|Shares Out. (in M):||145||P/E||0||0|
|Market Cap (in $M):||6,860||P/FCF||0||0|
|Net Debt (in $M):||0||EBIT||0||0|
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AerCap Holdings (“AER” or “the Company”) is the largest publicly traded aircraft leasing company, operating 952 owned aircraft and managing an additional 105 aircraft as of September 30, 2018. The Company has been written up as a long on VIC before and, more recently, competing firm Air Lease has been written up as a long. Those write-ups have a fair amount of background information on the aircraft lessors which we do not need to rehash at length here.
AER’s business model most commonly involves placing large orders for liquid wide and narrow-body aircraft from the major aircraft original equipment manufacturers (“OEMs”) several years out. These orders are generally for a large number of aircraft, come at significant discounts to list price and are worth multiple billions of dollars. In the years between order and delivery, AER attempts to place those aircraft on lease (generally a 10-12 year initial term) to airlines around the world. Generally these agreements have clauses that protect AER from rising interest rates and contain adjustments for certain other contingencies. Under ideal circumstances, AER will have leased out the assets it has committed to purchase well in advance of taking delivery.
From the perspective of the OEM, the large, well-capitalized lessors help to fill out production schedules and serve as an intermediary to facilitate the distribution of aircraft to airlines around the world. From the perspective of the airlines, the lessors help with fleet management. Leasing has grown rapidly in popularity as it has reduced the need for airlines to make massive capital outlays to secure delivery slots from the OEMs, allowed airlines to stagger lease expiries to manage their fleets over time and helped airlines to lay off residual value risk.
AER has a young fleet with an average portfolio age of just 6.6 years and an average remaining lease term of 7.1 years, providing significant visibility into future earnings. The Company has been earning low double-digit GAAP returns on equity on a sustained basis for years, has not reported a single year of meaningful impairments and has not posted an annual loss since going public in 2006 (including the period through the financial crisis). Despite this, AER today trades at just 6.9x diluted EPS and 77% of book value. Further, AER operates with a number of tailwinds, not the least of which is that global air traffic has grown more rapidly than global GDP for years. Passenger load factors and airline profitability have also improved significantly in recent years.
While much has been made of the positive factors in other write-ups and the associated comments, we’d like to focus on a few key concerns that we do not feel have been adequately addressed and seem to be a concern for the market. During the most recent market selloff in the fourth quarter, aircraft lessors were hit particularly hard (trading off as much as 40% from the local highs) and major lessors such as AER and AL traded down to nearly 60% of book value. Despite a recent and meaningful rally in AER shares over the past few weeks, we believe that considerable upside remains.
We believe a key concern for market participants is a “run on the bank” in which capital markets close to the lessors, leaving them in a position where they are unable to finance purchase commitments and maturities as they come due. This is evidenced by the lessors demonstrating significant beta during market downswings. At the lows in December, the S&P 500 had declined roughly 19% from the beginning of October. During this period, AER declined nearly 36%. Similar price action was observed in the January/February period of 2016 during another rapid market selloff.
While it is true that AER has meaningful leverage (2.7x adjusted debt/equity ratio as of the third quarter, down from 3.8x at the time of the ILFC transaction) we think that these fears are overstated and do not properly reflect the strength of AER’s liquidity position. We suggest reading a few of the quarterly AER transcripts to get a sense as to how obsessive the management team is about liquidity.
Some brief history is worth revisiting as there have been significant failures in the aircraft leasing space owing to short-term liquidity issues. Most notable is the failure of Guinness Peat Aviation (“GPA”) in the early 1990s. In 1989, GPA made headlines for placing an order for over 300 aircraft worth nearly $17 billion over the following decade (in addition to existing orders). This was at a time when GPA was generating net income of approximately $150 million. Eventually, a confluence of events strained GPA’s liquidity, leading to its ultimate failure. By way of comparison, the entirety of AER’s purchase obligations for its order book total $20.6 billion today and the Company reported over $1.0 billion of net income (and over $3.3 billion in operating cash flow) for the LTM period ended September 30, 2018.
GPA was a pioneer in the aircraft leasing industry at a time when many of the risks in the business were less well-appreciated. But the failure of lessors like GPA informed today’s management teams. Here is CFO Peter Juhas at AER’s 2017 investor day:
“Now let me talk briefly about how we approach liquidity and funding. We're committed to maintaining a strong balance sheet. It's critical in this area to remain disciplined. You have to make sure you always have plenty of liquidity. You have to have access to diverse sources of funding. You have to have an appropriate capital structure. And you have to be appropriately hedged. That's why we set targets across all of these key areas. In terms of liquidity, we always maintain substantial cash on hand and make sure there are sources of cash over the subsequent 12 months or at least 1.2x our contracted cash needs during that period.
Next, we make sure that we have access to diversified sources of funding around the world because we don't want to be overly reliant on any one market. We've raised over $36 billion worth of funding since the ILFC announcement. We keep our secured debt to 30% or less of our total assets. And we keep our leverage within our target range that I mentioned. And finally, we fully hedge our interest rate exposure on our debt through a combination of interest rate caps, swaps and natural hedges.”
As of the 3rd quarter, AER had $1.2 billion in unrestricted cash, $4.0 billion of availability under an unsecured revolver (due 2021), $5.8 billion across other facilities and contracted asset sales for total available liquidity of $11.0 billion. This alone covers NTM anticipated cash outflows of $4.1 billion for debt maturities and $6.0 billion of asset purchases. Add to this NTM operating cash flow (after interest expense) of $3.1 billion and you comfortably cover NTM cash outflows. Importantly, this assumes no financing for future purchases and no ability to finance presently unencumbered assets. If we look out through 2020 and assume 9 quarters of operating cash flow at the 3Q18 run rate (an oversimplification given asset sales and deliveries, but this is for illustrative purposes) AER has capital spending commitments of approximately $20.7 billion.
|Other Facilities & Sales||5,800|
|Operating Cash Flow (9 Quarters)||6,975|
AER can cover these payments based on its existing liquidity assuming it is able to get just 20% financing on its new aircraft purchases. This is assuming all of its unsecured debt is retired and not refinanced when due and the proceeds for the assets underlying its secured debt cannot be sold for value (setting aside the fact that these facilities generally mark the aircraft to market and have a 60-70% LTV cap).
It’s worth highlighting further that AER puts facilities in place that are relatively “all-weather.” Take the $4.0 billion unsecured revolver, for example. There are only three real covenants, each of which has meaningful cushion:
· Consolidated indebtedness to shareholder equity – The test level here is 3.75x against a 2.70x actual level in 3Q18
· Interest coverage – Minimum of 2.0x against an actual 3.6x in 3Q18
· Unencumbered asset test – Book value of unencumbered assets cannot fall below 135% compared to an actual level of approximately 148% at 3Q18
People we’ve spoken with highlight that the financing market for aircraft has come a long way since the days of GPA’s failure (the development of a robust ABS market, EX/IM financing among other things) and that, even in a downturn, they would be shocked if 50% financing for new aircraft couldn’t be found (today it is common to get 70-80% financing). Some of the operating cash flow could be lost as a result of counterparty defaults. While lessors point to high utilization rates (even through the lows of the financial crisis and post-9/11 period), we feel that this is somewhat misleading. It wouldn’t be difficult to keep the fleet leased up at uneconomic rates. Having said that, industry participants we have spoken to do not believe that default rates in stressed periods of time historically have resulted in more than single digit default rates.
Simply put, liquidity risk is not an unknown concern to the lessors and AER management has oriented this business around surviving a 1-2 year period during which the Company is totally shut out of the capital markets. This is not to say that such a period of time would be sunshine and roses, but a 36% decline in the value of the equity in the absence of any data suggesting a deterioration in fundamentals suggests to us that the market perceives that a recession is likely an existential risk for AER, which we do not believe to be the case.
Another concern that we believe is prevalent is lease rate compression. It is no secret that the aircraft leasing space has attracted considerable capital over the last several years from yield-seeking investors in a low-rate environment. We’ve heard multiple market participants talk about secondary market transactions in which equity investors are accepting low-to-mid single digit returns (and sometimes worse, with optimistic residual value assumptions being the key to earning an ‘acceptable’ return).
There can be no question that secondary market lease rates have collapsed, but we do not believe that this necessarily condemns the larger lessors to abysmal returns for the foreseeable future. To begin with, much of AER’s $20.6 billion order book was placed during leaner times. We believe nearly $10 billion of the order book still represents acquired purchase orders from ILFC (which transaction was consummated at the end of 2013). While AER cannot command higher lease rates for its aircraft than would otherwise be possible from another lessor or third-party, AER can buy the assets better than is possible in today’s secondary market, allowing it to earn superior returns. As a consequence, AER will continue to be in a position to grow its book at attractive returns over the coming years as a result of orders placed over the last 5+ years.
In addition to the foregoing, AER (and the other large lessors) benefits from longstanding relationships with the OEMs that allow the Company to purchase new assets at significant discounts to what would be available for comparable individual assets in the secondary market. While there have been a number of smaller entrants that have participated actively in the sale-leaseback market (driving prospective returns lower) there are still only a handful of lessors (large, global players like GECAS, AER and Avolon) that can place multi-billion dollar orders for dozens of assets to be delivered 5+ years into the future. The ability to do so provides real value to the OEMs (who can build out their production schedule knowing that there will be well-capitalized hands into which those assets can be placed) and that allows the large lessors to buy assets better than secondary market participants can. Anecdotally, we’ve heard that dozens of participants will usually show up to bid on individual assets or small portfolios of assets, but just a few of the larger lessors will engage the OEMs on large, long-term commitments.
We have looked at a great many businesses and we would not describe this as the most enduring moat that we’ve come across, but having spoken to a wide variety of market participants (not limited to the lessors themselves) we can only say that the evidence suggests that this advantage currently exists and is likely to exist for some time yet. But in the event that such advantage does not persist, we take comfort in having a well-aligned capital allocator at the helm of AER. Here is CEO Gus Kelly on the 4Q17 earnings call in response to a question about M&A and asset sales:
“Gary, look, we're always looking at allocation of capital. There are 4 avenues for us. We can do sale leasebacks in the markets, we can buy from the manufacturers, we can buy another company, we can buy ourselves. I'm excluding repayment of debt, because we have delevered quite a bit over the last few years. And so we're always looking at what's the most attractive alternative. And we've been very disciplined stewards of capital. If we believe that buying ourselves is a greater benefit to the company long term, then we'll do that. But look, we look at all the different opportunities, be it sale leasebacks. If interest rates rise a bit, I think we'll see more opportunity there. And the OEMs, at the moment, they're fairly full. On the M&A, we haven't seen much yet in that regard. Over the last couple of years, we've looked at all the different processes, but we've been very disciplined, Gary. So you can see our behavior over the last 3 years and we didn't pull the trigger on any of the M&A processes and bought back 30% of AerCap instead.”
Since the beginning of 2015, AER has spent more than $3.5 billion on share repurchases (acquiring roughly 33% of the issued shares) with the stock trading at a meaningful discount to book value. The message from management has been consistent about not deploying shareholder capital into endeavors with insufficient returns. If the sale-leaseback or OEM opportunities do not provide a sufficient return on capital, we believe that AER will continue to return capital to shareholders, particularly in the form of share repurchases if the stock should continue to trade at such a large discount to book value.
Having said all of this, we think that these two investment risks (a market correction causing tightness in the capital markets) and compression in leasing rates putting downward pressure on lessor economics offset one another to some degree. In the prior downturn, the well-capitalized lessors were able to put long-term orders on the books at attractive rates and pick up additional business as lease rates widened and market participants pulled back. We believe that, to the extent the market does correct, it should be seen as an opportunity for AER to bolster its long-term return prospects by picking up share and placing attractive new orders at a time when weak hands pull back from the market. Conversely, we think AER will continue to focus on monetizing its order book and pursuing share repurchases (in part financed by attractive gains on sale of its existing portfolio which has been bid up) if the market remains competitive.
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