Description

Aercap is the world´s second largest airplane leasing company, with ownership of just over 1,000 planes, behind GE Capital Aviation Services (GECAS). In 2014, Aercap became a major player in the sector after closing the acquisition of ILFC (at the time the second largest player) from AIG. AIG was a forced seller and current CEO, Aengus Kelly, orchestrated a terrific deal for Aercap shareholders. After taking more than $5 billion in impairments, AIG decided that it was in the best interest of the company to sell the air leasing division. Aercap agreed to acquire the company for 0.5x BV or less than 0.9x EV/appraised aircraft value, in a combination of 45% shares and 55% cash. Benefits of this deal were huge: cost & tax synergies, benefits of scale and a highly valued (in the money) order book. The market quickly recognized the brilliance of this transaction, as the stock price nearly doubled in a few weeks from ~$20 to the low $40´s.

At the time of closing (May 2014), AER traded at ~1.3x BV and 10x earnings. Since then, the stock price hasn´t moved from the mid 40s, but fundamentals have materially improved. Starting with leverage, debt to equity has been reduced from 3.7x to current levels of 2.7x and this has enabled the company to gain an investment grade rating. Share count has been reduced from 215 million in June 2014, to 176 million in March 2017, or 22%. During this same time frame BV per share has grown from $35.28 to $51.20, or 45%. In addition, the integration risks of the ILFC acquisition are now past and the transaction has proven to be a success.

So the company is in a better position now than 3 years ago, but the stock price is the same. This makes the stock much more attractive. Currently, AER trades at 0.9x BV and 7x earnings. In addition, BV is lower than the appraised value of the aircraft. Utilizing the appraised value of the fleet, BV would be $68 and price/appraised BV 0.7x. Also, appraised value might be lower than the real value of the company´s assets since these assets have contracted leases that have value and financial investors are willing to pay a premium for these planes with contracts. This is consistent with the gains Aercap has been realizing while selling aircraft to third parties (in practically all cases with attached leases). The company knows that their value is not reflected by the market price and is taking advantage of this discrepancy by buying shares at a discount using earnings and net proceeds from the sale of assets at a premium. As stated by management:

“In the current environment, we believe that effectively purchasing our own fleet through share repurchases generates greater value than purchasing aircraft in the open market.”

Air leasing is a spread business in which lessors buy airplanes from the OEMs (primarily Boeing or Airbus) and then lease these assets to airlines. In exchange, lessors get a monthly rent that should cover the main costs (interests, depreciation and SGA) plus an adequate spread.

The major benefits for an airline to lease an aircraft instead of directly buying it are: eliminates residual value risk, large lessors have purchasing power due to scale, high cost of capital for the ordinary airline and fleet flexibility. The difference of air leasing from a traditional spread business is that solid lessors add significant value.

There are also significant competitive advantages for large players with experienced management teams in this niche. In terms of scale, this is useful while buying aircraft from Boeing and Airbus since they can get better pricing and also enables players to have better information of the market since large players do more transactions (i.e. Aercap did 105 aircraft transactions during Q1 2017) which helps at the time of relocating assets. There is also a lot of capital that wants to come into the industry, but few management teams with the experience and ability to manage a fleet. Aengus Kelly is in my opinion one of the top CEOs in the world. By looking at growth in BV since he took over at Aercap and listening to his quarterly calls, an investor can understand his talent. Mr. Kelly has generated significant value for shareholders and thinks like an owner with his focus on maximizing value per share. He is also significantly invested in Aercap, with approximately $100 million worth in shares (most of his net worth).

So why is this stock cheap? No business without major headwinds trades at 7x earnings. I think there are 5 major concerns that have kept this stock down:

1)      Chinese capital: In 2007, the Chinese regulator for financial institutions reduced regulations on aircraft leasing and since then these players have been expanding their presence in the space. Mr. Market fears that this will cause yields to fall and reduce profitability for the whole industry while increasing risk. For several reasons, we believe this will not have the impact Mr. Market thinks it will. To start, consolidation over the last few years has left 3 players with major global scale (GECAS-13% market share; Aercap-12% market share & HNA-7% market share). Since there are major benefits to scale, we believe that these players have a competitive advantage. Second, the industry has only two major suppliers of planes which control the quantity of aircraft that comes into market. The order books of the largest players compared to the rest of the market show that they shouldn´t lose a significant amount of share (Air Lease is another emerging player that also controls a significant share of the outstanding order book). Third, the market is growing at 5% a year, so just to keep up with demand the industry needs a significant amount of capital. Finally, if this new capital wants to grow through purchases of used aircraft then they will have to pay a premium and Aercap is a willing seller at high prices. Also, if they want to grow through acquisitions, the large players might benefit (HNA bought Avolon for 1.6x BV and CIT for 1.2x BV, which are large premiums to the current AER stock price).

2)      Residual Value: The market has focused on the risk that residual values fall and this leads to major impairments. This is a real concern, but there are various mitigants in the case of Aercap. First of all, we believe investors don´t appreciate the value of the contracted cash flows. For example, the average remaining lease term for Aercap is 6.5 years (from 6.1 years at 3/31/16). This provides significant visibility, and historically the company has collected significant breakup fees in case the customer cancels the contract. Also, aircraft with leases can be sold at a premium to replacement value in the market, and Aercap has been successful doing this. They have been selling older aircraft in an effort to reduce the average age of owned fleet (currently at 7.3 years from 7.7 years at 3/31/16), while realizing gains and using the proceeds to repurchase undervalued stock. Lessors do constant appraisals and the appraised value of Aercap´s fleet is much higher than book value at the moment. This gives us confidence that there is a margin of safety, in case value for aircraft declines. During the GFC, average narrowbody asset values declined roughly 20% and wide bodies 17% (older planes had larger drops in value, those older than 10 years dropped 35%). There is significant variability between models and age of the aircraft, but this gives an idea of how much asset values can fall in a crisis. Current estimates, indicate that the appraised value is roughly 10% higher than the value reflected on the balance sheet. Assuming a 20% decline, which might be extreme since these are the peak to trough figures during the crisis, the appraised value for Aercap´s fleet would decline to 90% of balance sheet value. In this extreme case, appraised value per share (assuming current leverage levels) would decline roughly 35%. This is a steep decline but the real value of the aircraft with the contracted leases should provide protection. During the crisis, Aercap didn´t have major impairments. BVPS grew 17% in 2008 and 13% in 2009. Leases provided support for the value of the assets and in the case of defaults, planes were relocated in most cases (portfolio utilization remained over 99%).

3)      Oversupply of Aircraft: As orders for aircraft have ballooned, investors are concerned that this will results in a glut. About 18 months ago, Delta´s CEO commented that there was a wide-body glut and that they were able to buy a 777 for ~$8 million. The reality is that we don´t know the conditions of that particular aircraft and other transactions indicate that these are not ordinary selling prices (e.g. Aercap has recently sold 777s at a gain). Traditionally, OEMs have kept deliveries consistent with demand growth through the cycle. Orders on the other hand are much more cyclical. OEMs know they have a cyclical customer base that will constantly defer orders due to the nature of their business. The Boeing & Airbus duopoly serves as a check to keep supply at equilibrium, which is helpful for the leasing industry. In addition, current global load factor of ~81% indicates that there is robust demand for ASMs and no excess supply, and this figure has been improving in recent years. This is contrary to the view that there is a growing base of aircraft supply. Some think that the fall in oil prices can push airlines to fly older airplanes for longer. This might happen but after some years there are major costs associated with the maintenance of these assets. Historically, the retirement of old aircraft has been roughly 1.25% of global fleet. In addition, newer aircraft also provide a better experience for the customer. Global air traffic is expected to grow by ~5% per annum for the next 20 years, which should also help alleviate in case there is a real “glut” (which we don´t see at the moment as a real threat).

4)      Overearning: Some investors think that Aercap is overearning, since they believe there is no reason for this type of company to earn a 12-15% ROE. For the past 10 years which included the GFC, Aercap´s ROE has averaged 13%. As explained before, book value might be understated which results in an artificially high ROE. In reality, current market value of the Aercap fleet is much higher than book value. This explains the elevated ROE levels. If we would adjust book value to market value of the assets, then ROE would be significantly lower (closer to 10%).

5)      Credit Risk: Airlines are the customers and this customer base has a history of bankruptcies. This makes investors think that in case of a deterioration in airline profitability, lessors will get hurt with defaults. However, one major benefit of the asset class is that airplanes can be moved easily to different locations where there is demand. If an airline defaults, the asset can be allocated to another customer in a relatively easy way (if there exists demand for the asset). Between 2007 and 2013, credit losses were ~0.2% of assets, which is quite low in a difficult environment. Defaults were higher at 2.5% of assets, but the ability to repossess and relocate the aircraft kept losses low. Financial performance during the crisis was very solid as well, with low-teen ROEs, no large impairments and rapidly growing BVPS. The stock traded terribly, but this was mostly due to specialty finance companies as a group trading as if all of them were going out of business.

At current prices, we believe an investment in Aercap is attractive for the following reasons:

Ø  Company should earn an ROE of 13%, and trades at a 10% discount to book value. Selling aircraft at a premium of ~10% and using that capital for repurchases, results in a powerful combination that should drive TSR over current ROE, as BVPS grows at a faster rate. For example, in 2016 (which was an ordinary year for the company) BVPS grew 17%.

Ø  Current management is focused on driving shareholder value, instead of growing and building a large company. They have been flexible by purchasing planes when it made sense, acquiring ILFC at the right moment and with the depressed stock price they have been shrinking the equity. I wouldn´t be surprised that if they get an attractive offer, they would be willing sellers.

Ø  Aercap is the largest public player, with the best management team (in my opinion), has an investment grade credit profile, a valuable order book, domiciled in Ireland (low tax base) and a history of generating value, yet trades at one of the lowest multiples in the air leasing sector. Current average PE for the sector is 9.5x, while Aercap trades at 7x. There have been various recent acquisitions in the space at premiums to BV, but Aercap trades at 0.9x BV. We believe the stock is cheap on any metric (PE, BV, EV/Appraised Value, EV/Market Value of Aircraft with Attached Leases, etc).

If there is no multiple expansion, then Aercap can continue repurchasing undervalued stock and growing BVPS at a faster pace than ROE. In case we get a multiple that closer resembles reality, then investors will do well in the short term. In both cases, returns should be satisfactory. 

Catalyst

-Large player (likely Asian, similar to the CIT & Avolon transactions) acquires AER

-Aercap selling older aircraft at faster pace to finacnial inverstors and increasing repurchases below IV