Description

I’m recommending a long position in Fly Leasing (FLY), an aircraft lessor. I believe the sector on the whole to be attractive given generally strong worldwide growth in air travel and the generally improved profitability of airlines. FLY is the smallest (and cheapest) of the public lessors. I don’t plan to get into all the ins and outs of the airline leasing industry, except as specifically pertains specifically to FLY’s business. For background on FLY and the sector, I’d suggest checking out:

FLY by LuckyDog in 2017

Aercap (AER) by rickey824 in 2019

Air Lease (AL) by kalman951 in 2019

The latest IATA forecast (from Dec 2019) is for continued above-global GDP growth in air traffic (+4% expected for 2020) and for airlines worldwide to be solidly profitable in aggregate for the 11th straight year, both of which provide support for continue strength in the aircraft leasing sector. These forecasts would obviously have factored in what was known about the MAX at that time, but not the (as yet still unknown) impact of the coronavirus.

I believe FLY to be attractive now for a number of reasons, each of which I’ll get into further:

• FLY is focused on the most in-demand aircraft: newer narrowbody aircraft (i.e Airbus A320 family, Boeing 737 NG)

• After a multi-year transformation, FLY is well-positioned with low leverage to both grow their portfolio and aggressively buy back stock at a huge discount to book, both of which will accelerate EPS/ROE growth

• FLY is currently trading at/near historical lows on both P/B and P/E

• The MAX situation is a nice tailwind for FLY as it is putting upward pressure on both lease rates and resale values for non-MAX narrowbodies (the bulk of FLY’s fleet)

• Book Value per Share (BVPS), which is already up by 24% in the last year (through Q319), due primarily to large gains on aircraft sales, is set to have further step function jumps higher in both Q419 (to be reported Feb 27) and Q120

FLY’s History and Transformation 

FLY was originally set up by BBAM (world’s third largest aircraft lease manager) in 2007 primarily as an income vehicle that would hold (and lease) older, heavily depreciated aircraft and pay a handsome dividend. BBAM has always been the outside lease manager for FLY. After years of seeing their stock trade well below book value, FLY began a strategy in 2015 to shift to: 1) modernize the fleet/grow core earnings/ROE, and 2) shift their return of capital to shareholders from a large dividend ($1/yr, high single digit yield) to aggressively buying back stock at large discounts to book value. Excluding a one-time share issuance in 2018 associated with a large transaction with AirAsia (discussed in detail below), they have bought back 37% of shares outstanding since this strategy started in mid-2015 through Q319 (including the one-time share issuance, shares outstanding has been reduced by 26%) with all buybacks done at a significant discount to book. Over this transformation period, average fleet age was reduced from about 9 years to about 6 years in 2018, prior to the large AirAsia transaction. At that time, this gave them the second youngest fleet among public lessors. The benefit of a younger fleet is essentially that it’s less risky: it’s a more in-demand fleet that’s less susceptible to difficulty in re-leasing on favorable terms and/or write-downs. 

As FLY has undergone this transformation “core” EPS/ROE (excludes 1x gains on sale & end of lease revenue, as well as 1x impairment and debt extinguishment costs) has steadily marched higher, with core ROE most recently being in the 9%-10% range:

AirAsia Transaction

In 2018, FLY announced the single most transformative transaction in its history with AirAsia. AirAsia Group is the largest low-cost carrier in Asia (and third largest carrier in Asia overall). Headquartered in Malaysia, they operate out of Malaysia, India, Thailand, Indonesia, and the Philippines. This transaction involved FLY committing to purchase 34 relatively new (~6 years old) Airbus 320 from AirAsia (all on lease to AirAsia) and also committing to buy 21 new Airbus 320neo in 2019-2021 that would be on 12 year leases to AirAsia. All-in these purchase commitments increased FLY’s fleet size by 65% from 85 aircraft to 140, prior to any aircraft sales. It also required a temporary increase in borrowings (leverage ratio went from targeted 3.0x-3.5x to 4.9x temporarily) and issuing 3.3M shares to AirAsia and selling 1.3M shares to individual management/shareholders of BBAM at $15/share (a 29% premium to FLY’s market price at the time). 

Since completing the first phase (34 A320 purchases from AirAsia) in Q318, FLY has quite rapidly sold off planes at large gains and massively reduced leverage to just 2.6x as of Q319 (guidance 2.5x for Q419). By the end of Q120, which the company has indicated marks the end of the selling aircraft/de-levering phase, FLY will have increased BVPS by 39% in ~1.5 years, primarily a result of selling off a lot of their fleet (both acquired in this transaction and some of their existing fleet) at large gains. BVPS will have gone from about ~$21/shr to $29/share by the end of Q120, by my estimate. 

This massive (for FLY’s size) and highly accretive transaction was only possible due to their relationship with BBAM. The total AirAsia transaction (including planes purchased by those other than FLY was more than twice as large as FLY’s piece of the transaction). Basically BBAM had the scale to do this deal amongst its various lessor/airline relationships, and as a result FLY was able to participate in what has been a great transaction for FLY.

Lastly, the transaction included an option to buy 20 additional Airbus 320neo between 2021-2025. While I think FLY ultimately exercises this option themselves, this option could be worth 9 figures if sold (based on my checks) given the high demand for the A320neo, especially given the MAX situation. I am not assigning any specific value here except to note that it's another nice potential source of future earnings growth/value creation that came from the AirAsia transaction.

FLY is Well Positioned for Continued Earnings Growth

As noted above, FLY has significantly reduced its leverage to 2.5x at YE19 (based on guidance), below its historical targeted range of 3.0x-3.5x through significant aircraft sales post-closing of the AirAsia transaction. I expect FLY to modestly re-lever to about 3x as they begin to grow their fleet again post-Q120, primarily through taking delivery of 18 new A320neo in 2020-2021 (and 2 more in 2022) and buying back stock. This should enable FLY to continue its trend over the last several years of expanding its core EPS and ROE. This will continue further concentrate their fleet in newer non-MAX narrowbodies (78 of 92 aircraft as of Q319 were A320 family or 737 NG). 

Beyond that, they also have the option to buy 20 more new A320neo (as noted above), an option that looks increasingly interesting:

Colm Barrington, CEO on Q319 call:

“Uncertainty about the MAX. I think, Koosh, that uncertainty about the MAX both in its timing and how it's going to be picked up by airlines has certainly helped the A320neo family aircraft and has certainly made us more enthusiastic about our options for those aircraft.”

These options are for so-called “naked” aircraft (not on lease), so to the extent demand for A320neo stays high, it’s likely these options could be an additional source of substantial profitable growth for FLY.

Lastly, as the company is sitting on $432M in unrestricted cash as of Q319 (up from $180M at the beginning of the year), a number that likely keeps going higher in Q419 & Q120, they plan to fully redeem their 2021 unsecured notes ($325M, 6.375%) at par in October 2020, which will save them about $18M after tax annually, or ~$0.60/shr. While this debt will be replaced over time with cheaper secured debt as they regrow their portfolio, this repayment will still be a meaningful source of core earnings growth beginning in late 2020. For further context, this repayment is for just over half of their current unsecured debt balance, with the remainder being $300M of 2024 notes paying 5.3%. The rest of their debt ($1.9B) is secured debt. 

MAX Situation

The 737 MAX situation is unquestionably a net positive for FLY in several ways. First, they have just 2 MAX in their existing fleet (representing just 3% of net book value as of Q319) and they have no orders or purchase commitments for any more MAX. The two MAX they do own are on long-terms leases that are current (as of November ’19). So the bottom line is there’s very little risk to their portfolio from the MAX.

The reason that the MAX situation is a net benefit is fairly simple: with the MAX grounded, demand for other narrowbody aircraft (A320 family, 737NG) has been pushed higher, both in terms of lease rates and resale values. 

A couple relevant comments from FLY management on their Q319 call in November:

Colm Barrington, CEO

“Meanwhile, uncertainty regarding the MAX continues to give support demand and lease rates for other Boeing 737 models and A320 family aircraft, which comprise the core and majority of FLY's fleet.”

Steve Zissis, FLY director and BBAM President/CEO

“Sure. So it has had a direct impact, obviously, on the NGs. We've seen a pickup in lease rate and demand for the NGs as the airlines are finding themselves short of lift. So that's been positive for FLY. I think the question for all of us is how long that will last. Obviously, the MAX isn't going to be resolved overnight, even if they get it recertified. In the fourth quarter or first quarter next year, we expect this to play out over the next 2 years. So it's not going to be immediate kind of a flip back, right? So there'll be opportunities, I think, for the next couple of years on the NG side. And then on the MAX situation, it just depends where lease rates and values go and how fast that aircraft gets picked up in the general marketplace.”

I found the comment about it taking 2 years for the market to normalize post MAX return to service interesting and surprising at first, but there are a number of reasons (and open questions) that would cause this to be the case. First, I should note that as of the last earnings call about 1 quarter ago, the expectation being put out by Boeing and the airlines was that a MAX return to service would occur in Q120. In the roughly 1 quarter since, that expectation has pushed out by ~2 quarters to Q320 currently. As far as why it would take 2 years post-RTS for the market to renormalize, potential reasons/questions are:

• Boeing production has been reduced and subsequently stopped so even after re-certification/RTS, Boeing will be well behind the pre-MAX crisis delivery schedule
• Once the FAA recertifies, how quickly does the rest of world follow?
• What will consumer willingness to fly the MAX look like once it returns to service?
• Will uncertainty around that question cause airlines to continue to not place new MAX orders for a period of time even after RTS, instead opting to place A320neo orders?

It seems reasonable to think that the MAX situation will continue to be a tailwind for FLY for several years. 

Outside Manager (BBAM)

One major area of pushback I hear from other investors regarding FLY is the outside manager BBAM. I certainly understand why this a potential area of concern, primarily regarding conflicts of interest, FLY potentially getting forced into bad terms from BBAM, added cost of using an outside manager, and so forth. 

Here is a good summary of the fees BBAM collects (borrowed from LuckyDog’s write-up):

“With all the positive things mentioned, one consideration with investing into FLY is that it is managed by BBAM.  FLY has a long-term contract that goes out until 2025 with BBAM (w/auto extension for another one term of 5 years).  BBAM charges a rent fee of 3.5% rent collected + $1k/aircraft/month, and gets 1.5% for originations and dispositions.  There is also a mgmt. fee of $5.7mm + 0.3% of the change in BV (up to $2bn increase over $2.7bn and then 0.25% change in BV above $2bn).  Other fees include base and rent fees, change of control, break fees, other fees, termination fees, etc.”

I believe the negatives (or perceived negatives) of having BBAM as an outside manager are substantially mitigated and probably outweighed by these positive aspects of the relationship:

• First and foremost, as noted above BBAM enabled the AirAsia transaction to be possible for FLY, and it has been massively accretive to BVPS in a very short amount of time
• Regarding potential conflicts of interest, I believe this is mitigated by BBAM management personally (not BBAM the entity) owning 17% of FLY, so they personally have significant alignment of interest with FLY shareholders. This is clearly a positive in my mind. Most recently these management members of BBAM put up their own cash to increase their FLY stake from 13% to 17% in 2018, at a 29% premium. In addition to further aligning their interest with FLY’s other shareholders, it was also a significant vote of confidence. 

Valuation

I’m using $29, or 1x Q120E BVPS as a price target, implying 59% upside. I believe this is justified (and perhaps conservative) for several reasons: 

• Every aircraft sale for the last 4-5 years has been at a premium to book.
  •  FLY CEO on the Q319 call: “These continuing sales, which now total more than 100 aircraft for the last 4 years and all have been a significant premium to book value, show the FLY's ability to trade aircraft at significant gains continues and is not limited to any one time period.”
• Another smaller player (AYR, which is about twice the size of FLY in terms of total assets) had been trading consistently at a large discount to book value until the announcement that it was being bought at 1.15x BV (~12/ P/E) in November 2019
• The fleet has been transitioned to young narrowbodies which is the aircraft category that is in highest demand worldwide, and therefore BV is at low risk of impairment
• Publicly traded comps AER, AL, AYR, BOC Aviation (2588.HK) currently trade between 0.86x-1.56x BV, with a mean of 1.12x
  • I also find AER & AL at <0.9x P/B to be fairly attractive, as an aside
• From a more theoretical CAPM perspective I estimate FLY’s Cost of Equity at 7.8%. Given FLY’s core ROE has been 9%-10% since the AirAsia transaction, this would theoretically justify a valuation above 1x P/B

I’d also note that based on my Q120E BVPS of $29, FLY currently trades a 0.63x P/B, near the very low end of its own historical range. FLY has traded almost entirely between 0.6x-0.9x P/B with a mean of 0.74x over the last 10 years:

Also, from a P/E perspective, FLY has essentially never been cheaper (currently 5.4x 2020E, 4.5x 2021E):

Risks

• While their fleet of primarily newer non-MAX narrowbodies is currently in high demand for both sales and leases (and 100% leased right now), coronavirus must be stated as an obvious risk factor that could eventually negatively impact demand for all aircraft
• Given the current unpredictable (at least to me) coronavirus situation, the ~60% exposure to Asian carriers is a risk, though I’d point out exposure to China carrier specifically was only 6% as of Q319 (weighted by book value) and this China % should only be going lower as brand new A320neos leased to AirAsia are added to the fleet
• Concentration with AirAsia: Currently AirAsia Group across its 5 countries is approximately 20% of FLY leases (as a % of net book value), and this should actually move higher over 2020-2021 as they take delivery of the 20 A320neo to be leased to AirAsia are added to fleet. AirAsia concentration should decline after that.
• The parent company AirAsia Group Berhad (listed in Malaysia) has seen its stock decline rather substantially YTD, down 32%, but this would seem to be due 1) coronavirus (they've suspended many of their flights in and out of China from elsewhere in Asia), and 2) Founder/CEO stepping down for a least 2 months while authorities investigate bribery allegations (bribes supposedly from Airbus)
• While the stock performance has been ugly, there don't appear to be any obvious signs of financial distress: as of 9/30/19, they had $523M in cash, only $166M in total debt, and were generating $600M+ in annual EBITDA

• 

Catalyst

• Two more quarters of large jumps in BV upcoming in Q419 and Q120 earnings reports
• Further growth in core earnings/ROE leading to multiple expansion
• Any hints coronavirus siuation is improving