Description

THESIS

Air Lease Corporation (NYSE: AL) has faced numerous challenges in recent years, but we contend that it:

1. Is a better business than most equity investors realize

2. Has significant industry-level tailwinds

3. Is poised for improvement in asset-level returns and ROE

4. Benefits from lower intermediate- to long-term interest rates

5. Has a clear self-help opportunity for value creation

6. Comes with a free call option on Russia recoveries

DESCRIPTION

AL is the #2 player in the global commercial aircraft leasing market, with $26.2B of book value of flight equipment and 541 managed commercial airplanes. Founded in 2010 by Steve Hazy and John Plueger, AL is the second act for Hazy, who is credited as being the godfather of the modern aircraft leasing industry. AL raised $3.3B of debt and equity in 2010 and has grown steadily and organically to 8X its original size. Its portfolio of aircraft is about 50/50 Airbus vs. Boeing, and 70/30 narrowbodies vs widebodies. 

AL is an order-book lessor, meaning that it acquires aircraft from the two major OEMs for future delivery as opposed to purchasing aircraft in the secondary market. AL places these new aircraft on lease with airlines around the world. The raison-d’etre for aircraft leasing is that airlines are generally non-investment grade credits with high borrowing costs. They undergo financial restructurings with high frequency and tend to be very susceptible to regional economic slowdowns. On the contrary, aircraft lessors tend to have investment-grade credit ratings, enjoy a low cost of borrowing, and operate in a global market for their assets. Lessors are thus able to make money by purchasing aircraft from the OEMs, financing those purchases at modest leverage (2.5x target for AL), and leasing them to airlines at a positive spread. Lessors also have the advantage of being able to pull aircraft from a defaulted airline in one region and move it to another carrier in a region with healthier economic or demographic trends. A lessor is thus successful if it can acquire aircraft from the OEMs at good/fair prices, keep its borrowing costs low, underwrite airline credit effectively, and maintain relationships with airlines around the world for placing owned aircraft on lease.

By this definition, AL is a successful lessor. It is among the largest customers of the OEMs and enjoys favorable pricing on its order positions. It has the lowest borrowing costs among non-bank aircraft lessors. It has the most experienced leadership team in the industry with a large rolodex of customers and a core competency in underwriting and lease structuring (this is a qualitative statement; judging underwriting ability is complicated by the COVID-19 pandemic, which put nearly every airline in the world into financial distress).

CURRENT SITUATION

AL launched the business to tremendous fanfare, but excitement about the stock has steadily waned. While AL once garnered a premium valuation to its primary peer AerCap (NYSE: AER) due to its faster growth and perceived best-in-class management team, the stock now trades at a depressed level on an absolute and relative basis. See Figure 1.

Figure 1. AL Historically Enjoyed a Premium Valuation but Is Now at a Discount

Source: Bloomberg

One reason for this is that the company has faced a series of fundamental headwinds, including the pandemic, an aggressive Fed tightening cycle, and a war in Ukraine that led to 3.5% of its fleet (or 11% of its equity) getting confiscated by Russian airlines. If only one of these were not bad enough, the combination of all three has caused even the most unflappable of investors to question his thesis. This is evident in the shareholder roster, with many esteemed long-only firms bailing out of the stock over the last year (see Figure 2). Returns, as measured at the asset level or the corporate level, have also declined significantly from pre-pandemic levels due to the aforementioned headwinds. A crude heuristic for specialty finance companies is that they must generate a 10% ROE in order to trade at 1.0x book value. With a current ROE in the high single digits, AL justifiably trades at a discount to its book value.

Figure 2. Heavy Selling Pressure from Prominent Long-Only Firms

Source: Bloomberg

Another reason for the capitulation in the stock is that the management team has done a poor job of managing expectations. Sell-side analyst estimates routinely predict unrealistic earnings growth, and estimate revisions heading into and out of quarterly earnings reports have been consistently and materially negative. See Figure 3. AL refuses to provide guidance on KPIs, such as lease rates, margins, ROE, or EPS. The management team seems to derive some pleasure from having consensus estimates that suggest EPS growth will be strong, even if it knows that it will fall short of those estimates. 

Figure 3. AL EPS Consensus Estimate History (Red Lines)

A final reason is that the analyst and investor community has low personal regard for the AL management team. While most observers have respect for Hazy’s career accomplishments, they question how hard he is really working at age 78. CEO John Plueger is a polished executive but seemingly redundant with Hazy still in the Executive Chairman seat and making all of the deals with airlines and OEMs. At age 69, Plueger is presumably also nearing retirement. As CFO, Greg Willis has maintained good relations with debt rating agencies and fixed income investors but has never been popular with equity investors due to his standoffish demeanor and unwillingness to provide meaningful details on KPIs, such as lease rates or unit-level IRRs. He has also done a poor job of asset-liability management, routinely funding his long-dated aircraft assets with shorter-dated bonds and credit facilities. The company also has a weak investor relations function, which, as mentioned above, has routinely allowed sell-side numbers to decouple from reality.

OPPORTUNITY

1. AL is a better business than most equity investors realize

While there are plenty of legitimate criticisms of AL and its management team, the stock performance and valuation belie the remarkable stability and consistency of the business model. The company survived a brutal depression in the aviation industry beginning in 2020, and it endured the shocking loss of 3.5% of its assets due to international sanctions against Russia, yet it still produced $11.86 of cumulative GAAP EPS from 2020-2023 (which equates to 25% of its 12/31/19 book value). See Figure 4.

Figure 4. AL Historical Book Value per Share

Source: Company Filings

AL also maintained a solid BBB rating through this tumultuous period and enjoys the tightest debt spreads among non-bank aircraft lessors, as shown in Figure 5. Also worth noting, AL maintains this investment grade rating while many other leasing companies that are valued much more highly in the market (e.g. URI) are unable to achieve such a rating. The principal advantage of having investment-grade ratings is access to debt capital during periods of stress, and, indeed, AL just survived the ultimate stress test to its business without any interruption to its access to debt. While other leasing companies have enjoyed much more robust returns in recent years, we conclude that AL is a better business than most equity investors realize.

Figure 5. Aircraft Lessor Issuer Credit Spreads (bps)

2. Industry headwinds have shifted to tailwinds

Industry fundamentals are improving, with air travel above or approaching pre-COVID levels in nearly all geographies, as shown in Figure 6. Secondary-market aircraft values are also increasing, as shown in Figure 7. Consistent with this trend, AL saw gains of 14% on its sales of aircraft in 4Q23, which is well above its historical average of 8-10%. Lease rates are also increasing and have surpassed pre-COVID lease rates, as shown in Figure 8.  OEMs are also sold out through the end of the decade, creating scarcity of supply that should support the value of AL’s order positions.

Figure 6. Scheduled Flights for Week Beginning March 10, 2024