Aercap
Equity wipeout explained.
06/04/2020
A couple of weeks ago I wrote about Aercap and made it the first addition to the All in Stocks Portfolio. Here are the previous write-ups:
Aercap: A Fundamental Analysis
Aercap: Q1 2019 results analysis
Aercap: Q2 2019 results analysis
Some of you have asked me what I meant by the equity wipeout stuff. I’ll try to explain it without getting too technical:
As we’ve seen on the previous analysis, currently Aercap is facing 2 risks: Liquidity and Solvency. Liquidity is the ability to pay their bills in the short term and solvency is the ability to pay them in the long term.
Liquidity is usually calculated by subtracting the “uses” of capital from the “sources” of capital. On my previous analysis, I think I made it clear that the risk of liquidity is somewhat reduced given that the company has cash or equivalents to hold on for more than 1 year, even if it doesn’t make a single dollar in revenue (which is highly unlikely).
Now, regarding solvency, one way to calculate it is by subtracting all liabilities from the assets. By doing this, you will get the equity in the business. What belongs to the owners of the business (aka shareholders).
Let’s say you open your own dental clinic. In order to do this, you’ll have to buy a bunch of equipment and you may or may not buy the building as well.
Below, you’ll find a basic representation of what the balance sheet for this clinic could look like.
You’ve got your assets on one side (buildings, equipment, etc in green) and on the other side you’ve got your liabilities (bank loans, supplier payables, etc, in red). If you were to liquidate the company today, you would sell roughly half of your assets to pay for the debt (the debt is senior to the equity, which means that the lenders have to be paid before the owners) and the blue area would be the equivalent to the amount of assets left for you. In this example, the assets your clinic owns are funded roughly by a 50%/50% mix. They are funded with 50% debt and 50% shareholders money (equity).
By the way, when you sometimes hear that Microsoft or Amazon are worth more than $1 Trillion, that $1 Trillion is called the Market Capitalization or Market-Cap, and that Market-Cap is the market value of the blue area, the equity.
The equity can also be called book-value because it’s the value that is written on the books. Usually when you talk about one stock, you’ll talk about book-value whereas when you’re referring to the whole company you’ll talk about equity. They’re more or less interchangeable.
Now, when we look at a financial company like Aercap (which works more or less like a bank), we will find that the balance sheet is “more leveraged” (it uses more debt in relation to the equity). Here’s what Aercap’s capital structure looks like:
Do you see the difference? The red area (the liabilities) is much higher than on your typical dental clinic.
And in times like the ones we’re living in right now, this may constitute a problem.
Let’s first look at the dental clinic example. If by any reason the market prices of real-estate and second-hand dental equipment materially decrease and are expected to stay that way in the future, the dental clinic would have to say that its assets aren’t worth what they were worth a couple of months ago. That is called an “impairment“: a drastic reduction in the value of a company’s assets.
Given that the clinic operates with conservative levels of debt, the market prices of real-estate and equipment would have to come down by 50% just for the equity to get wiped out. This in turn would mean that if your lenders had strong reasons to believe that you weren’t going to be able to repay that debt, they could claim their right to all of the assets. Your company would be Kaput, Finito. You, as the owner of the clinic, would be left empty-handed. The bank (or any other lender) would have the right to own those assets, not you. Here’s a picture in case you’re a more visual person.
Now, depending on where your clinic is located, on the age of your dental equipment, etc, I would say that a 50% decline on your assets value is unlikely to happen, right?
But what about Aercap?
Well, for Aercap the issue is a bit different. Given that it operates with a lot of “financial leverage”, it would need a much lower decline in its assets’ market value to wipeout the shareholders equity. 26% to be exact.
Here’s the company Balance Sheet. As you can see, if Aercap’s airplanes are revalued for $9,3B (or 25%) less than before, the lenders will be entitled to the company’s assets leaving its owners (aka shareholders) with nothing.
Now, the 1 Million dollar question is: How likely is this to happen?
This is the question I’ve been trying to answer for the past couple of week or so. I’ve read a lot about it and I’ve contacted several experts. There was one in particular who has been of great help by answering all of my questions. He asked me to remain anonymous.
Here are my conclusions so far, and I apologise if this gets too technical:
– No bank would want to be stuck with hundreds of airplanes in a time when it couldn’t sell them.
– The impairments are usually calculated by comparing the carrying value of the airplanes (the value at which they are stated in the company’s books) to the “Appraisal” values reached by independent valuation companies. If the carrying value is higher than the appraisal value, the company must record an impairment.
– The appraisers give 2 different valuations: 1) Base values – which refers to the long-term value of the assets which shouldn’t be affected by the current market conditions and 2) Market values – which refers to the short-term value of the aircrafts and is heavily influenced by supply/demand trends (in today’s world, the short-term value has decreased a lot).
– The impairment is usually based off of the comparison between the carrying value and the Base Values, so it shouldn’t be that high given that the Base Values shouldn’t vary much.
– The impairment usually works by asset type, meaning that if the company has 10 Jumbo-jets which are more than 15 years old and one gets impaired, the other 9 will see their value decrease as well.
– This impact is mitigated if the aircraft is leased at good rates. The Net-Present-Value of those rental cash-flows (one technique to value airplanes) may exceed the carrying value of the aircraft, decreasing the chances of having to impair them.
This last point is important because about 25% of Aercap’s aircrafts are leased to state-owned airlines and as we’ve been seeing recently, those governments will intervene by ways of capital injection. This means that a great part of those 25% shouldn’t cause many problems (other than delaying payments, but as we’ve seen on the previous write-up, that won’t be a problem as long as they repay those debts within the next 12 months).
At $18,91 share price, and assuming that this should trade at book-value, the market is saying that the impairment will be 19%, which would be excessive.
All of this to say that the experts I’ve been in contact with are expecting a 10% maximum impairment. How do they get to this number? That’s a great question and the answer isn’t as easy as it might seem at first. We would need to get into the weeds of the aircraft leasing industry. I will probably write an article about this as well.
The important thing here is that this 10% impairment would only happen in a very unlikely and dark scenario. And if it were to happen, the book-value of each share would come down to about $40ish which is still more than 2x the current stock price.
I hope this was helpful for those trying to better understand Aercap and not too technical. If you still have doubts, just ask. I don’t have all the answers, but I will do my best to find them.
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