Description

How do you increase the return for what is already a reasonably good business? You buy back a bunch of stock at roughly half of book value and you keep doing it with free cash flow.

Aircastle (AYR) owns and leases modern jet aircraft. The company currently owns 155 planes that are leased out to airlines around the world. AYR does not operate the planes, deal with unions, have fuel price risk or do anything that remotely resembles running an airline. Rather, it is a bunch of finance guys in Connecticut who are running a business based on the concept that they can borrow money more cheaply than airlines and then lease aircraft to those airlines. These airlines tend to be in emerging markets or in need of shorter term planes (4.9 year average lease term) and prefer to lease rather than own. Therefore, AYR has the attributes of a leasing company and not those of an airline. Compared to most leasing companies, AYR’s leases tend to be longer term and globally mobile which reduces risks caused by regional declines in demand and utilization.

I think that a commodity leasing business should be valued based on some multiple to book value. What makes this strange is that AYR’s 2Q book value is $20.5 and the shares closed at 11.62 leading to the shares trading at 56% of book value. Even more importantly, the company continues to aggressively repurchase shares (12% in the past six quarters) which is rapidly increasing book value per share. The company is also growing organically using retained earnings.

Normally, when you can buy something at 56% of book value, you probably don’t want to own it. AYR has consistently earned a mid-teen return on equity with cash flow coming in a bit higher due to the nature of working capital in the industry. It’s not a bad business and not particularly leveraged for a financial company (net debt to equity is 2.0). It even grows at a high single digit rate.

I’ve spoken with people in the airline industry, airline leasing industry, and read a bunch of analyst reports. As with most things in life, everyone has their own opinions on the market, lease rates, and future jet values. However, no one has a particularly bearish view of things outside of normal macro-economic pessimism. Passenger seat miles tend to grow at a GDP+ rate and were largely unaffected by 2008/2009 (+0.7% and -1.9% respectively). More importantly, during 2008/2009, AYR did not experience a high number of planes put back to it. Despite short term concerns related to everything related to financial companies, AYR went through the whole crisis unscathed besides reducing the dividend to retain short term liquidity.

I should point out that earnings per share jump around a bunch each quarter due to impairments to assets, asset sales, changes in maintenance revenue, etc. I think that this is partly responsible for the very low multiple as most financially engineered companies have rather consistent quarterly numbers.

Here's where it gets interesting, Aircastle recently ordered additional aircraft for $200 million, which will serve to continue to grow their earnings. In the first half of 2012, they earned $0.68 a share, but that also includes a $10 million impairment on an aircraft, add that back, and earnings come to around 80 cents a share for the first half before minor adjustments for tax. I should point out that this annualizes to $1.60 a share for the full year, but this is deceptive for two reasons. Firstly, there will be more planes in the second half of the year (those added in the first half that haven't had the benefit of being in the portfolio at the beginning of the year and also new planes to be purchased in the third quarter), secondly, the company just refinanced their debt in a way that will save them approximately 50 cents a share each year. Add it all up, and I figure that run-rate earnings are better than $2.00 a share, and you're not paying much more than six times earnings for the shares. I should naturally point out that it is difficult and unwise to try and get too precise on the earnings forecast because of the volatility in earnings caused by impairments, gains on sale, and maintenance revenues.

Despite leasing being something of a commodity business, the size, scope and diversification of AYR’s assets and leases is beginning to create something of a moat as AYR is able to borrow at increasingly lower rates while being able to increase utilization by being flexible in aircraft positioning.

In summary, I’m not going to tell you that AYR will do heroic things as a business, but it will likely continue to earn a mid-teen ROE while growing organically at a high single digit revenue rate. The company will also continue to retire shares at a discount to book, which will substantially increase book value per share. With numbers like that, it probably shouldn’t trade at just over half of book. Finally, the company pays you 15 cents a quarter to sit and wait for them to continue to close the discount to book value. That works out to about a 5% yield. In terms of low risk ways to make money in a market that is largely priced for perfection, this seems better than most.

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