Description

FTAI : Price target $50 (+186%)  – one of the most asymmetric return profiles we have ever seen

Executive Summary

Fortress Transportation and Infrastructure (FTAI US) offers one of the most asymmetric return profiles we have ever seen. The aviation leasing business is on the cusp of transforming into a unique aerospace business that, by virtue of its unparalleled cost advantage, will have created its own monopoly within the world’s largest engine market. In this scenario, we believe the shares to be worth more than $80/sh (5x current price).

Also having weathered the worst of the Covid-19 crisis for aviation, and with infrastructure projects now ramping up, we think the current dividend of $1.32/sh is sustainable even without a vaccine. At an 8% yield, this puts a floor for the stock at $16.5/sh, just 5% below the current price.

Currently, FTAI is comprised of two businesses, an aviation engine leasing business and an infrastructure business. The aviation leasing business is focussed on CFM56-5B/7B engines used in Airbus A320s and Boeing 737s (narrowbody aircraft) and is about to create its own monopoly as the only low-cost engine management and overhaul service provider. Airlines are desperate to reduce and make their cost base more variable in the current environment. That along with upcoming engine market deficits, put FTAI in a unique position to capitalise. The infrastructure business has a track record of buying/building assets for 3-5x EV/EBITDA and then selling them for 12-15x. There are currently 2 assets, Long Ridge and Jefferson, which we view as likely to see value crystallisation in the next 6-24 months, raising up to $3bn for FTAI set against its current market cap of just $1.5bn.

Whilst huge opportunity exists in the infrastructure business, we view the current transformation of an already underappreciated leasing business into an aerospace company as a game changing event.

Once this transition is complete, we think the Aerospace business could trade on a 15x EV/EBITDA multiple, putting the stock north of $80/sh. We see a clear catalyst driven path to creating value, with upcoming events outlined below:

Financial summary

We have identified $1.2bn of EBITDA potential at FTAI from already announced/potential projects (see EBITDA bridge at end for full breakdown). We believe FTAI will generate $700m in recurring EBITDA in 2022, and $6.7/sh in FAD (Funds Available for Distribution). Given an intention for a 2:1 coverage ratio on a sustainable basis, we believe this could translate into a dividend of $3.3/sh (20% div yield at current price).

 Engine Leasing Business – creating its own “monopoly” 

The engine leasing business is a globally unique asset due to its scale and cost advantage for CFM56-5B/7B engines. Through a series of targeted partnerships and investments, most recently with Lockheed Martin, FTAI’s engine leasing business is rapidly transforming into a fully integrated leasing, overhaul, PMA parts and USM business. Once this transformation is complete, FTAI should be considered a true aerospace business, with an unrivalled cost position in managing and performing overhauls for CFM56-5B/7B engines. In short, FTAI will have become the partner of choice for all airlines looking to further reduce their cost base in the wake of Covid-19.  

FTAI’s existing aviation leasing business is a much better business model as compared to its listed peers such as Air Lease (AL US), AerCap (AER US) or Fly Leasing (FLY US). This is demonstrated by the significantly higher returns it has generated over time. 

Adjustments made to exclude gain on sales and other exceptionals

FTAI’s superior returns can be attributed to its unique business model:

• -        Focussed on engines and specifically CFM56-5B/7Bs with an unrivalled understanding of how to recognise and create value. The company has never sold an engine for a loss.
• -          Scale advantage and balance sheet strength in an otherwise fragmented market
• -          Ability to perform MROs for less than the sum total of maintenance reserve payments collected allowing consistent earnings generation from maintenance events

Aviation leasing background : focused on Engines vs. Aircraft frames

In our view, engine leasing is a far superior business to aircraft leasing. With 1.5x over the cycle returns, better downside protection due to fungibility of customer base and aircrafts that can lease the engines sitting idle, as well as frequent MRO requirements that can tighten the supply- demand dynamics in a very short space of time. Because of Covid for example, the engine market will be moving into a deficit in 2021 as 20% of the engines need to be overhauled every year, else they are essentially “out of the market”. When cash flow is tight, airlines will chose not to overhaul engines that they own and look to lease new ones instead. This is in sharp contrast to the aircraft leasing market which will be facing excess supply for multiple years even post vaccine availability.

Traditional aircraft leasing businesses make up 60% of the aviation leasing market. These companies aim to make a 6-8% unlevered return, mid-teens if they lever it up. The average age of the planes they own is 3 years, average lease term is 7 years, and they generally focus on wide-body aircraft.

The remaining 40% of the market is where FTAI operates. The market is characterised by smaller players who are not as well capitalised, and the market is fragmented. The larger players do not operate in this space for the simple reason that you need to be more nimble, and that it simply doesn’t move the needle for them – they lease $75-125m planes, whereas FTAI is more focussed on leasing $3-6m engines. FTAI makes 15-25%+ IRRs (planes typically 15-20%, engines 25%+), and aims to maintain a number in excess of 20% for the overall portfolio. Although FTAI does have aircraft leases it is generally only as part of a strategy to acquire the engines. For example, FTAI engages in sale and leaseback deals whereby it has a guaranteed income stream for up to 3 years but is then free to do what it wants with the aircraft (and engines). In these instances, FTAI will generally sell the airframe for part-out and is often left having bought into two engines for less than $2m apiece, the value of which is closer to $5m each. FTAI is uniquely placed to capitalise on these opportunities because of its relative scale and balance sheet strength in this market combined with an understanding of which engines will make a good investment. The company has never sold an engine for a loss.

CFM56-5B/7B Market

FTAI operates primarily in the CFM56-5B/7B market – the world’s largest engine market. The CFM family of engines are manufactured by the GE/Safran JV, >30,000 engines have been produced globally. Today there are approx. 22,000 -5B/7B variants in operation

-          CFM56-5B: 14,000 in operation, the engine of choice for the Airbus A320 family

-          CFM56-7B: 8,000 in service on Boeing 737s

Engines typically have a 30+ year life cycle, requiring maintenance every 5-7 years, and more frequently as they get older. The average engine age for FTAI is 15-17 years, and the average value of an engine of this age is generally $4-6m; value is generally a function of how well it has been maintained, and how much capital has been spent on it. In other words, the value of the engine is essentially equivalent to the cost of the last MRO it underwent. An OEM overhaul today will cost $6m per engine, whilst a new CFM56 engine will cost $10m.

FTAI currently owns 79 aircraft, and 193 engines – 351 engines in total, of which more than 200 are the CFM56-5B/7B. The remaining engines include RR engines designed for Boeing 757 and 767s (i.e. not Trents) which have been largely deployed towards freight. Overtime FTAI intends to increase its weighting towards the CFM56s and away from other engine platforms. The current earnings potential of FTAI’s assets is more than $340m assuming a 75% engine utilisation, with a further $70m identified for 2021 from $200m of LOIs expected to be signed in 4Q20.

A looming engine deficit

Our own research, corroborated by discussions with industry and independent analysis, points to a looming CFM56-5B and -7B engine deficit. In short, because of the ability to switch engines in/out of aircraft and given that airlines are prioritising cash preservation in the current climate, they are delaying MRO shop visits and instead swapping in spare engines that still have greentime. Running down greentime on an engine and not conducting the MRO visit essentially removes the engine from supply. We believe engine supply could be reduced by as much as 20% by mid-2021, creating an engine deficit as demand recovers for domestic narrowbody back towards pre-Covid levels. An engine needs overhauling every 5 years, so in a normal year 20% of the market requires an MRO. Acknowledging that this is not a typical year in terms of flying hours, and adjusting for that fact, we see a shortage emerging at some stage in early to mid-2021. A typical MRO takes 9 months, and MRO shops were already struggling to deal with the number of CFM56-5B/7B engine overhauls each year (as the largest engine market in the world and still growing) before the Covid-19 crisis. As such there is no excess capacity in future years to bring those engines that are sitting on the sidelines quickly back into service, creating a sustainable deficit which makes FTAI’s market leading position a key competitive advantage. In such a scenario we believe you will see 1) upward pressure on engine prices 2) higher lease rates 3) higher engine utilisation rates and 4) more engine leasing or engine management outsourcing by airlines.

The importance of MRO costs

FTAI operates a relatively unique operating lease model because it takes security deposits and collects maintenance reserves. Most importantly, every month, alongside lease payments, operators are asked to put up a maintenance reserve, calculated based on usage and expected maintenance, which covers any upcoming maintenance requirements. The maintenance payment is broadly equal to the cost of the lease payment. These maintenance payments then cover the cost of the engine overhaul – in other words, the lessee is paying for the upkeep of the engine. Importantly, the cash from the maintenance reserves belongs to FTAI in the event of default by the operator.

The benefit to the airline, as opposed to owning the engine themselves, is switching from fixed to variable cost – not having to pay $6m in one go for an engine overhaul – as well as reduced downtime as FTAI can switch in a new engine whilst the engine is undergoing an MRO. An MRO historically has taken up to 9 months. Under more traditional lease arrangements, the airline is still responsible for paying for the cost of the maintenance, it is just not expected to put up a maintenance reserve.

The key thing for FTAI however, is that, because of their scale, knowledge and engine availability, they can conduct the MRO for sustainably less than the headline OEM cost, and hence maintenance reserve collected. The difference between what FTAI is able to conduct the engine overhaul for, and the maintenance paid, is FTAI’s to keep. FTAI has never had an engine maintenance event cost more than the collected maintenance reserve.

For example, if a $6m engine overhaul comes due, FTAI will have already notched up a maintenance reserve of $6m from which the maintenance is then paid. If FTAI can perform the MRO for $5m, they are making a $1m profit.

Transitioning to be the global low cost CFM56-5B/7B partner of choice

FTAI have been making investments and forming partnerships to potentially reduce the cost of an MRO to just $2.5m. This has been a long-term project, which should come to fruition over the next quarter. In 2021 FTAI will establish itself as a unique business with clear competitive advantage, if not monopoly, on performing engine overhauls for airlines. With such a busines model, the company should no longer be considered a “leasing” business, but an aerospace company.

The transition has been many years in the making, but the foresight is about to bear fruit as various parts of the jigsaw fit into place:

1)      “The Module Factory”:

After more than two years of discussions, FTAI announced a partnership with Lockheed Martin in October 2020 for the creation of the “Module Factory”. The “Module Factory” is a unique partnership that will firstly offers FTAI favourable pricing in return for a very small volume commitment (less than FTAI’s current annual requirements, so <40 engines per year). This will reduce the cost of an MRO to FTAI by $500k per visit, creating >$20m in EBITDA every year.

More importantly the “Module Factory” is a vehicle to transition FTAI’s business. We have spoken to LMT, and they have confirmed that the agreement includes a commitment by them to utilise the PMA parts produced from the joint venture with Chromalloy. This is vitally important as LMT is a major player that is essentially backing these PMA parts, putting its name to their potential, but also willing to stand up to the traditional OEMs in the space. In short, this partnership creates and provides a clear route to market for FTAI’s PMA parts.

2)      PMA Parts:

FTAI has invested $28.5m into a JV with Chromalloy for a 25% ownership stake. The partnership began in December 2016 and is focussed on producing PMA parts for the hot part of a CFM56 engine. The JV has designed 5 parts, the first of which, a vein, is currently awaiting imminent FAA approval. The JV creates 2 benefits to FTAI. Firstly, it can purchase parts at cost from the JV, potentially saving the company >$50m per year in overhaul costs, or $1-2m per engine overhaul – this is how FTAI can achieve the $2.5m overhaul cost. Furthermore, FTAI’s 25% ownership stake is worth $50-100m per year in equity income if the PMA parts achieve a 5-10% market share.

3)      USM and other PMA parts

We believe the logical next step to FTAI’s transition is to announce further partnerships to further utilise the potential at the “Module Factory”. FTAI’s PMA parts are focussed on the hot part of the engine, but PMA parts can be used in other areas of the engine to further reduce overhaul costs. A partnership with another PMA parts manufacturer would make strategic sense. Finally, when conducting up to 300 overhauls a year, the company will start generating and have access to a huge amount of Used Serviceable Material. Trading USM would provide a means to further enhance the returns profile or reduce costs when performing engine overhauls and offering management services. FTAI has already announced a foray into this market with the potential to generate $20m from the part out of 20 engines in 2021 using the spare floor space at the “Module Factory”.

4)      Airline partnerships

With capacity for up to 300 shop visits per year, the LMT deal allows FTAI to market engine management services to airlines with a dedicated capacity and a unique service offering. It is called the “Module Factory” for a simple reason – engines are built of several modules, and modules can be switched in and out. Just because one module has run out of greentime does not mean the whole engine needs an overhaul. By switching modules in and out you can reduce engine down-time, and reduce overhaul costs, markedly reducing costs. FTAI wants to combine this unique approach with providing low-cost PMA parts, allowing the company to conduct engine overhauls at just $2.5-3m compared to an OEM cost of $6m. FTAI will then share some of this benefit with the airlines, by offering them a saving of up to $1m per engine, but keeping the difference when compared to the actual cost. The airlines benefit from lower costs, lower down-time and not having to spend time and money on engine management services. FTAI has already announced the intention to sign airline deals worth up to $50m in EBITDA for 2021.

Infrastructure Business

FTAI seeks to invest in strategically located infrastructure assets, buying and building at 3-5x EV/EBITDA, seeing it trade at 8-10x and selling at 12-15x. The company has a proven track record given as shown by the Central Maine and Quebec Railway (CMQR). FTAI bought CMQR out of bankruptcy for $14.5m in 2014, invested approx. $15m to turn it into a $10m EBITDA business and then sold it for $130m in 2019 and retained a car cleaning business which is probably worth $5-10m. There are currently 3 main investments on the infrastructure side of the business.

Jefferson

Jefferson is a multi-modal oil and refined products handling and storage terminal located on some of the only remaining open land next to Exxon’s Beaumont facility and with strong connections to Motiva’s Port Arthur Refinery. FTAI has an 80% stake, with the remaining 20% held by Wes Eden. In August 2014, FTAI paid approx. $70m net of liabilities for 60% of Jefferson. They acquired a further 20% in an equity for shares transaction after the owner was unable to make capital calls. FTAI have invested a further $250m since 2014 to create a >$80m EBITDA business, their share of which would be expected to fetch more than $800m in any sale.

Most excitingly however, there exists the capacity to expand Jefferson into a 20mbbls storage facility from its current 6mbbls. Each additional 1mbbls capacity costs $50m to build and can be expected to generate at least $10-15m of EBITDA per year. This is a perfect example of an organic project that FTAI will engage in, building at 3.3-5x EBITDA within an asset that we believe could be sold at 15x. The timing for which we believe could be the next 12-18m.  

Ports and Terminals:

The Ports and Terminals business consists of two main assets, Repauno and Long Ridge. These are solid businesses which could see significant value unlocked in coming years, but they are longer-dated projects when compared to the aviation transformation.

Repauno

FTAI purchased Repauno in 2016 from DuPont. Repauno is a 1,630 acre deep-water port on the Delaware River, uniquely positioned close to underground granite storage caverns that could transform the terminal into an NGL export hub. The capital plans have been broken down into two phases, with Phase 1 fully sanctioned and costing $70m to build the infrastructure needed to support rail to ship exports at the terminal. This will support a $20m run-rate EBITDA post completion. Phase 2 is to build a further 3mbbls underground storage cavern (compared to the existing 0.2mbbls butane storage) underwritten by long term NGL export contracts. Total capex for which would be approx. $450-500m, to generate an EBITDA of $150m. FTAI is also exploring the potential development of an offshore wind power development to create a transloading base.

Long Ridge Energy Terminal

Next is Long Ridge Energy Terminal, set to be the US’ first hydrogen fuelled power station through a partnership with New Fortress Energy. FTAI acquired the facility for $30m in 2017, and entered into a fully debt funded $430m EPC and PIE agreement for a 485MW combined cycle natural gas fired power plant, backed up by long term contracts underwriting the first 457MW for 7-10 years, locking in an annual EBITDA of approx. $120m once completed in November 2021. In December 2019 FTAI sold a 49.9% interest to GCM Grosvenor for $150m plus an earn out of $25-50m.  In October 2020, a partnership with New Fortress Energy was announced to transition Long Ridge into the US’ first carbon-free hydrogen fuelled power plant. NFE will fund the construction of an on-site hydrogen electrolyser and the infrastructure required to support it, whilst the plant will require minimal adjustments in the transition. FTAI is currently looking to secure a data centre deal which could increase the EBITDA potential of the business and extend the longevity of the long-term fixed price contracts. With a data centre deal, EBITDA at Long Ridge could be $140-150m, locked in for 12 years, which should take their 50% interest to a valuation of close to $400m if they were to sell. In short, FTAI could realise a total sale of $600m in the next 6-12m without taking any risk or committing any cash beyond the initial $30m investment plus $100m of interest payments to date.

Corporate Structure and History

Fortress Transportation and Infrastructure (FTAI US) was formed in February 2014 by former Aircastle CEO Joe Adams and is structured as a Delaware LLC that is externally managed and advised by FIG LLC, an affiliate of Fortress Investment Group, now owned by SoftBank. FTAI IPO’d in May 2015 at a price of $17.00/sh, issuing 22m shares. FTAI pays a 1.50% management fee to FIG LLC, payable monthly in arrears, based on the two most recently completed months of GAAP consolidated average total equity. There is also an income incentive allocation based on net income, the hurdle rate for which is a 2% quarterly (i.e. 8% annualised) net income return on the average value of net equity capital. Between 2% and 2.2223%, there is a 100% payment to FIG, and a further 10% payment for net income above 2.2223%.

CEO Joe Adams holds 175k shares, alongside a further undisclosed position in preferreds. This, alongside an incentive fee structure which has a hurdle rate that is only triggered when an 8% return on net equity capital is triggered, we believe aligns management to shareholder interests.

Longer term, we believe that there are two separate >$1bn market cap businesses existing within FTAI, and would expect a transition towards a C-corp to unlock further value by removing K-1 requirements.

Base Case

We believe FTAI should be valued on a FCF multiple, and we adapt FAD to create a sustaining cash flow metric, CAD. Based on our CAD of $5.70 in 2022 and applying a 7.5x multiple discounted back to today at 10%, we arrive at a base case target price of $35/sh.

Recognising the binary nature of the FAA approval for PMA parts, our base case valuation does not include this authorisation. Our base case and bull case assumptions are outlined in the EBITDA bridge at the end of this report. We believe we have line of site on all base case assumptions. The key variable in our base case assumption is the 75% utilisation rate for engines which we believe could be conservative giving a looming CFM56-5B/7B engine deficits.

Bull case

Not included in our base case, but which we believe highly likely outcomes:

-          FAA approval for the 5 PMA parts from JV with Chromalloy, these are worth $16.5/sh

-          Initial airline engine management partnerships we believe are worth $2.5/sh.

-          Jefferson expansion for 10m bbls of storage would add further $6/sh

Our bull case identifies a scenario where FTAI is worth at least $60/sh purely on an earnings accretive basis and is an outcome we view as very achievable. There is also a re-rating potential for the business – if the aviation business were to trade of 15x EV/EBITDA, a not unreasonable outcome given HEICO (HEI US) trades on >30x EV/EBITDA, and we see a path to at least 50% of the business EBITDA being generated from non-leasing activity, this leads to a valuation in excess of $80/sh.

Bear case

We think the dividend well covered at its current level of $1.32/sh, which assuming an 8% yield implies a valuation of $16.5/sh. This yield approach places a floor under the share price. In both 2Q and 3Q20, the periods most impacted by deferrals in the aviation business, the dividend was fully covered by FAD[1] and with recent actions by airlines to strengthen balance sheets and further government support we think the outlook can only improve from here. Therefore, we view this as one of the most asymmetric investment opportunities we have ever seen.

EBITDA Bridge

A final note on Fortress and multiple attempts on VIC to go long this stock

We have historically been very skeptical about Fortress entities. In fact we have only been short multiple Fortress stocks, a lot of them to zero (including Eurocastle, Newcastle, Brookdale to name a view). We think the opportunity here exists in large part to this reflex cynicism around Fortress managed vehicles. We think Joe and his team have stumbled upon a gold mine (engine MRO) that is not well understood and are now uniquely positioned to transform an asset based leasing business into an expertise based low-cost aerospace company. This is a new story entirely once the parts JVs get FAA approval. As the FAA approvals come in, and additional JVs are announced, we think FTAI's credibility to achieve this goal will rise meaningfully, along with the multiple. 

Disclaimer:

This write-up is intended for informational purposes only and you should not make any financial, investment, or trading decisions based upon the author's commentary. Although the information set forth above has been obtained or derived from sources believed to be reliable, the author does not make any representation or warranty, express or implied, as to the information's accuracy or completeness, nor does the author recommend that the above information serve as the basis of any investment decision. At any time, the author of this report may trade in or out of any securities that are mentioned in the write-up without disclosing this information. This is not an offer to sell or a solicitation of an offer to buy any security.

Catalyst

FAA Approval

Additional sale-leaseback transactions

Additional JV announcements

Jefferson offtake 

Long ridge sale