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

Figure 7. Narrowbody Aircraft Values Over Time

Figure 8. Airbus A321 Lease Rates Over Time

3. Asset-level returns will soon improve, leading to higher ROE

These industry tailwinds will translate into improving asset-level returns and, in turn, ROE for AL. In the early days of AL, it enjoyed gross lease yields of north of 10%, and a pre-tax ROE in the low teens. Gross lease yield is basic rental income divided by the cost basis of the aircraft. This is the best measure of asset-level return for a new aircraft, because it ignores the impact of depreciation on the aircraft’s value. Net lease yield, with is basic rental income divided by the depreciated value of the aircraft is a less reliable measure of asset-level return because it is dependent on the aircraft age and thus favors older, depreciated aircraft. Pre-tax ROE is the most important measure of corporate-level returns, because it accounts for the fact that aircraft leasing firms generally do not pay cash taxes as a result of accelerated depreciation for tax purposes. So long as an aircraft lessor is growing, it will typically not incur cash taxes on its income. 

A decade of rock bottom interest rates and limited geopolitical conflict attracted significant capital into aircraft leasing, and this competed lease rates down from the levels that AL enjoyed in its early years. Most pernicious among these inflows were those from Asian banks, which enjoyed not only low borrowing rates but also low expectations for equity returns. As a result of this competition, industry lease yields fell from the historical 10%+ level to something far lower in 2016-2019 (exactly how low is unclear, but 7% is a reasonable assumption, based on our discussions with industry participants). Then, during the pandemic, lessors were forced to accommodate requests for lease-payment concessions from nearly all global airlines. This led to some short-term re-pricing of existing leases that may have previously been at healthy lease rates. Finally, demand for aircraft was depressed due to the lack of air travel in 2020-2021, and lease rates on aircraft leased during this period reflected the soft demand environment. We understand that AL re-priced 20-25% of its portfolio to lower yields during the depths of the COVID-19 period. It also placed substantially all of its 2022-2023 aircraft deliveries on lease during this period, meaning the gross lease yields on these aircraft reflect soft market conditions. These factors are all reflected in the current gross lease yield on the AL portfolio.

As shown above, market conditions have tightened considerably over the last two years, and lease rates have rebounded to attractive levels once again. Based on our conversations with industry participants, we believe the gross yields on spot leases are in the neighborhood of 10% and moving higher. This is corroborated by recent commentary from appraisal firms Cirium and Ishka Global. As shown in Figure 9 below, a gross lease yield of 10% translates into a pre-tax IRR (fully loaded for opex) of roughly 13%. As aircraft with these lease yields deliver over the coming one to two years, the average gross lease yield on AL’s portfolio will move higher.

Figure 9. Aircraft Lease Unit Economics – New Aircraft

Importantly, leases that were written on aircraft during the fallow period of 2020-2021 will progressively drive better pre-tax ROE as their corresponding aircraft depreciate. As shown above, the pre-tax ROE of an individual aircraft steadily drifts higher over time, assuming constant leverage (which is a reasonable assumption for AL, since it manages to a leverage target of 2.5x). The effect of both higher gross lease yields on the portfolio and the passage of time will combine to drive AL’s consolidated pre-tax ROE back to respectable levels (e.g. 10%+) over the coming years. See Figure 10.

Figure 10. AL Gross Lease Yields

Source: Company Filings

4. AL is a beneficiary of lower rates

CFO Greg Willis has never match funded the assets and liabilities of AL since he took over as CFO, and the company has paid the price for this during the rising-rate environment that began in 2022. Because of the depreciating nature of an aircraft, match funding requires a ladder of small amounts of short- and intermediate-term funding along with a large bullet at the end of the lease term. When considering upcoming bond maturities and variable-rate debt compared with contractual lease payments, Willis allowed the liabilities of the company to re-price faster, to the tune of about $900MM in 2023 and $3.2B in 2024. See Figure 11. Aggressive use of the company’s revolving credit facility, which bears interest at a floating rate, in the last two years has exacerbated this mismatch. However, if long-term interest rates have peaked during this cycle and short-term rates follow the forward curve, AL will benefit from lower interest expense in the coming quarters. If AL were to receive delivery of a new aircraft with a 10% gross lease yield and a 1% lower cost of debt, it would increase the pre-tax IRR on that asset by more than two percentage points to 14.7%.

Figure 11. AL Asset-Liability Management

5. AL has numerous self-help projects that can create value for shareholders

Godfather or not, Hazy has taken a back seat to Aercap’s Gus Kelly as the industry’s thought leader, and investors have begun to think of his involvement in AL as more of a liability than asset. While Hazy works the air show and conference circuit, making keynotes with regularity, he seems to have little interest in speaking directly with investors or taking feedback on how to improve AL’s stock price. His intransigence about not offering financial guidance is particularly confusing considering the visibility the company has into its future contractual cash flows and the fact that AL’s closest peer, AER, gives guidance on virtually every line of its income statement. See Figure 12. During a time of significant transition in the business, investors would benefit from management laying out a clear path to improving returns. Hazy has indicated that lease rates have improved, and he comes across as giddy about how attractive lease rates currently are, but he refuses to quantify the lease rates or provide any timeline over which investors will see those lease rates in the published financials. Hazy is exhibiting poor leadership on this topic and revealing himself to be out of touch with his shareholders. His rolodex brings a certain level of value to AL, but shareholders are right to question whether Hazy should retire and turn the reins over to a leader with more of a shareholder orientation, like Gus Kelly. 

Figure 12. AER Financial Guidance

Source: AER 4Q23 Earnings Presentation, Slide 13

Perhaps a different set of incentives would motivate AL’s management to adopt more of a returns focus. A look into management’s incentive compensation structure in Figure 13 reveals no mention of returns. Instead, the bonus plan has a heavy focus on revenue, which is more dependent on delivery of new aircraft than anything else, adjusted pre-tax margin, which is heavily influenced by episodic gain-on-sale income, and placement of aircraft far into the future. These incentives rewarded management for placing 89.8% of its scheduled 2022-2024 deliveries on lease in a weak leasing market, with no governor on lease yields or ROE. The long-term incentive plan has 50% of the weighting in book value growth, which could be a good proxy for ROE, but the hurdle for management to achieve in order to hit its target payout was 8.25% growth over three years. 8.25% growth in book value over three years, even after accounting for the scheduled dividend payout, implies a realized ROE of 4.2% over that period. Clearly, AL’s board, and specifically its compensation committee, could use some help thinking through how to motivate its management team. The equity market has clearly spoken that recently-produced returns are too low. An update to the compensation plan might drive a better outcome for shareholders.

Figure 13. AL 2022 Compensation Program

Source: Company Filings

Capital allocation is another opportunity for improvement at AL. Historically, AL has used virtually all of its cash flow to purchase new aircraft from its order book. The organic growth that the order book provided was once one of the key investment merits of AL, and the stock’s premium valuation reflected that growth story. While there is still plenty of room for growth (AL is less than one-third the size of AER), the wisdom of committing such a large percentage of internally-generated cash flow to purchases of new aircraft is questionable. The equity market has not rewarded that future growth with a high multiple in many years (if ever), and buying new aircraft at 1.0x book value when AL’s existing portfolio trades at 0.77x book value is a clear misallocation of capital. Of course, order positions are placed years in advance, and AL management cannot know where its stock will be trading when the orders finally deliver, but it is fair to say that leaving no flexibility to repurchase its own shares when they are materially cheaper than new airplanes is a poor business decision. AER owes its premium valuation, in large part, to its demonstrated willingness and ability to repurchase its own stock below book value. Recent comments from AL management suggest that this dynamic could soon be changing. AL has an opportunity to sell more of its airplanes or monetize its future order positions as a way to free up capital for share buybacks. Such a move would provide important technical support for the stock and signal a shift to a more shareholder-oriented capital allocation philosophy. Provided that management maintains its leverage around its stated target of 2.5X debt-to-equity, share buybacks should have no impact on its investment-grade ratings, as AER has aggressively repurchased stock over the last 12 months and still has positive outlook from both Moody’s and S&P. 

As mentioned above, AL has long struggled to keep sell-side numbers in check. The sell-side analysts following AL are a mix of aerospace and defense analysts and specialty finance analysts. Most of them are following AL simply for the read-throughs to their core coverage names. Few do real work on AL, specifically (take a look at the Citi analyst’s model to see how little effort is being put into covering this company). Still, a strong IR professional could manage the obvious mistakes out of sell-side models and bring consensus numbers to something closer to reality. AL clearly needs a better IR professional. However, another way to prevent the continuous negative revision cycle that AL has faced for years would be to provide more guidance on KPIs. Given the contractual nature of AL’s business, there really is no excuse not to provide more guidance.

Another potential source of value creation is increased vigilance on SG&A. As shown in Figure 14, the company has seen a considerable increase in SG&A as a percentage of lease revenue since 2018. Management blames higher insurance expenses following the Russian confiscation event. While true, most large companies have faced material inflation in input costs since 2020 and have managed through by pruning in other areas. A layoff or other cost program would provide evidence that management is conscious of improving returns.

Figure 14. AL’s SG&A Trend

Source: Company Filings

6. Russia recoveries are a free call option

AL stands to recover a meaningful portion of the $802MM of losses it incurred when Russian sanctions led to confiscation of 21 of its airplanes in 2022. It did, in fact, recover $67MM from Russian insurance companies in 4Q23, but this leaves several hundred million to go. At 0.77X book value, recovery of value for these aircraft does not appear to be embedded in AL’s valuation, despite clear evidence that recoveries are occurring. This is a free call option worth $5 per share of after-tax book value, or 11% of the current stock price. Importantly, any future recoveries would reduce AL’s leverage ratio and increase cash available for share repurchases.

VALUATION

As shown in Figure 15, AL trades at 8X 2025E GAAP EPS and 0.77X TBV. This makes it the cheapest stock in the peer group on multiple dimensions. With the industry tailwinds, improving asset-level returns, and call options on self help and Russia recoveries, there appears to be minimal downside to the stock at this level. If management is unable to seize any of the opportunities presented above, then the company will still produce a 7% ROE in 2024 and a higher ROE in each of the next several years. As the ROE improves, the fundamentally-justified P/B ratio will follow, and the total shareholder return should benefit from both accretion in book value and a better valuation. If, over the next twelve months, AL delivers the consensus 7% ROE (2% dividend yield and 5% growth in book value), and the P/B moves from 0.77x to 0.85x (still a healthy discount to peer AER at 1.0x), it will produce an 18% total return. If the board takes any action to improve returns, there is further upside. If the company recovers any value from Russian airplanes, there is further upside. And then, at only 0.85x P/B, there would still be outsized return potential in the following year from the (higher) ROE plus potential for further upward re-rating. After a multi-year run of underperformance, as showing in Figure 16, AL is cleared for take-off.

Figure 15. Comparable Company Valuation

Note: 2025E ROE for TGH reflects a lack of analyst estimates due to the pending acquisition of the company by Stonepeak Partners.

Figure 16. Total Shareholder Return for Leasing Companies

Source: Bloomberg

RISKS

• Inertia at the management and board levels

• Rising long-term interest rates

• Another pandemic

• Military conflict in Taiwan

Catalyst

• Improving returns as new aircraft deliver and returns on older leases improve due to natural depreciation.

• Management change.

• Introduction of short- and long-term guidance.

• Recoveries from Russian airlines or US/UK insurers.

• Improved capital allocation, especially including share buybacks.