Aercap,
a fundamental analysis!
March 28, 2019
SHARE PRICE: $45,2
MARKET CAP: $6,2B
March 28, 2019
Share Price: $45,2
Market Cap: $6,2B
1. INTRODUCTION
I’ve decided to look at Aercap for two reasons. First, I’ve never studied an aircraft leasing business and I want to widen my circle of competence, and second, because I’ve heard that Aercap is currently undervalued by my dear friend Mr. Market.
Since I didn’t know a thing about the aircraft leasing business, I really had to go deep on this one so I’ve decided to write a bit more than usual just so I can lay down everything I’ve learned so far.
If you are the type of reader that wants a short analysis, this one isn’t for you. You can just scroll down to the conclusion.
2. BUSINESS OVERVIEW
2.1. COMPANY PRESENTATION
With 962 owned aircrafts and 200 customers across 80 countries, Aercap is the largest independent aircraft leasing company in the world. So how does this leasing thing works?
It’s simple. Aercap buys significant quantities of airplanes from Boeing, Airbus and Embraer at steep discounts and then goes out and leases those planes to airlines like American Airlines or Air France. The difference between its cost of debt and the income it gets from the lease is called the spread.
Let’s imagine that the company buys a plane for 100M. It borrows those 100M at a 4% interest rate and then leases that same plane for a 12% interest rate. If we take out the depreciation & amortization expenses that are usually 4% (the plane’s lifetime is about 25 years), the operating expenses, and the taxes, there are 3% left, and that’s the profit the company makes (the spread). It’s a simple business model, but a very hard one to put into practice.
And why does this business exist? It exists because it’s a huge cost for an airline company to buy an airplane, especially for the smaller ones who can’t buy them in bulk from Boeing and Airbus and because airline companies don’t usually want the risk associated with having dozens of aircrafts on their balance sheets (residual risk). Around 43% of today’s world commercial aircraft fleet is leased.
Curious fact, Aercap is also one of the largest engine buyers in the world.
Just so you don’t get confused, Aercap was incorporated in the Netherlands, but its headquarters are in Dublin, so it can take advantage of the 12,5% corporate tax. And on top of this all, it trades in the NYSE. Fortunately, it reports its numbers in USD.
2.2. LARGEST SHAREHOLDERS
Because financial companies are typically very opaque (banks being the most opaque of them all), an investor looking to put money into these companies should always look for skin in the game. The management’s interests should be well aligned with the rest of the shareholders.
Although Aengus Kelly, the CEO, isn’t one of the top 10 shareholders, he has a 2,4% stake on the company equivalent to about $123M, so I would say he is pretty much aligned with the rest of the shareholders.
The famous value investor David Einhorn is also one of the largest shareholders through his hedge fund Greenlight Capital.
2.3. MANAGEMENT TEAM
The CEO, Aengus Kelly, has a perfect understanding of the business and he is highly concerned with optimal capital allocation and shareholder return. Here’s an interview with him, and here’s something he said on the latest conference call:
“We are stewards of your money and we have to make sure that we get the best risk-reward return for that money that you’ve given us”, Aengus Kelly, Aercap CEO
3. HISTORICAL CONTEXT
3.1. LONG TERM CHART
The stock price went up 80% in 2014 following the ILFC acquisition but it hasn’t moved since then. We can buy a share of Aercap today for $45,2…
3.2. MARKET CAP AND SHARES OUTSTANDING
…or we can buy the whole company for $6,2 billion.
Ever since 2015, the company has been aggressively buying back its own shares, having already repurchased 35% of the shares outstanding. Adding to this, a new Share Repurchase Program was put in place recently as the management deems that its own shares are still undervalued.
The big increase in the number of shares outstanding in 2014 was due to the acquisition of the ILFC (international LEase Finance Corporation) from AIG when AIG was going through a rough patch after the financial crisis.
3.3. SALES - OPERATING INCOME - OPERATING MARGIN
And as we can see, that acquisition has catapulted Aercap to be one of the largest lessors in the world.
The company’s revenue has been declining ever since because it has been selling old planes that were acquired from ILFC and during this period the new leasing contracts have been signed at lower rates. With new airplane deliveries coming in the next years, we should start to see the revenue improving.
The operating margin has been kept stable around the mid to high 40’s.
3.5. REVENUE BY GEOGRAPHY
The geographical distribution of Aercap’s revenue has been quite stable over the years, with the Asia Pacific region and Europe being the company’s main geographies.
3.6. REVENUE BY SEGMENT
As expected, the leasing business is the company’s main generator of revenue.
3.6. FLEET
Aercap currently has 962 aircrafts and 363 ordered from Boeing, Airbus and Embraer.
The average age of its fleet was 6,3 years in December 2018 and the average utilization rate for Aercap’s planes is 99%.
An important info to add to this is that the average remaining lease term is 7.4 years, which gives a lot of visibility to this business.
3.8. ORDER BOOK
These are the different airplane models the company has on its order book. I think it’s safe to say by now that those 17 Boeing 737 Max won’t be delivered on time, and with the recent engine delays, I’m not sure about all the other orders as well.
3.7. NET INCOME, NET MARGIN
Net income for 2018 was around $1,1B and analysts are expecting it to lower to $939M in 2019.
3.8. CASH FLOW
Financial companies shouldn’t be looked at through the FCF, but there are still some things we can look at, like the annual CAPEX.
They took delivery of 76 new aircrafts in 2018, for a CAPEX of $5,9 billion. Just to put that into perspective, those 76 aircrafts are roughly equivalent to a mid-sized aircraft leasing company.
3.9. SEASONALITY
There is no relevant seasonality to Aercap sales.
3.10. DIVIDENDS
The company doesn’t pay dividends.
3.11. PROFITABILITY RATIOS
The average ROE for Aercap has been 12%, which is quite good for this asset heavy sector. The return on assets average has been 3%.
3.12. FINANCIAL RATIOS
The current ratio is 8.9 which is very high due to the nature of the business and the need for available cash.
Now for the debt averse investors out there, let me tell you that being a specialty finance company, a high level of debt is somewhat normal, but with an investment grade credit rating from the three major agencies, Aercap can raise debt at a lower interest rate than most of its competitors and most of the airlines out there.
The Debt-to-Equity ratio is at 3,3 and the Adjusted Debt-to-Equity ratio is 2,86. The management has said in the Q4 conference call that they expect to maintain an adjusted 2.8/1 debt to equity ratio going forward. Two thirds of its debt is fixed, and the rest is covered by swaps.
Aercap always tries to keep a liquidity level (cash+existing credit) of at least 1.2 times its next 12 months expenses, just in case something goes wrong in the industry and in fact, it has managed to do better than that. Last quarter, its liquidity ratio was at 1.4x.
With $10B on its balance sheet plus an estimated operating cash flow of $3.2B, the company has enough liquidity to cover the next year uses of capital ($9,6B) without the need for new financing.
3.13. PRICE RATIOS
Because of their financial structure, financial companies are usually valued using the Price-to-Earnings ratio and the Price-to-Book ratio.
The forward 2019 PE ratio is 7 and the current P/BV ratio is 0,68, which indicates a severe undervaluation, even for a financial company. This should be trading at least for 10x earnings or 1x book value.
4. GAINING PERSPECTIVE
4.1. INDUSTRY AND STRATEGY
Air traffic doubles roughly every 15 years, and with just two major OEM’s (Original Equipment Manufacturers) on the entire planet, getting new airplanes isn’t easy.
Aercap is one of the world’s largest buyers of new airplanes and engines, so it has privileged access to these manufacturers and can get its planes before everyone else does. This gives it tremendous advantage over the smaller lessors and airline companies.
At the beginning of this analysis I’ve stated that Aercap is the largest independent lessors in the world. The largest lessor by aircraft number is GECAS, which belongs to GE.
This is an industry prone to mergers, acquisitions and divestitures. In fact, there have been rumors that GE is thinking of selling GECAS (although they deny it) and that HNA is trying to find a buyer for Avalon.
There are few things a company can do with its money: Invest in the business; acquire new businesses; pay down debt; share buybacks or pay dividends.
The CEO Aengus Kelly has been a masterful capital allocator, constantly concerned with growing book value. He has made a huge acquisition when he bought ILFC from AIG in 2014 at a ridiculous 0,5x book value. He has paid down debt ever since, he is investing in new planes and because he doesn’t see any good acquisition targets at the right price, he’s buying back massive amounts of shares.
Don’t get me wrong, share repurchases just for the sake of the repurchase are meaningless and they can be one of the best ways to destroy shareholder value if they are made when the stocks are overvalued.
In this particular case, I don’t think that’s what’s happening and neither does the management. Every year the company sells assets at a profit of about 10%. That means that the amount for which these assets are carried in the books is understated by about 11% (probably because these planes still have lease contracts attached to them that can’t be recorded on the balance sheet).
This means that not only is the company buying back its own shares at a very low price-to-book, but that book value is also understated effectively making the Price-to-Book even lower.
This is capital allocation maestry: They are selling planes for more than the book value, just to use that money to buy back shares at less than the book value. Aercap sells a $100 asset for $110, then takes that $110 to buy an asset worth $130.
This arbitrage scheme is one huge advantage that only a public listed company can have.
These are Aengus Kelly words on the latest Conference Call:
“…from our perspective, looks quite clear what we would think represents the best value in aircraft acquisitions in the world today, and that’s quite clearly, buying ourselves at a discount to book when we’ve been able to consistently for the last 13 years and 52 quarters, sell our own mid-life part of our fleet at a gain for book value, and redeploy that capital into the residual portfolio of AerCap. which was increasing in quality, all the time. And so, as we look at the world today, that is the most attractive use of our funds.”
4.2. RISKS AND COMPETITION
The main risks a company like Aercap faces are:
Residual value risk:
The residual value of an aircraft can vary a lot depending on the market conditions and aircraft model. For instance, after the 9/11 the general residual value of airplanes took a huge nose dive but it soon came back up again.
We could even compare it to the stock market. The company doesn’t lose if it doesn’t sell but unfortunately it isn’t that simple because the book value will surely suffer temporarily raising its debt-to-equity level, leading to a harder time trying to raise capital, and that’s why its liquidity and investment grade rating is important, allowing the company to wait for better days or access capital if things turn sour.
Luckily, the residual value risk variations affect older planes more than new ones and Aercap’s fleet average age is currently 6.2 from the 7.7 in 2014.
Interest rate risk:
Although one might think that the company would suffer if the interest rates were to rise, it isn’t exactly as it seems. Even if a client defaults, Aercap justs brings the plane back home or directly to another client. Some of the times this gets a bit more complicated like the case of AirCastle and Avianca, but that’s the exception to the rule.
From Aercap’s side, around two thirds of its debt are long term fixed rate and the contracts with the airlines specify that if interest rates go up, so will the lease values.
In fact, if interest rates rise, the company can even benefit from that. Higher interest rates lead to an increase of leasing contracts because the airlines won’t be able to support those high interest payments on their books and they will prefer to lease rather than to buy airplanes. That’s when we’ll see a lot of sale and leaseback contracts.
Even during the financial crisis, when a small percentage of planes came off lease, the company was able to keep its planes and lease them at not so good prices with short term contracts. When the cycle came back up again, the company substituted those leases for long term ones with better prices.
Oil price variations:
The general idea is that when oil prices lower, the airlines won’t mind flying with older, less fuel efficient aircrafts, but the oil prices have been relatively low for a long time and the demand for new planes is still huge. If oil prices rise, that’s when airlines will be looking for even newer, more efficient planes, exactly the ones Aercap owns and has on its order book.
Competition:
This spread business could be seen as a “perfect competition market” as at first sight there aren’t any differences between leasing an airplane from one company or the other.
Almost everyone with deep pockets or easy access to capital can become competition. In fact, several hedge funds and financial companies do that, they buy a plane and rent it out. But that hasn’t really been working in their favour. The debt-laden chinese HNA, for instance, bought Avalon, the third largest lessor in the world, and has been selling assets ever since in order to reduce its debt. Just last year it sold a 30% stake in Avolon to the japanese Orix.
The expertise needed to operate at such a large scale isn’t easy to replicate. Because of its scale, and its wide overview of where demand is, Aercap can rapidly re-lease a plane to a different lessee in a much shorter time than the small or newer competitors. Because of this network and its demand, the company has a much higher bargaining power with current or new clients when it has to find a new lessee for an airplane.
A smaller or newer competitor without access to a broad range of clients will likely accept worst terms so it doesn’t risk having an airplane grounded waiting for a favourable contract.
Like Aercap CEO has said “There’s more to this business than spread”.
4.3. TYPE OF PLAY
I define Aercap as a value play due to its low valuation.
5. OVERVIEW AND CONCLUSION
5.1. OVERVIEW
This is a cyclical, capital intensive industry which will no doubt suffer with an economic downturn. Having said that, with 7.4 years average remaining lease term, the company has great visibility on its future revenue, it has a well diversified customer base, its scale allows it to borrow at lower interest rates than the competition and due to its great relationship with Boeing and Airbus, it can get the newest airplanes before everyone else. Oh, and did I say it’s also very cheap?
Usually a specialty financial business with ROE of 10% should trade at a price-to-book of around 1 or 1,1 and a PE of at least 10. Aercap’s average ROE for the last decade has been 12% so its stock should at least trade for the multiples I’ve just layed out.
So let’s put this into perspective:
Not only is Aercap trading at really low valuation multiples, it seems that Mr. Market is offering us the whole industry at a bargain. I think I’ll be looking at some of Aercap’s competitors soon so we can get a better feeling of the whole industry.
Now let’s make some estimates. Let’s say that Aercap doesn’t grow at all in the next five years, and it will continue to use its cash to repurchase its own shares at an average price of $65 (may I remind you that the stocks are trading for $45 today?).
For the last 3 years it has never spent less than 75% of the previous year’s net income on its share buybacks, so that’s the percentage I’ll use on my calculations.
In five years time, there will be 90 million shares outstanding so the EPS will be $11,3. If we apply the current super depressed PE ratio of 6.6, we’ll get to a $74.5 share price, or 11% CAGR for the next 5 years.
If we look at the book value and do our math with it as well, in 5 years time, it will reach $113. Let’s continue to think that Mr. Market will be super negative and he will apply the same multiple he is applying today of 0,75. We will reach a share price of $85 or a 13% CAGR.
Even in a no-growth-scenario, this stock can give investors an adequate return on their money.
But what if Mr. Market decides to properly evaluate this stock? What if he’d be willing to pay a 10x earnings multiple or a 1x book multiple like he should? If that were to happen, the CAGR for the next five years could go up to 20%.
5.2. CONCLUSION
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