the value of the combined entity using its P/B ratios versus a peer group of global airports. I prefer to use P/B ratios instead of P/Es because any earnings approach is distorted by different positions of airports in their capex cycle. According to HMIA announcements, pro-forma end-2009 book value post-acquisition is RMB 5.30 (HK$ 7.74). Using a mid-cycle P/B ratio of 1.5 implies a post-acquisition price of HK$ 11.60.

Company Background: Hainan Meilan International Airport Company operates the airport terminal and associated facilities at the international airport located 15 km outside Haikou, the provincial capital of Hainan province in South China. Hainan is China’s only tropical island, located on the same latitude as Hawaii. The airport began operations in 1999. Its runways can accommodate airplanes as large as the B747-400, and its terminal building, with a floor area of 399,000 sq. meters can handle 9.6 million passengers per year. Nationwide the airport is ranked 19th in terms of passenger and cargo throughput, and 18th in terms aircraft movement in 2011. The company is engaged in both aeronautical and non-aeronautical businesses. The aeronautical business of the Company consists of the providing terminal facilities, ground handling services and passenger services. Its non-aeronautical businesses include leasing of commercial and retail spaces, franchising of airport related business, advertising, car parking, tourism services, cargo handling and the sale of duty-free goods.

The airport has seen rapid growth in passenger and cargo throughput in recent years. Total revenue was RMB 453M in FY 2010 (January 2011), of which aeronautical services accounted for 67.6% of revenues and non-aeronautical services accounted for the remaining 32.4%.

Discussion:

1. Current prices do not reflect the potential for the company to benefit from an increase of tourist traffic to Hainan. The airport has seen strong growth in all three revenue drivers– passenger throughput, aircraft movement, and cargo volumes – even during the global economic crisis of 2008 and the H1N1 outbreak of 2009. In FY2011, passenger volumes increased by 15.9%, while aircraft movement and cargo volumes increased by 10.3% and 9.8% respectively compared to FY2010. However, the number of tourists traveling to Hainan is set to surge after the State Council approved measures in 2009 to promote the island as an international tourist destination. The following key measures aimed at increasing travel to the island are expected to increase passenger throughput to the island’s two major airports to 50 million passengers by 20203.

Establishment of the citizen tax exemption policy in April 2011. The program is applicable for all persons (including China domestic tourist, Hainan citizens and foreigners) above 18 years of age leaving Hainan province. Eligible tourists can claim rebates on customs duties, excise taxes and business taxes, enjoying about 30 percent off regular prices. The program covers imported goods in a total of 18 categories, such as jewelry, handicrafts, watches, perfumes, cosmetics, and clothing.

The rebates are a significant development - in 2010, 50% of Chinese purchases of high-end luxury items was made overseas. Additionally, according to a report released by the World Luxury Association Chinese consumers spent 7.2 billion U.S. dollars on luxury goods overseas during the new year holiday, an increase of 28.57% y/y4. The National Bureau of Statistics of China states that

3 Passenger volumes at Hainan's two airports hit 10 million in 2011, 29 Dec 2011. http://www.whatsonsanya.com/news-19456-passenger-volumes-at-hainan-s-two-airports-hit-10-million-in-2011.html

4 Biz China Weekly Issue No. 31, Chinese holidayers splurge on luxury goods overseas, 06 Feb 2012. http://news.xinhuanet.com/english/china/2012-02/06

tax-free shopping could increase Hainan’s annual tourist traffic by 20%-25%, and consumption per person by 15%-20%. One of the key parts of our thesis is the ability of the company to increase revenues from non-aeronautical activities, which currently comprise only 32.4% of HMIA revenues. The island’s first airport duty-free mall opened in Meilan Airport in 2011 and average daily turnover is set to exceed RMB 6 million5.

More favorable visitor visa policies. Current rules stipulate that tour members coming from 21 approved countries with at least five members may be granted 15-day visas upon arrival. It has been proposed that this be extended to groups of as few as two members, that the number of approved countries be raised to 26, along with permitted stays of up to 30 days.

To authorize more international air routes as a means of attracting as greater number of foreign tourists. Since the approval the Freedom III, IV, and V traffic rights by the Civil Aviation Administration of China (CAAC) in 2003, international flights and passenger numbers on the island have increased considerably.

Investment in infrastructure.

Airports are predominantly fixed-cost businesses. The majority of expenses link to the cost of operating and maintaining fixed assets, such as runways and terminals, rather than traffic volumes. Consequently, as traffic grows, I expect HMIA to demonstrate increases in productivity against its fixed-cost basis, resulting in improved EBITDA margins.

2. In 2010, HMIA announced its intention to buy out its only competitor the Sanya Phoenix Airport (Sanya), by acquiring a 54.5% stake in HNA Airport for RMB 2.2B. To date, HMIA has purchased a 24.5% stake from Kingward, a third party, and intends to purchase a 30% stake in HNA Airport from HNA Group, an affiliate of HMIA, following an A-share offering.

Figure 1 Shareholding structure of HNA Airport before the transaction

Source HMIA announcement

5 China News Center, Hainan Opens An Offshore Duty-Free Shop at Meilan Airport, December 23, 2011. http://www.chinamedia.com/news

HNA Group51%

Sanya Phoenix 67%

Dongying Yong An

90%

Manzhouli Xijao67%

Yichang Sanxia

90%

Dunhuang Mogoa 100%

Qingyang Xifeng100%

Lanzhou Zhongchuan

100%

Jiayuguan 100%

HNA Airport

Kingward24.5%

Worldwide24.5%

Figure 2 Shareholding structure of HNA Airport after the transaction

Source HMIA announcement

Post-acquisition, HMIA will become the controller of HNA Airport Group. Besides effectively controlling 36.5% of Sanya, HMIA will gain access to seven other airports, with substantial traffic growth potential. HNA Airport owns, wholly or in part, eight PRC airports; their combined passenger throughput and aircraft movement grew 30% and 22% y-o-y, respectively. Sanya is the largest airport owned by HNA Airport and accounts for over half of HNA’s total earnings and net assets. The remaining seven airports are second- and third-tier, the largest being Lanzhou Zhongchuan Airport in the capital city of Gansu province and Yichang Sanxia Airport near the Three Gorges Dam tourist destination. These airports have lower profitability than Sanya and HMIA.

I view the acquisition as positive. HMIA will monopolize air traffic in and out of Hainan Island, giving the company significant pricing power in terms of negotiating landing and franchise fees. In addition to benefiting from economies of scale, acquiring Sanya, an airport less than 200 kilometers away from Meilan Airport, will allow HMIA to resolve the horizontal competition issue of “one island, two airports” and reduce the effects of the diversion of traffic volume by Sanya. The acquisition is significant because in 2009, the Civil Aviation Administration of China (CAAC) laid out the strategic direction of national airport network based on three national airline hubs (Beijing, Shanghai and Guangzhou) and six regional airline hubs (Shenyang, Wuhan, Xi’an, Chengdu, Kunming and Urumchi). Though Meilan Airport used to be one of the ten largest airports in the PRC, it was not selected as one of the airline hubs. This decision would have limited HMIA’s ability to grow organically. Hubs – major airports that serve as feeders for smaller regional airports – tend to be the most profitable airports primarily because hubs command premium prices for landing fees and attract quality tenants to occupy terminal space6.

According to HMIA announcements and based on FY2009 figures, on a pro-forma basis, the acquisition would raise HMIA’s operating profit by 155% and net profit by 58%. Based on the announcement, HNA Airport has higher revenue per passenger than HMIA. This is offset by higher unit cost. Thus, on a pro-forma basis, the combined entity should deliver higher operating profit overall due to increased traffic, but no operating margin improvement. However, net profit is expected to fall 9ppt, due likely to higher finance costs incurred by HNA Airport versus HMIA.

Total assets are expected to increase by 375%. Meanwhile, HNA Airport looks highly geared versus HMIA. Following the A-share offering, shareholders’ equity is expected to double post-acquisition. Return on assets and equity are expected to fall 5% and 2% respectively, as HNA Airport has lower returns than HMIA.

While I do not consider the acquisition price – 1.1x FY2009 book value and 21x FY 2009 earnings – to be cheap, the price did represent a discount to that of many PRC-listed airports prevailing as of May 7, 2010.

PE PB

Hainan Meilan International Airport H’ 26.2 2.4

6 Aisling Reynolds – Feighan, The US Airport Hierarchy and Implications for Small Communities, August 2008. http://usj.sagepub.com

HNA Group21%

Sanya Phoenix 67%

Dongying Yong An

90%

Manzhouli Xijao67%

Yichang Sanxia 90%

Dunhuang Mogoa 100%

Qingyang Xifeng100%

Lanzhou Zhongchuan

100%

Jiayuguan 100%

HNA Airport

HMIA54.5%

Worldwide24.5%

Beijing Capital International Airport H’ 68.6 1.6Shanghai International Airport A’ 36.8 2.0Guangzhou Baiyun International Airport A’ 20.5 1.8Shenzen Airport A’ 18.4 2.0Xiamen International Airport A’ 19.0 3.9

The intensive liquidation of Chinese stocks in 2011 - the Shanghai SE Composite declined 20.2%, while the Hang Seng Composite Mid Cap Index fell 27% - delayed the planned issue of 200M new A shares and HMIA’s acquisition of an additional 30% of HNA Airport. However, I believe the merger will be successfully completed since both the Hainan Meilan and Sanya airports are controlled by the same entity, the HNA Group.

Asset-based Valuation of HMIA Post-acquisition While we do not have enough information on privately held HNA Airport to use a discounted cash flow approach, we can estimate the value of the combined entity using its P/B ratios versus a peer group of global airports. I prefer to use P/B ratios instead of P/Es because any earnings approach is distorted by different positions of airports in their capex cycle. According to HMIA announcements, pro-forma end-2009 book value post-acquisition is RMB 5.30 (HK$ 7.74). Using a mid-cycle P/B ratio of 1.5 implies a post-acquisition price of HK$ 11.6.

3. Airport management companies are capital intensive and returns on capital tend to be highest for companies that receive government assistance. Governments, most notably in the Middle East and China, have been willing to subsidize the development of airports since the benefits to a country of well-developed airports extend beyond airport revenue, and into wider employment through increased business opportunities, tourism and economic development. These benefits outweigh small returns on capital available for national governments.

Besides the ability to borrow cheaply from provincial banks – interest rates on bank borrowing in H1FY2011 ranged from 3.2% to 5.1% - HMIA benefits from government assistance in the following forms.

The Ministry of Finance levies airport fees of RMB50 per domestic and RMB70 per international ticket with 48% of the fees going directly to subsidize growth at first tier airports such as HMIA and the balance used to finance secondary airports and air traffic control development. In late 2010, the State Council decided to extend the levy to 31 December 2015. In H1FY2011, Airport fees constituted 20% of revenues.

HMIA benefits from a preferential tax rate of 11%. However, under the new EIT law, this tax reduction period will expire in January 2014, increasing tax rates to 25%. This represents an earnings drag for HMIA. Sanya, however, will continue to benefit from the 50% tax reduction until January 2017. My model takes into account both changes in the enterprise tax rate and the airport fee regime.

State assistance helped HMIA earn net margins of 50.8% in FY2010, the highest in its peer group of 25 global airport management companies.

4. Investing in China – A top down perspective.

Recent BRIC underperformance

Asian and Brazilian markets have traded poorly for the past eighteen months, but this should change as their central banks inject liquidity into their banks. Moreover, the true source of sovereign risk is being re-evaluated. Bond issuance by countries in Asia and Latin America is finding far better reception than that of the developed nations. Emerging government entities sold $11.3 billion in bonds in the first two weeks of 2012, and even smaller issuers like the Philippines, Indonesia and the municipality of Shanghai can regularly access the credit markets. Brazil just sold a $750 million global bond issue at 3.5%7. Large global investment managers such as Blackrock Inc. are launching mutual and exchange traded funds in the

7 Natasha Brereton-Fukui, Reversal of Fortunes in Debt Market, Wall Street Journal, January 12, 2012. http://online.wsj.com/article

growing market for Yuan denominated bonds. To me, this signals that the investment is beginning to flow back to emerging markets.

A cooling off in Chinese real estate is equity bullish, I believe. China’s household sector holds the equivalent of the combined GDP’s of Brazil, India and Russia in bank deposits. Additionally, government policy makers have proposed market friendly reforms such as investing state pension assets in stocks. These policies usually work in China.

McKinsey and Co. notes that China’s middle class (incomes of $8,000 - $30,000) is projected to rise from 135 million to over 200 million by 20158. Obviously, China’s economy cannot continue to grow debt at recent rates and government will be called upon to recapitalize the nation’s banks. However, the market is pricing in a far too severe growth slowdown, in my opinion. Domestic consumption is far less credit and resource intensive. It can be supported not only by liquidation of China’s huge stock of domestic savings but also rapid productivity and personal income growth.

Secular trend in domestic consumption

I believe one of the most compelling investment opportunities over the next few years is likely to be in companies that serve domestic demand within emerging markets. As poor countries get richer, they save as much as they can. Savings rates usually rise until countries reach a range of $3,000 to $10,000 per capita GDP9. Once in that range, savings rates begin to decline and consumption becomes a larger part of GDP growth as society starts to provide a social safety net. At this level of wealth, per capita consumption of all goods and services rises in a highly non-linear fashion. For example, while Chinese per capita GDP quadrupled from $1,000 to $4,000 during the past decade, auto sales rose from one million vehicles per year to over 17 million10. Markets rarely anticipate this kind of non-linear growth. Fifty percent of all emerging markets (by market capitalization) are now in this sweet spot of shifting from savings to consumption. Further strengthening the economic case is a shift in demographics: a record number of people are coming into their earning years in emerging markets at the same time that baby boomers are starting to retire in the developed world. As a result, I believe that the world is in the midst of a massive shift in demand from the developed world to emerging markets.

5.There are a number of risks to an investment in HMIA. The biggest negative, in our view, is the significant capital expenditure outlay required to increase capacity at Sanya by 2013/2014. Additionally, capacity of the international terminal and west-side passage at Meilan will also have to be significantly expanded. The designed capacity of the Meilan terminal is 9.6M passengers per year. Once capacity constraints are reached, the expansion of facilities, such as terminals, results in an increase in costs that include labor, maintenance, utilities and capital depreciation charges.

The Sanya acquisition is likely a short-term negative due to EPS dilution. While we have insufficient data on privately held HNA Airport to precisely model the dilution, proforma EPS numbers released by HMIA, based on FY2009 numbers, indicates a base case post-acquisition dilution of 13.7% on reported earnings.

6. No discussion of Chinese stocks today is complete without addressing the issue of financial statement fraud (a Google search of the term RTO fraud returned 2.9M hits). However, a study of the more prominent frauds such as SinoForest - which overstated its Yunnan timber investments by approximately $900 million11, and Sky People Fruit Juice – which claimed to own the largest Kiwi fruit plantation in Asia, while

8 Diana Farrell, Ulrich A. Gersch, and Elizabeth Stephenson, The value of China’s emerging middle class, McKinsey Quarterly, June 2006. https://www.mckinseyquarterly.com

9 Arjun Divecha, Capturing Domestic Demand in Emerging MarketsNeither Small Caps Nor Multinationals Are a Good Proxy, GMO Insights, Jan 4, 2012, http://www.gmo.com/America/GMOInsights

10 Bloomberg News, China 2010 Auto Sales Reach 18 Million, Extend Lead, Jan 10, 2011. http://www.bloomberg.com/news

11 Zero Hedge, John Paulson Could Lose Up To $650 Million On Latest Alleged Chinese Fraud. http://www.zerohedge.com/article

documents filed with the State Administration of Industry and Commerce (SAIC) revealed the company to be 10% of the size stated in its SEC filings12, reveals a common thread. Most fraudulent Chinese companies misrepresented the size of their productive assets, which were often difficult to verify. HMIA’s productive assets consist of the Hainan Meilan and Sanya airports. Further, reported data on passenger throughput and aircraft movement can be verified with the Civil Aviation Administration of China (CAAC)13, and the data appear to be consistent with HMIA filings. Additionally, I failed to find a single Chinese company reported as being an RTO fraud that paid dividends consistently. HMIA has paid a dividend every year since it listed its H shares in 2003. Finally, long-term institutional shareholders control most of the free float. While the quality of reporting by Chinese mid-caps and small caps does leave much room for improvement and none of the mitigants stated above definitively preclude financial statement manipulation, they do significantly reduce the probability that HMIA is a fraud.

BEFORE MERGER AFTER MERGER

Shares (m) % Shares (m) %

Parent 238 50% 238 35%Oriental Patron Financial Group 94 20% 94 14%UBS 36 8% 36 5%Other long-term investors 9 2% 9 1%Other H-shareholders 96 20% 96 14%A - Shareholders 0 0% 200 30%Total 473 100% 473 100%Table 2. Shareholding Structure Before and After the A-share issue

Source. HMIA announcement, Capital IQ

7. Recent resultsIn the most recent interim report, ended June 30 (1H11), revenue increased by 10.1% to RMB289.05M. Revenue from passenger charges increased 14.3% to RMB 80.8M. Revenue from aircraft movement fees increased 8.4% to RMB 26.2M, while sales from ground handling services increased 11.8% to RMB 24.1M. Passenger throughput increased 6.7% y/y, while cargo throughput increased 2.1%, due partly to promotional measures established in 2010 by the provincial government.

Gross margin increased to 62.3% in 1H11 vs. 60.9% y/y. SG&A increased 1.0% to RMB 30M. As a % of sales, SG&A was flat y/y at 10.4%. EBIT increased 16.5% y/y to RMB 159.2M. The EBIT margin was 55.1% vs. 52.1% in the prior year. We note that the first fiscal semi-annual reporting period is not a seasonally strong period for HMIA. Net interest expense and other income were up 54.3% y/y at RMB 6M, largely due to the debt accumulated to acquire the 24% stake in HNA Airport from Kingward. After applying a normalized tax rate of 12.5% and dividing by average shares of 473.2M, EPS was RMB 0.55 in 1H11, +41% y/y.

For the first half of FY 2011, free cash flow was RMB110.7M, or $0.23 per share. This compares with RMB 243.6M or $0.52 in the first half of 2010. At 6/30/11, cash was RMB 553.7M; debt was RMB 475.2M. Net debt was RMB -78.5M compared to RMB -736.7M at 6/30/10. Total debt/EBITDA was 1.5x on a TTM basis. Book value was per share.

8. Financial assumptions

12 Roddy Boyd, How They Do It: The White Shoe Lawyers, Sky People And The Case Of The Disappearing Documents. http://www.thefinancialinvestigator.com

13 http://www.caac.gov.cn/English/Data

For FY 2012 (ended Dec. 31, 2012), our assumptions are as follows: Total revenue increases 14.0% to RMB 662.6M. Revenues from passenger charges should increase by 17.4% to RMB 192.17M, while revenues from aircraft movements and cargo throughput revenue increases by 10.0% and 6.4% to RMB117.86M and RMB 67. 94M respectively. These increases are driven by the fact that Sanya has reached its terminal capacity and diversionary pressures should be minimized until capacity expansions are completed in 2014.

For 2012, we estimate a consolidated gross margin of 85.01% vs. 85.60% in 2011. Our gross margin remains flat largely because we do not envisage any increase in airport and logistic service fees in 2012. Next we estimate SG&A to be RMB 53M, essentially flat y/y, primarily driven by increased passenger throughput offsetting a slightly higher overall marketing spend. This results in EBIT of RMB 330.9M, or a 49.94% margin compared to RMB 288.9M or a 49.82% margin in 2011. We have modeled a drag of 300-400bp from the ramp up in utility and repair and maintenance expenses given the capex cycle of HMIA. Next we subtract net interest expense of RMB 184.6M (up 180% y/y given the reduction in cash and increase in debt incurred to acquire the 24% stake in HNA Airport) to arrive at a pretax income of RMB 183.17. Subtracting tax at a 12.5% rate, we arrive at net income of RMB 147.9M, or RMB 0.31. Average shares should be flat y/y. Based on expected capex of RMB 53M, FCF would be RMB 206.4M or RMB 0.44 in 2012.

For FY 2013, our assumptions are as follows: Total revenue increases 17.6% to RMB 779.2M. Revenue from passenger charges should increase by 8.1% to RMB 229.1M, while revenue from aircraft movement and cargo throughput should increase by 5.1% and 6.2% to RMB 131.6M and RMB 76.6M. These increases are driven by the reduced diversionary effect of Sanya capacity expansion and a y/y increase in non-aeronautical revenue of 10.2%.

For 2013, we estimate a consolidated gross margin of 87.4%, a slight increase y/y largely due to fixed-cost leverage. Next we estimate SG&A to be RMB 62.3M, an increase of 17.6% y/y. This would result in EBIT of $417.9M, or a 53.3% margin compared a 49.9% margin in 2012. Next we subtract net interest expense of RMB 185.9M (flat y/y) to arrive at a pretax income of RMB 275.7M. Subtracting tax at a 12.5% rate, we arrive at net income of RMB 231M, or RMB 0.49, +57% y/y. Average shares should be flat y/y. Based on estimated capex of RMB 62.3M, FCF would be RMB 239.7M or RMB 0.50 in 2013.

11. I think the risk reward equation for HMIA is attractive. HMIA is undervalued both on a relative and absolute basis. I believe that HMIA will be able to grow traffic meaningfully due to the heavy promotional efforts of the provincial government. Most importantly, however, the rollout of duty-free stores appears to be on track, and should add substantially to the top-line. As we detailed in the report, we expect EBIT margins to remain steady in the 49.9% - 53.4% range (my model includes a 300bp drag in FY2012 from expanding capacity at Hainan) compared to 50.8% in the most recent 12-month period. HMIA’s PRC-listed peers have margins in the 30% range. Barring a severe downturn in the domestic economy, I think these forecasts are readily achievable if not conservative.

I recognize that HMIA trades at a discount to peers for valid reasons – Hainan is a leisure island heavily reliant inbound domestic tourists and Haikou is currently regarded as a secondary city. However, I believe that the acquisition of HNA Airport can result in a meaningful rerating of the stock as HMIA comes to be viewed as a regional airport company. I also believe that the probability of the merger going through is extremely high. Both Hainan Meilan and Sanya are controlled by the same parent entity, the HNA group, and the proposed merger has received shareholder approval. I also believe that the HMIA is favored by certain secular tailwinds - tax incentives and other promotional efforts to market Hainan as an international tourist destination will lead to increases in inbound traffic over the long-term, especially as the ranks of the Chinese middle-class grow.

HMIA shares appear to be inexpensive based on several valuation metrics. HMIA trades at 6.31x consensus FCF for 2012. The shares also are valued at 1.1x TBV and 5.43x 2012 consensus EBITDA. A current dividend yield of 6.2% in addition to the relatively low valuation should provide investors with downside protection. It is important to point out that PBY operates in a seasonal business in which 2H results are typically greater than those achieved during the 1H period. Thus, PBY shares could potentially be volatile during the seasonally weak first half of FY 2012.

Using our 2012 forecasts, we have established a price target of HK$10.55 based on a DCF valuation for HMIA. This implies a total return of 78.8%.

12. Financial Models