Description

Summary:

Aercap is a leader in an industry with attractive dynamics selling at a very slight premium to an understated (as shown below) book value.  There is a clear path to a 50% appreciation in book value by the end of 2018, when the company should be earning $7-8/share.  Hence, the stock should provide decent returns even without commanding a premium to book, which I believe is very possible assuming a continuation of strong operating performance.  If the stock traded at a 20% premium to book in three years, which seems pretty reasonable for a company with a solid record in all kinds of economic conditions, a culture of and demonstrated ability at capital management and solid returns the IRR would be in the 18% neighborhood.

Background:

I highly encourage interested readers to start with the VIC writeup by jso1123 from January, 2014.  The thesis has played out almost exactly as jso forecast. Subsequently, the stock has been a decent performer and, at one point last April, was up 45% from the date of the recommendation.  There are also useful industry comments in VIC analyses of Air Lease and Avolon Holdings, which was recently acquired by Bohai Leasing.  It is also well worth reviewing the slide deck from Aercap’s Investor Day last September, available on the company website, and also the comments from the meeting by CEO Gus Kelly. 

Industry Structure:

The aircraft leasing business really started in the 1970’s with Guinness Peat.  The roots of Aercap and General Electric Capital Aviation Services (GECAS), today the two largest factors in the industry with a combined 40%+ market share, both come from that Irish company.  CEO Gus Kelly notes that since the earliest days of the industry, there have been two very large factors, five genuine global platforms and lots of smaller players.  

Leasing has captured a growing share of a growing market. Not only is worldwide traffic growing about 5%/year, but there is an important replacement cycle:  By 2025 30% of the fleet will be at least 25 years old.  Currently leasing has a 40% share (up from 20% 20 years ago) and Boeing believes that should grow to 50% over the next few years.  

Even the airlines in the strongest financial position lease airplanes for a series of reasons:  First is simple availability to capital to fund massive purchases.  Second is residual value risk:  Airlines have a poor history of trading airplanes.  Third, and what Aercap management perceives as the factor that has become increasingly important in recent years, is fleet flexibility.  Airlines increasingly manage leases like a debt maturity profile with a certain percentage expiring each year.  They can add and shed leases to adjust more readily to market conditions.  Aercap is an extremely active participant in the market, on average executing one transaction every day.

Asset Value:

Book value at 9/30 was $40.80/share. Independent appraisers have calculated that the market value of the owned aircraft is $3.3 billion ($16/share) above the carrying value on the balance sheet.  As a check on this number, Aercap has a long history of selling aircraft at a premium to book—400 planes since 2005 with an average gain of $1.6MM/plane.  At the same time, total net impairments for the company since 2006 have been only $53MM.  Several other players in the industry, including ILFC before the acquisition, have had to take meaningful write downs.  

Beyond the current fleet, there is value in Aercap’s order book.  On the announcement of the ILFC acquisition two years ago, CEO Kelly called its order book the “jewel in the crown” and added that it was “deeply in the money reflecting further embedded value [in the deal].”  Management has not yet quantified this but hinted at the Investor Day that more details would become available over time.  ILFC was an early and large customer for both the A350 and 787 and presumably received very attractive terms.  These planes largely enter the Aercap fleet from 2016-18; all of the 350s have been placed with customers and 80% of the 787s. Aercap also has large orders for the A320 NEO (200 firm plus 50 options), 100 Boeing 737 MAXes and 50 Embraer (plus 50 optioned) E2s.  

Balance Sheet/Rate Exposure:

Aercap levered up to acquire ILFC but has delevered rapidly and is almost at its target debt/equity ratio of 3:1, at which point it should be eligible for an investment-grade rating.  Management understands that a stable capital structure can produce competitive advantage:  In the aftermath of 2008-09 it was one of only a couple of industry participants with access to capital and profited by it.  Additionally, a consortium of Chinese investors had negotiated a deal with AIG to purchase ILFC; the financing did not come together and only then did Aercap get involved.  

70% of the debt is fixed and the average term approximates the average lease term.  6% is capped or swapped and the residual 24%, while floating, has a natural hedge through floating rate leases or other means.  The CFO projects that an 100 basis point rise in rates over the next year would create a $30MM rise in costs (driven largely between current rates and the strike rates of the caps, which would drop sharply thereafter.  Historically there has been a very good correlation between interest rates and the lease rates that Aercap commands. 

Entering 2015 AIG owned 77M shares of Aercap but sold it all in two tranches:  first in June (in which Aercap repurchased $750MM in stock, funding $500MM with sub debt which AIG took back) and the balance in August. While the stock has not done poorly this year, I think one reason it has not done better is that there were a lot of AIG owned shares for the market to absorb.  Management has an orientation toward share buybacks and, barring exceptional opportunities to acquire aircraft, will probably buy back more stock once the target leverage ratio is achieved, which should be  reached by the end of Q1.  It is worth noting that the long-term plan also calls for at least $1 billion in annual aircraft sales.  In fact, there were almost $2 billion in sales in 2014 and this year the company is on track to between $1.5 and 2 billion. This provides additional financial flexibility, ability to tailor the portfolio and opportunities for profit. 

Guidance and Valuation:

Rather than paraphrase management, here is the CFO at the Investor Day in September:

Okay, let me get into the guidance. Let me start first with contracted portfolio growth. Now, you've heard us in the past talk about 4.5% contracted growth. Now that was from the end of 2014 to the end of 2017. Now let's roll forward one additional year.

So from the end of 2015 to the end of 2018, as Ted pointed out, we have contracted growth that would grow our top line effectively 5% to 6%. Next year, we have roughly $5 billion of CapEx committed. And in 2017 and in 2018, we have $6 billion in each of those years. We have depreciation, economic depreciation of just over $2 billion per annum. If we continue selling $1 billion plus of aircraft per year, all of that would translate into a portfolio of $37 billion at the end of 2015, growing to $44 billion by the end of 2018.

In the coming years, we expect our portfolio yields, net of depreciation, to remain relatively stable. The average age of our portfolio right now is 7.7 years. As the order book delivers, and as the old aircraft from the IOC portfolio run off, that average age will drop to less than seven years. This will continue to decrease the risk profile of our portfolio.

That will also drive a change in the topline yield as well as the depreciation rate. Now you can see in 2015, the net of these two rates is roughly 7%. Going forward, both the topline yield and depreciation rates will decline slightly, but again, the net of those two amounts will remain relatively constant -- 6.8% to 6.9%.

We currently get roughly $100 million of profit contribution from the maintenance portion of our business. Now, this is the result of the amount of maintenance revenues that we recognized. Now this is the revenues effectively that we collect from lessees and do not have to reimburse lessees with. So we are averaging around $250 million of maintenance revenue per annum right now.

We have costs -- leasing costs of roughly $150 million, with a contribution of $100 million, is expected to continue now for the next few years, and expected perhaps to even grow to $150 million to $160 million by 2018. This profit contribution as a percent of average lease assets is roughly 27 basis points today. And we would grow to $150 million to $160 million, that would grow the 27 basis points another 10 basis points to 37.

Other expense items, we expect modest variation. We are currently experiencing interest costs all-in of roughly 3.6%. As the impact from purchase accounting and the fair value of the ILFC debt runs off, our interest costs will stabilize at roughly the 4% level. The 4% level is really the blended costs of debt that we are raising in the marketplace today. Other costs, SG&A is expected to remain stable and flat in the coming years. And the tax rate of 13.5% in 2015 is expected to decrease to 12.5% to 13% in the coming years.

Gus pointed out again the rapid deleveraging that we've had since the acquisition date. The original plan was to achieve 3-to-1 by the end of 2016, early 2017. And obviously, we are going to get there much quicker by the end of this year. Once we achieve 3-to-1, we'll begin creating excess capital of $500 million or more per annum. And going forward, we expect to run the capital structure in the [decree] range of 2.7 to 3-to-1.

You've seen this slide before. Simple slide just showing you, obviously, the alternative uses for this excess capital -- reinvesting in the business, buying additional aircraft or returning capital to shareholders, like buying back shares. So from 2016 to 2018, we expect to generate $1.5 billion of excess capital or more. Either we invest that in additional aircraft purchases or buying back shares. And most likely it's going to be a combination of both. But this excess capital should be able to drive an additional 5% earnings-per-share growth from now until the end of 2018.

And this slide tries to bring all the components together. This is the earnings-per-share growth -- or the expected earnings-per-share growth from the end of -- from 2015 to 2018. Again, as I just repeat the components -- 5% to 6% would come from contracted growth, growth that we already have in place. The use of excess capital is to drive another 5% earnings-per-share growth. And then the impact from interest expense and other portfolio modifications, if you will, will leave us with a earnings-per-share growth of 7% to 9% -- again, from where we are at in 2015 to where our expectations are in 2018.

Note that growth in 2016 should be more muted than that in the next two years.

While earnings undoubtedly are important, I believe it makes more sense to evaluate Aercap on a price/book basis, as gains on sale can be lumpy and distort earnings.  As noted above, I believe book value should grow to roundly $60/share by the end of 2018.  

Risks:

1. Hedge fund concentration.

2.  Worldwide depression.

3.  Pandemic or cyber terror.  

Catalyst

1.  Investment grade rating.

2.  Greater understanding by the investment community.