|Shares Out. (in M):||147||P/E||0||0|
|Market Cap (in $M):||8,000||P/FCF||0||0|
|Net Debt (in $M):||0||EBIT||0||0|
Aercap is a high quality specialty finance company that has grown its book value at an average rate of 17% a year over the last 10 years, without a down year. The company focuses on leasing commercial jets to airlines and its book value and earnings potential is based on an evolving portfolio of around 1,500 planes. The average age of a plane in the portfolio as of today is 7 years and the average remaining lease term is around 6.6 years. The company has repeatedly had its assets appraised by outside advisors at a premium of around 5%-10% to the stated book and that metric has been verified annually as they sell assets and recognize an average gain on sale of around 7% (showing the FMV>Book in real time marks). Buying this stock at $54.00 would be at only 0.8x our 2018 year end book value and even less on an intrinsic value considering the conservatism in depreciating their assets. This seems to provide a margin of safety to the downside – especially given the nature of the assets (described below) and history of continued book value growth even through the recession. This also translates into around 8.5x this year’s earnings (2018) on a reported basis and 9.0x on a core earnings basis. The difference between the two is primarily the gains on asset sales as they sell around $1 billion of assets a year as part of their operations. One way to look at the gains is that they are just reversing the over depreciation that depresses core earnings as they depreciate planes faster than their value actually depreciates. Like most financials – the growth of earnings is a function of how management allocates capital and manages the business. They can invest in additional assets when they have attractive returns or sell assets when the market is tight and prices are high and return capital to shareholders by buying back stock. In this case, the history of this management team is strong – as you can see in the results of the earnings growth (averaging 14%) and book value growth (averaging 17%) and neither with any real draw down to speak of including during the financial crisis. This management team has consistently generated a ROE in the mid teens with a conservative balance sheet – levered now only 2.7x – and the only independent aircraft finance company that is investment grade. I think they can growth book value to around $80-$85 by 2020 and if it traded at just book, then our investment would generate a 17%-19% return. If it traded to 1.2x (which would be historically high but consistent with the ROE and returns demonstrated) the stock would be $98-$101 or a 26% to 29% compounded return.
Getting to a higher than book value multiple seems realistic. While there are concerns about the cycle and overproduction, the aircraft leasing business is more attractive through the cycle than many specialty finance segments and arguably deserves a higher multiple. Looking at returns on assets and returns on equity, aircraft leasing is more stable and predictable than many other niche finance companies that get premium multiples, a gap that should close over time.
While trading close to an average type multiple, as the chart below demonstrates, there is an opportunity to rerate as the industry matures and investors spend more time beginning to really understand the fundamentals. In addition, stock prices have lagged earnings growth, leading to multiple compression despite strong fundamentals and potential upcoming catalysts.
The business is relatively stable and predictable given its all under contract/lease. 95% of the company’s revenue through 2020 is already contracted. The company does not take interest rate risk and hedges changes in interest rates. A 100 bps change in interest rates would only have a $25 million effect ($0.14 per share). In a rising interest rate environment – given the all in yield on a plane is about 13% with current debt costs of about 4%, they would not need to push price much to maintain margins and the alternative of buying vs leasing gets equally more expensive so presumably pricing power remains intact as long as demand is not destroyed. The obviously offset also being if higher rates are indicative of higher demand then price/values should be higher to meet demand. This is particularly true if stronger global growth is lifting commodities and the emerging economies as that is where most of the incremental demand for aircraft will be. Lastly, it is also likely that in a higher inflationary/higher interest rate environment, the asset value of planes depreciates more slowly especially if the price of new planes is being inflated, thereby increasing the value of the portfolio.
They maintain good liquidity with at least 1.2x the NTM cash needs (which includes cap ex and debt maturities) and usually around 1.5x the NTM. The business has shown remarkable stability in margins. The basic math on an aircraft is that it is leased at an 11%-12% yield (the younger the avg plane the less the yield because its less depreciated therefore higher denominator vs a more depreciated plane). The interest cost is about 4% leaving a Net Spread of about 8%-9%. Depreciation runs 5%-6% (lower on younger fleets because it’s a higher denominator), for a consistent 3% Net Margin.
In a very basic analysis – you can see how a well run company can generate low/mid teens ROE’s from a plane by plane perspective (AER runs 2.7x-3.0x):
The core of the investment thesis rests on the quality of the assets and the quality of the management team – both of which seem high here. Management is very well regarded and considered the best in their space. They have been smart allocators of capital, having bought back 28% of the shares outstanding since 2015 below book value. They have also found smart and highly accretive deals to do, like purchasing the aircraft leasing business out of AIG at an attractive price that proved to be a catalyst for the stock. Of note, GE is said to be shopping their aircraft leasing business, which might make for either a smart/accretive deal by Aerocap or a good mark for what these businesses are worth should someone step up and pay more than book for the business. The elevated debt levels from mid-2014 were the result of the highly accretive AIG deal – which they quickly reduced to below target levels on strong free cash flow and asset sales.
The asset underpinning the book value – planes – seems a good asset to finance. There are long term secular trends driving air miles flown globally. Since 1986 air traffic has doubled every 15 years – a trend that should continue if not accelerate for the foreseeable future according to all forecasts. In 2017 global air traffic is growing at 8%. This secular growth is driven by a number of factors. First is the global growth of the middle class which correlates well with air travel (both leisure and business). The global middle class is expected to grow from 2.9 billion people to 4.9 billion people in the next 20 years. In addition, much of the emerging middle class in coming from countries where the average distance traveled is much further than the existing average distance traveled in mature nations. For instance, travelers in the middle east, India and China have a propensity to travel distances greater than their counterparts in the US (flights from NYC to Chicago, NYC to Boston, DC to Florida…etc are relatively short flights compared with common flights out of Dubai or Hong Kong). And lastly net fleet increases have not kept up with traffic as airlines have driven efficiency in seating – a game that seems to be coming to a close (ie getting more people on a plane and flying the plane more hours/day). In addition retirements of airplanes have been below normal, signaling that the global fleet has been stretched and aged beyond what is normal. This might have been helped by low fuel prices as it has allowed older less efficient planes remain economical for longer than normal, but over time these trends should regress to the mean and drive further demand as the plane parc stops aging.
In addition to the growing secular trend of global air traffic, there has also been a secular trend for more airlines to lease vs buy aircraft. This is being driven by several factors. Among the large established air carriers some of this trend is driven by balance sheet concerns and increasing returns on capital for shareholders. In addition, as air traffic grows in emerging markets, new airlines with less balance sheet power and weaker credits are becoming an important source of growth. For emerging airlines lacking the financing and the strong industry standing to get orders into Boeing and Airbus, they are increasing relying on lease companies like Aercap for their planes.
In thinking about the risks to an investment in Aercap, from a credit perspective, one concern would be the financial stability of the airlines leasing the planes. One consideration is that airlines are currently in an unprecedented period of profitability. Some argue that airlines have finally discovered that if run correctly, they actually have real businesses. Seems like even Berkshire has bought into this theory. But as Aercap points out what really matters is that someone is flying planes – its easy to repaint the tail. Planes are easy to take back and replace – they are very liquid assets. So a failed airline will just have its routes replaced by another airline that needs planes assuming air traffic continues to grow. They point out they grew book value through the financial crisis. In addition, as highlighted below, this is one area that they think they excel at given their size, sophistication and expertise – they can react quicker to any credit issue than any other competitor.
In addition to a strong management team and good demand for the underlying asset that Aercap finances, Aercap has some other unique characteristics that help distinguish it in what most would assume is a rather commodity like industry. First and foremost is the size and scale of Aercap. This gives it market insight into an otherwise opaque market (private aircraft sales) such that they claim they know better than anyone where demand is, for what planes and at what prices in both the new and used market place. They claim that information advantage is core to them delivering best in class results – and leads to optimal decision making…Buy/Sale/lease decisions as they manage their portfolio.
Aercap’s focus is on maintaining a liquid portfolio of the most desired planes. Keeping a conservative cap structure, conservative leasing terms with high security deposits and maintenance reserves and not taking interest rate risk. As already mentioned Aercap is the only independent aircraft leasing company that is Investment Grade, giving them a financing cost advantage over their competition and many of their customers. In addition, their size (largest buyer of many versions of aircraft) gets them better pricing and better placement in the order book. For instance, they are the largest buyer of the 787 and made up a lot of the early deliveries. This puts them in an advantaged position to basically “sell their place in line” to lesser airlines that would need to wait years to get the 787.
Aercap is the world’s most active trader of mid life aircraft, giving it unique insights and abilities to place aircraft. One example given is there is a current industry concern with the number of widebody jets on order from a select group of Middle Eastern airlines. In some cases, certain Middle Eastern airlines have more new widebody jets on order than they currently fly and this at a time of weak economic environment in the Middle East driven by low oil prices. In addition to the large widebody order book, with the ramping of Boeing’s 787 (Dreamliner) and the upcoming revamp of the 777 (Boeing’s most successful widebody plane of the last several decades), investors have been concerned with residual values and demand for existing 777’s in the portfolio. As the chart below shows, Aercap has successfully placed or sold almost their entire 777 fleet – something they point to as a good example of their expertise and market knowledge.
Another example given was the recent bankruptcy of Berlin Airlines. Their claim was that most of the lessors or OEMs with aircraft placed with the bankrupt airlines were left waiting around, in part because of pressure from the German government, waiting to see if Deutsche Air was going to assume the leases. Aercap had the strong leases, expertise and infrastructure to immediately take the planes back, get them out of Germany and placed with other airlines around the world before a single other plane in Berlin Air’s fleet was taken back by another creditor. As it turns out, Deutsche Air did not take any of the widebody planes, leaving other lessors with unpaid leases for sometime and then they first had to try and begin getting their planes re-placed.
One reason for this expertise is the business model Aercap has. They look to trade out of airplanes midway through their life and have extensive networks of investors and contacts that they place hundreds of planes with. The Aercap business model is to buy airplanes and place them with airlines under 12 year leases. This gives them high visibility into revenue and lets them manage through downturns. They sell most of their planes within 8-15 years, usually with at least 3-4 years left on lease (or lease extension) mostly to investors looking for stable yield.
Overtime, management can flex their portfolio – buying newer planes to expand and get younger, and selling more planes to shrink the portfolio and return capital and let the average plane age a bit. Currently, Aercap is in the process of getting the fleet a little younger as it takes deliveries of newer planes – which in theory should make the portfolio more valuable.
Like all specialty finance companies, Aercap needs access to external financing. Any debt crisis is an issue. Management tries to mitigate this by always operating with a prudent amount of liquidity to manage through any crisis – assuming that they can re-access capital markets within a reasonable period (2 years or so). The company itself generates in the area of $3 billion of operating cash flow a year and usually sells around $1-2 billion of aircraft a year – so it internally generates large amounts of cash before cap ex/new plane buys. Furthermore, its average debt maturities roughly matches its average life left on leases (about 6 years) to keep the duration of debt and lease rates consistent. See debt maturity schedule (below).
A second consideration would be residual values of planes. One issue would be an oversupply of planes by OEMs into a market (because of over production or decreased demand as a result of a recession or political/terror concerns) could depress plane values and lease rates leaving residual values below Aercap’s book and making placing/selling planes that are coming off lease book value losses. Historically this seems to have not been the case and the current demand forecasts seem to lead that supply and demand should be in balance. In addition, Aercap thinks the duopoly structure of the industry has imposed discipline and that the OEM’s are careful to keep the supply well matched with demand. Furthermore, Aercap thinks the development of the aircraft leasing industry has helped stabilize residual values as before the lack of visibility, expertise and liquidity would lead to larger swings in residual values during downturns as assets were dumped into illiquid and unsophisticated markets. But this remains something to track. Residual values are something to watch. With $34 billion in assets – a 5% change in residual values would lower the book value by about $10/$11 per share or about 19% on its face…ie ($34 bn * 5% / 157 shares) but if you assume book is understated by about 7% on average then the net effect would be about $4.00 less. But the real math is more complicated. First, Aercap is in newer more liquid planes, where moves in residual values are much less than the overall market. Where softness in the industry has the largest effect on residuals is on older planes in a segment where new versions are launching – that was the concern with the 777 within the Aercap portfolio described above and they manage the business to avoid those issues. The second thing to keep in mind is that Aercap planes are on leases and generally sold with leases attached, so near term fluctuations in residual values have little to no effect on current fundamentals. Should leases need to be signed during a period of panic or weak global conditions, what Aercap did during the recession was sign short term leases at a discount to cover costs on deliveries or planes coming off lease, then look to resign them at better rates for a normal length lease a year or two later. While not optimal, with the fleet under long term contracts and the sale of most planes before they get to the end of its contract or contract extension, there is usually on a relatively small % of planes coming off lease in a given year that have not already been placed of sold, so this effect should not be dramatic but bears watching as the portfolio is in constant motion. Lastly, it is worth thinking about reported book represents a plane with an average age of about 6 years under a 10-12 year lease. The time frame that residual value would matter most is the end of a lease – or about 6 years later on average. Depreciation is straight line, so the delta between expected residuals (predicted by book) and potential discounted values as a result of a weak market, would be based on the much lower depreciated value of a 10-12 year old plane, not the average book today. Not sure how that exact math would work, but is you assume deprecation is about 6% a year and on average there are 6 more years left on the average lease – the base for a hit to residual values on a like-for-like basis is probably closer to $23 bn than $34 bn such that a 5% hit would be more like $7.00/share and $3.00-$4.00 net of the imbedded conservatism. But will need to verify this calculation with the company. From the chart below, you can see the weakness in values hits older plane models much more than newer ones. The hit to the 777-300, 787, A-330-300, and 737-900 during the crisis was much less than many of the older models that were facing newer versions in the market place. Aercap has managed through this whole period taking gains on sales – including net gains in 1q 2016. Book value has grown throughout.
In addition, one concern might be the increased competition from easy money looking for yield which could depress margins for what looks like a commodity business from the outside. Aercap points to the increased interest from Chinese and other Asian banks in the space. But Aercap explains its view that there has always been competition in the space, so that is not new. It claims most of the easy and “dumber” money goes to sales-leaseback deals, something Aercap has not done in years now because of the lower yields. Those deals are competitively shopped and require less sophistication – more just providing of balance sheet financing to an airline that already has a plane. Aercap sees their value added in the form of the platform they have built and the expertise they have developed to buy the right planes, place them and then sell them across their network over the course of the plane’s life cycle. The stability of the ROE and margins generated seems to speak to this claim, but again, this is something worth watching. It does make some sense given the biggest cost to the lessee is basically covering the deprecations. The net margins are not that wide and Aercap has an advantage in being investment grade on the debt costs. The wide network of placing planes helps Aercap with the residual values and high utilization – both competitive advantages and barriers to anyone that wanted to buy hundreds of planes on spec without that knowledge and infrastructure as opposed to a plain vanilla sales-leaseback.
Lastly there is the risk to how the stock trades vs the actual fundamentals. Although the fundamentals are not correlated, it does seem that these stocks often trade in sympathy with airline stocks, at least over the short term:
There have been periods of strong drawdowns in the stock – especially in early 2016 when the stock was briefly in a free fall:
Looking back at the early 2016 time frame – this seems to have been panic driven as a number of overlapping concerns came together:
Boeing and Airbus both announced production issues and delays – which hit their stocks (particularly Boeing). Ironically, this should be a positive, as less production and a slowdown in the Dreamliner deliveries should have made Aercap’s position more valuable – but people shoot first. (BA stock chart:)
Although a stock chart of BA post that sell-off seems interesting and does not speak top a pending collapse in the cycle:
There was a growing concern about a China slowdown. Aercap has about 10% of its portfolio in China – and China is an important source of growth. Aercap was quick to point out air miles flown was still strong and growing – whether China grew at 4% or 8% and that they had strong demand from their customers there.
There was a concern about air traffic in Russia and Russian airlines going BK especially with the collapse in the Ruble. Aercap had anticipated this and already reduced its planes in Russia from 90 to 70 on a base of about 1500.
Boeing and Airbus were both having trouble placing end of life aircraft and new versions were about to launch. This is why Aercap was focused on getting out of the 777 it owns over the last few years.
There was a risk off trade. URI fell 45%, HTZ fell 65%, MS fell 38%, GS fell 39%, GLNG fell 70%...levered risk assets tied to global growth got hammered and post the AIG deal, Aercap was more levered then.
Couple of interesting points about that period:
Citibank did a FMV analysis plane by plane of Aercap in 1q 2016 and came up with a value still greater than book despite all the panic – which represented almost 50% upside.
The mgt team stepped up with aggressive buys. The CEO and CFO each bought around 500,000 shares personally.
The company got very aggressive on the share buyback.
As mentioned above – the company continued to realize net gains on sales of aircraft during the period.
Required Debt Repayment Schedule:
Stock buybacks, M&A, and continued increase in market cap which can bring more attention to the name/sector and help close the book value discount to other financials.
|Subject||market perception of this stock|
|Entry||06/23/2018 02:54 AM|
this is my largest PA position so clearly i agree with most everything you say. one thing i have trouble with, however, is your contention that over time the valuation will rise to a more appropriate multiple of book value given the track record of RoE significantly above cost of equity and the returns of the business through the cycle. What exactly is going to drive this? This is not a small/uncovered company; it is incredibly well owned by a diverse investor base (indeed regularly called a hedge fund hotel); and there is not much new or novel about what you are saying or the business's performance (indeed that is its main strength, the long-term consistency of the returns). surely the market isnt missing something here - it has simply decided that - for spurious reasons, we would agree - aircraft leasing is simply not worth the multiple of other financial services businesses.
the stock can continue to do fine give astute and shareholder friendly management (ie driving returns through funneling capital mostly back to shareholders). i fully expect the shares to be bought back, continously, for the next 10yrs. but absent an acquisition - which would likely occur at 1.2-1.3x book value - i dont necessarily see how we can expect the stock to ever get back to those kinds of multiples.
|Subject||re: over depreciating|
|Entry||06/25/2018 11:53 AM|
Can you speak further to your conclusion that they are over-depreciating? I think all the public lessors depreciate to 15% resiudal over 25 years, or 3.4% straight line. The US airlines depreciate more aggressively I think, DAL uses a 5-10% residual but has some range on their useful life period depending on the plane, I don't know for sure but I think they use a number higher than 3.4%.
|Subject||Re: re: over depreciating|
|Entry||06/25/2018 12:03 PM|
Mostly- while Seastreak explained it as over-depreciating as a way to highlight they could be reporting higher 'core' earnings given the consistency of sales gains over a decade, perhaps a better way to think about it is in terms of the business model: when lessors commit capital to buy plans on order from the OEMs, they get pretty chunky discounts vs list prices (which are more reflective of market values) to account for committing capital years in advance of delivery; large order sizes; and helping the OEMs get the capital needed to develop new technology aircraft. I believe a good chunk of the experienced gain on sales in AER's portfolio, for example, came from embedded gains from the below-market-value order book held at ILFC (one of the major reasons for AER's takeover, given ILFC had been the first customer for a couple of new technology aircraft and so go really generous deals).
so it is not that they are 'over-depreciating' versus the useful life in a way different to airlines or other lessors, just that for lessors like AER (and AL to a lesser extent), the underlying cost basis of the assets is, from inception, lower than the market accepts (and has been consistently over a decade). They are simply amortizing this structural cost advantage into the PnL over time using the medium of asset sales. Of course supply/demand has a lot to do with this but ultimately they will still be able to source aircraft cheaper than most any other lessor (or airline) given the size of their orders/power vs the OEMs and so this advantage is definitely structural.
|Subject||Re: Re: re: over depreciating|
|Entry||06/25/2018 01:06 PM|
Well put. i meant over depreciating as in the fmv > bv, largely for reasons puppyeh explaind. Or said another way core eps is understated a bit as the true cost of the planes is to aer is being overstated given their discounts...which then just comes back as a gain.
|Subject||Re: market perception of this stock|
|Entry||06/25/2018 01:19 PM|
My sense is that there has not been much market cap in the space for very long. Its not the hedge fund guys that will help rerate it, but the bigger long only guys who need to have a reason to do the work and hold it. It sort of falls between aerospace guys - who get the asset - but likely are much more focused on where the beta is...like BA (if you like the cycle go with the OEM's or some of the parts guys) and the specialty fianance guys who likely paint it with the same brush and have not invested the time to get to know the asset as there is just no enough going on in the space.
What might close it? Not sure. maybe need to make it through the cycle...maybe some M&A (like GE asset trading). Over time the markets tend to be efficient - what gets them there is less clear. I have wondered why some big Japanese financial in desperate need of yield does not take one out. Guess we will see.
|Entry||06/27/2018 04:48 PM|
Defy - what price do you think would be acceptable for management and co to sell? There is no way Gus Kelly and co would sell anywhere close to tangible book (nor should they); it is also less clear to me why Buffett would pay the 1.3x P/B it would take to get the deal done...
|Subject||Re: Re: Buffett?|
|Entry||06/27/2018 05:46 PM|
Buffett was asked about aircraft leasing at an annual meeting, and here's what he said:
But you will not see us get in — aircraft leasing doesn’t interest me in the least. We’ve looked at
that a lot of times, at various aircraft leasing companies offered to us. And that’s a scary
business. And some people have done well in it by, in recent years, by using short-term money
to finance longer-term assets which have big residual risks, and that just isn’t for us.
CHARLIE MUNGER: I think you’ve said it pretty well. We’re well located now but we — I don’t
agree that we have huge opportunities.
|Subject||Re: Re: Re: Buffett?|
|Entry||06/27/2018 05:56 PM|
point taken, but he said much more negative things about airlines themselves and now owns a bunch, so he's not above changing his mind. that said - the 'buffett might buy them' part of the thesis here should be well below the fold in terms of why anyone should think about owning the stock...
|Subject||Re: Re: Re: re: over depreciating|
|Entry||06/28/2018 04:21 PM|
I think the large lessors are buying at 40%+ discount to list, but concentrated buyers like LUV get better deals than that. How much difference do you think there is between what a large scale lessor pays and where the market rate is?
|Subject||Re: Re: Re: Re: re: over depreciating|
|Entry||06/30/2018 10:56 AM|
Are you sure the airlines get better deals than the lessors? It may be possible in isolated cases, but conceptually I find it hard to believe - for the largest lessors at least. AER and GECAS, for example, are by far the OEMs' largest customers and far more important to them than any one airline so that should be reflected in prices. They also have a history of committing capital to new models in advance of some airlines (not all, but definitely earlier than LUV) which again should translate into value.
you are of course right on the time arbitrage, it is helpful in rising markets and the opposite in falling markets, and it has certainly been helpful in the last few years. having said that - remember AER has made money on aircraft sales every year in aggregate the last 10yrs - in other words throughout the credit cycle. Aircraft values have not been secularly rising for AER's entire listed history, and yet they've kept making money. so the embedded discount must be a big contributor to this.
also, having thought about it more, AER has actually been selling mostly quite old aircraft that has been bid up by new buyers, low interest rates, low fuel, etc, and not really new technology aircraft (makes sense as their avg fleet age has been coming down). in other words we dont really know how much embedded value there remains in the newer planes, especially the ones coming into the fleet over the next couple years.
|Subject||Re: Re: Re: Re: Re: re: over depreciating|
|Entry||07/02/2018 12:07 PM|
Since they are the largest and often earliest buyers of new aircraft - i beleive they get the biggest discounts. As far as cycles go - they have not only taken gains every year in the last 10, but they grew book value even in the recession. One nice thing about the business model is that their assets are under long term leases. So even in a down cycle, only a small % come off lease or need to find a home when things are weak. In the great recessson they manged this by placing planes on short term leases at bad prices rather then sell or lock in long term leases at the bottom. Then as the environment noralized, they were able to place those planes at much better rates. So while it is true, when the global economy turns down, that is not great for asset values, luckily they only have a small number of planes that will likely come up in that market, so it makes it much more managable. In addition, the new planes should make the portfolio even stronger as they have new technology and better economy as fuel prices rise.
|Entry||07/02/2018 12:34 PM|
There is a very good book on this business, Crash Landing, that details the history of GPA and gives very good insight into what can go wrong in aircraft leasing. Aercap management seems really good and well-incentivized so they could avoid many of the problems that befell GPA, but probably worth being aware of nonetheless.
|Entry||07/05/2018 12:53 AM|
|Subject||Re: Re: Re: Re: Re: re: over depreciating|
|Entry||07/05/2018 01:19 PM|
puppyeh - not 100% sure. I've heard Air Lease say that Southwest gets a better discount than any lessor, but that they are "competitive" with most buyers. Aercap is bigger and spends $5B buying planes, shared across 2 manunfacturers and a variety of plane types. Southwest spends a little less than half that, but they only buy 737s... I assume that Indigo or Air Asia with 400+ A320/321s on order get the best pricing available.