Description

Long: DNA LN Equity

Disclaimer:

This is more of a small PA idea given small size / illiquidity.

Overview:

Doric Nimrod Air One Ltd. (DNA LN) is a small-cap, UK domiciled closed end fund that owns a single asset – an Airbus A380-861. The fund was established in 2010 for the sole purpose of providing investors with income returns and ultimately a return on capital for its shareholders by acquiring, leasing, and selling a single aircraft. The market clearly disbelieves management’s stated NAV (based on a 3rd party valuation of the asset post-2022 Emirates lease expiry), as it implies a 23% IRR through 2022. We suspect the market may be assuming the A380 is parted out post-lease expiry, as marking the asset in line with recent parting out transactions would suggest an ~7% IRR. The security offers investors an unusually robust margin of safety (even with draconian assumptions, we struggle to envision a scenario with material loss of capital) and a free and valuable option on 1) the A380 platform’s recovery between now and the expiry of Doric’s lease to Emirates in 2022 and 2) a renewal of the asset’s lease (we assume at economic terms that are substantially more favorable to Emirates, which has made the A380 a core piece of its fleet). In addition, we like the money good (at least until lease expiry) 8% dividend.

Lease Structure:

Given the fund mandate stated above, upon fund establishment in 2010, Doric GmbH, the fund asset manager, purchased a single Airbus A380-861 and leased it to Emirates, the UAE state-owned airline, which is also the largest operator of A380s globally (102 of 219 in service). Doric has a history of setting up funds like this one for aircraft purchases (including two sister funds, DNA2 and DNA3), renewable power plants, and other transportation and infrastructure assets, and acts as fund advisor / external manager. The lease is structured with a fixed quarterly payout until the end of 2022. Additionally, Emirates effectively has a ROFO for the plane upon lease expiry at “fair market value,” which is determined by three external, independent valuation consultants. The current third-party valuation estimate of the lease value is $101mm USD.  Note that this compares to $110mm USD in the fund’s prospectus, but since 2010, the outlook for the A380 is substantially more negative as the market has shifted away from wide body jumbo jets and most airlines have lost interest in incorporating the platform into their fleet (many have even doubted continued production of the aircraft). Emirates bears all costs related to aircraft maintenance during the term of the lease, and the asset manager conducts an annual aircraft inspection.

Capitalization:

Valuation / Equity IRR:

The equity payoff structure here is contingent upon 2 things:

i.                     The level of Emirates interest in the fund asset upon lease termination

ii.                   What valuation the asset is sold for if the elected path is a liquidation

Equity IRRs are driven by a constant dividend that is paid out over the fund life, which provide significant downside protection as they provide an 8% annual yield and we view this as money good (Emirates is an investment grade credit). The below table indicates the range of scenarios that we view as most likely, with an additional draconian downside case.

• Management Appraisal – mark the asset at management’s latest $101mm post-expiry appraisal

• Lease Renewal – Emirates renews the lease (actions demonstrate a long-term commitment to the A380 platform and the airline has designed key infrastructure around it), but at terms that are substantially less favorable to DNA LN. Because the 2022 market structure could be monopsony (Emirates is the only meaningful buyer of the assets), we assume a 50% reduction in rent / asset value and that the asset is relevered at a 50% rather than its initial 68% LTV. We view this as the most likely scenario

• Market Parted – we mark the A380 in line with 2018 parting out transactions that have valued A380s at $40 – 50 million. This is somewhat aggressive as if the aircraft is parted, there are likely to be more A380 sellers in the market and our aircraft will be a few years older than the ones being parted in 2018

• Downside Parted – we assume the A380 market deteriorates to such a great extent that the asset is parted out at 50% discount to the Market Parted scenario. Notably, while this seems to be a very conservative scenario, our numbers still imply under 10% capital loss over the life of the investment

We run the Lease Renewal scenario with the following assumptions:

Emirates Demand:

One fear of investors in this space is the ultimate demand for A380s. These planes are infamously cost ineffective (with an HBS case study about them) and have a history of production and competitive issues when compared to BA planes such as the 787.  We feel reasonably protected by the dividend payout / parted plane value and Emirates’ history of wanting to operate A380 planes in the past. From an airline’s perspective, a platform is “all or nothing”. Given that so much maintenance and operating infrastructure must be designed to support the fleet composition, switching from A380s would be expensive for Emirates.

Industry expectations for A380s have been negative for years, but Emirates placed an order for 10 new A380s in February & confirmed an existing order for another 10, and Airbus has publicly committed to continue to produce these planes for another 10 years. Emirates flies a higher percentage of economy-class seats than other airlines that run major routes (London to Dubai in particular), and the extra capacity offered by the A380 is what they cite as the main factor that allows them to do so. Emirates President Tim Clark is on the record about the value-add of A380s, and independent consultant reports believe that replacing the A380s with 777s would have a significant negative impact on Emirates’ capacity for some of its more significant routes. Consumers also like the A380; given the scale with which it operates the platform, and A380 is much more economically viable for Emirates than the other airlines that never incorporate the platform into their fleet. Emirates has also publicly discussed wanting to operate these planes until the end of their useful lives, so there could be strategic interest in owning older planes too. We believe it is somewhat likely that Emirates exercises its option to purchase the plane upon lease expiry.

Underfollowed:

Part of the reason this opportunity exists is its small size and lack of following. The lack of liquidity here means there is no sellside coverage or active following behind this name.

Other DNA Funds:

A big issue with owning this fund is its lack of liquidity. While the risk/reward is certainly better than the other DNA funds, DNA2 and DNA3 offer similar structures, slightly more diversified asset ownership, and more liquidity / a bigger market cap than DNA One.

Risks / Mitigants:

A380 Value in 2022:

One mitigating factor we have not yet discussed: at a certain price, the authors MAY consider submitting a bid for the plane (we have been flying economy for too long and Gulfstreams are expensive), providing an additional lever for downside protection. In addition, many billionaires are waking up to the fact that real luxury is no longer attainable with a narrow body platform such as the 757.

Emirates Credit Quality:

Emirates is currently IG credit.

Illiquidity / UK Domicile:

As discussed above, this will be an issue for individual investors / funds without foreign trading capabilities or that have issues with the small size. The 30-day average volume for the security is 17,110 shares.

Catalyst

None until Emirates is faced with making a fleet decision in 2022.