Description

There have been a number of write-ups on VIC recently (Aercap, Air Lease, Fortress Transportation) advocating for investing in aircraft leasing companies.  Each of these ideas are similar in that they focus on aircraft leasing but differ in their segment/niche (e.g. age of aircraft, OEM vs. sale leaseback, underwriting style, type of plane, etc.).  The purpose of this write-up is to highlight to the VIC community another way to invest into the aircraft leasing space.

In general, I believe this industry is undergoing positive long-term trends: strong global air traffic growth (esp. in international/emerging markets), improved airline profitability (Buffett is investing now), strong demand for aircraft from airlines, healthy financial markets, and strategic interest from Chinese and Asian companies.  I previously wrote up FLY four years ago, but believe an update is warranted now given management’s recent changes to the business (e.g. fleet age, # of planes, profitability, duration of contracts, etc.) and revised capital management approach. 

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To begin, unlike Air Lease and Aercap, FLY only does sale leasebacks.  They do not place orders with the manufacturers (Boeing, Airbus), but instead buy only from other lessors, airlines, and financial institutions.  The OEM purchasing strategy, while can provide higher growth, is more difficult and has higher execution risk: You need to pay PDPs years in advance and not earn capital, place an order for aircraft upfront but not receive delivery ~5 years later (and at that point you may not know who will be leasing your plane, what the lease rate would be, whether you have financing lined up, where oil prices would be, etc.).  Furthermore, if a downturn comes, holding onto orders costing billions of dollars could be risky.

On the other hand, many of the unknown and risky parameters of the direct OEM strategy are mitigated with sale leaseback transactions b/c much of the uncertainty is known upfront (e.g. lessee credit ratings, lease rate, aircraft cost, financing, etc.).  Relative to OEM players, FLY is a more conservative, lower risk player.  They are a leader in the sale-leaseback market and built the portfolio one by one over the last 25 years.  They are not trying to hit homeruns, but rather focus on hitting consistent doubles and singles and managing a fleet of quality lessees, keeping the pool diverse, and managing the capital base prudently. 

When it comes to underwriting, FLY typically buys in the 2-4 year old range and do not hold planes beyond a 10-15 year life.  They underwrite a low to mid-teens return.  Given the emphasis on sale leasebacks, the VAST MAJORITY of planes have leases attached upfront, which de-risks the investment substantially.  Moreover, they focus on the most widely used narrow body 737 and A320 aircraft (and maintain a policy to never go above 25% in widebody).  They also require maintenance reserves on all planes. 

In the last few years, the Company has gone through a rejuvenation strategy.  They have reduced the number of aircraft down to 76 planes today, increased the average lease term from 5.2 to 6.6 years, and reduced the average fleet age from 8.0 to 6.4 years, which makes them the 2^nd youngest fleet among public peers.  Compared to before, they are leaner, meaner, have longer term leases, operate at 100% utilization, and are earning as much today as they were before when they had 120 aircraft a while back.  They are driving towards double digit ROEs this year and have a lot of capital on hand.  In my discussions with the Company, they expect to beat their acquisition target of ~$750mm and see upside to EPS, BVPS, and ROE growth.

In terms of capital management strategy, the Company has been selling older, underperforming aircraft and then using capital to either acquire new aircraft, buy back debt, or repurchase shares at a discount to book value.  Since September 2015, the Company has bought back a quarter of their shares O/S at a 30% discount to book value along with retiring 20-25% of their corporate debt.  Moreover, the share price has not changed much over the last three years but the share count has declined from 41mm to 32mm today, so share buybacks should accelerate BVPS and EPS growth.  In terms of financing, they have reduced their cost of secured debt from 5.1%+ in 2012 to 3.9% today.  There is limited refinancing risk in the capital structure with no significant maturities until 2020.

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.  The fees collected are sizable relative to the 13% insider ownership of the Company.  There could also be less appetite for a strategic sale given the fees BBAM is enjoying on the portfolio.  In my discussions with management, they said they would absolutely consider a strategic sale if there was something worthwhile on the table, but I still handicap this potential and believe shareholders returns are more likely to come from compounding BVPS/EPS instead.

Another consideration is that the space is getting more competitive.  A lot of the new players that come in, especially the Chinese and Asian companies, tend to start with sale-leasebacks as opposed to going OEM.  While management has significant liquidity and dry powder for growth, one must be cognizant of the increasingly competitive landscape and the ability to deploy capital. 

Nevertheless, the bar to drive up EPS and BVPS is not difficult given that the stock is trading at ~75% BV and 6.7x P/E.  The March end BVPS was $18.62 and the Company has been buying back shares this year at $12.85.  Unlike before, FLY does not pay dividends anymore and has changed their capital return policy to share buybacks now.  Given the discounted valuation, this is a nice time to be buying back stock.  In my conversations with the Company, they view share buybacks as an easy way to drive up EPS and BVPS, and expect to continue the capital return playbook.  This provides a nice setup for the tontine math, and I believe the stock’s valuation multiples will re-rate higher as BVPS and EPS accelerate upwards.

Catalyst

More aggressive share repurchases, completing attractive acquisitions, reaching annual growth target of $750mm