I came across AerCap as I was scanning through Mohnish Pabrai’s Portfolio, It’s his third largest position with 11% of his U.S funds. I am a big fan of his investment approach where he bets on businesses with low risk and high uncertainty, that have higher reward potential in the future. His key targets are undervalued businesses that have long runways for growth, competitive advantages and excellent management. Below is my effort to understand his thesis and share my views by providing appropriate resources. AerCap is listed in the U.S. at NYSE stock exchange.
Air travel demand has been doubling every 15 years since 1986 irrespective of global recessions. Existing fleet of approximately 24,000 commercial aircraft is expected to be doubled by 2036 with Asia Pacific, Europe, and U.S. forecasting the highest growth. 40% of the existing airline fleet is currently leased with a forecast to be at 50% by 2020. To put that into perspective, there are approximately 9,600 aircraft in the world that are on lease with a growth forecast of approx. 21,000 by 2036. Currently, only two companies in the world own 32% market share of these 9,600 leased aircraft, namely AerCap with 1,100 and GECAS with 2,000 aircraft.
Business overview –
Arbitrage with low cost of finance
Aircraft leasing companies buy an aircraft at a discounted price from manufacturers with large orders and at the low cost of finance. Then lease them to airlines at a higher rate. Simply an arbitrage! Moreover, the lessor (aircraft leasing company) leases the aircraft to airlines under operating lease where the lessee is responsible for the ongoing maintenance & servicing. A commercial aircraft ranges anywhere from $200-300 Million, thus airlines benefit from acquiring aircraft under lease because it greatly reduces their upfront capital requirement and allows them to manage their fleets more efficiently. No wonder the aircraft leasing has gained a market share of 40% from less than 2% in 1988 Additionally, lessors provide third-party portfolio management to a few airlines at an additional fee.
Global nature of higher demand
The global nature of this business insulates the company from country-specific economic downturns as lessor can easily cancel the lease if not paid and move their aircraft to countries where the demand is coming from. The value of these assets is maintained as the depreciation is at 4% with an average life of 25 years. Due to high demand, used aircraft are being sold at a premium to their book value as airlines like to suck the remaining juice out of them before making them scrap. Nevertheless, the residual value of an aircraft is still 15%.
Capital intensive business
This business model is capital intensive, however, has a vast history of successful implementation similar to that of banks. They operate by lending the money at a higher rate than the cost of finance. Capital intensive businesses especially require great capital allocation skills for the company’s growth and shareholder’s value. Thus, a brilliant management is of great significance which can focus on increasing value for its shareholders. Favorable risk ratings such as Moody’s, S&P are great indicators of good management.
Maintaining high demand aircraft & lease rates require skill.
The lease rate is the most important factor affecting a company’s revenue dependent on the demand in the market. If a lessor decides to sell their planes in the market, consolidation could cause lease rates to plummet. There are only three major aircraft manufacturers namely Boeing, Airbus, Embraer in the industry causing dependency over aircraft deliveries. However, the big players have an advantage with large orders from these manufacturers.
AerCap Holdings –
AerCap holdings is the world’s largest independent aircraft leasing and selling business. They are not related to any air frame or engine manufacturer, which allows them the flexibility to purchase an aircraft or engine models from any manufacturer. The business is global with approximately 200 customers in 80 countries. AerCap buys, sells or leases out an aircraft every 24 hours. Additionally, they provide aircraft asset management in exchange for a management fee. They currently own 1093 aircraft with 400 more on order for the next 24 months. The order book is placed with forwarding lease payments, i.e. an aircraft is already leased before it is ordered from the manufacturer. They have had a 99% utilization rate of their fleet since 2010 consistently. Annual defaults were only 2.5% between 2007-2013 (global recession), and losses were 0.2%. 80% of defaulted planes were repossessed and then released or sold. 20% went back to airline under restructured lease maintaining the utilization rate of the fleet.
Certainty of revenue
Future revenue growth is secured by the forward lease payments. The average age of AerCap’s fleet is 6.8 years and is reducing as new aircraft are getting added to the portfolio every month. The average remaining lease is for 6.9 years. AerCap has varying lease terms of up to 16 years which insulate them against cyclical market conditions. Usually, they look into longer-term contracts during periods of high demand with higher rates and short-term contracts during low demands. The aircraft downtime risk is protected by taking proactive measures for lease extensions with existing customers. In case a lessee decides to cancel the extension, management is proactive about finding the new customer or selling the aircraft. In most cases, there is some maintenance required when the aircraft is moved to a new lessee which is less than 2 months usually.
A lot of Chinese lessors with lower cost of finance are trying to enter this business due to the high demand coming from Asia. However, sustaining such a capital-intensive business is not easy. Moreover, airlines prefer to be with a lessor who provides good service and flexibility of aircraft that meet their needs. AerCap is strategically placed in Dublin which has industry-wide lower taxation.
Airlines prefer the flexibility of having their passengers being able to catch a transcontinental flight at several time periods during the day, rather than having one large aircraft transport many passengers at less frequent time intervals. Thus, AerCap has strategically placed its portfolio of in-demand narrow-body aircraft.
Aircraft productivity seems to be flattening out in recent years. Management highlighted in their November investor day presentation that aircraft productivity increased from 10.4 hours a day in 2004 to 11.5 recently, but further gains of this magnitude seem unlikely. With that, airlines are going to have to add more planes to their fleet to keep up with traffic growth. Given rising interest rates, high capital costs, and difficulty to jump ahead in the production queue, that demand is likely to be served by companies like AerCap, GECAS, and AirLease that have significant order books with Boeing and Airbus.
AerCap has hefty operating margins of around 48% with the net margin of 21%. Depreciation and interest expense are eating most of their margins. The capital-intensive business model works due to a low cost of finance and higher lease rates in the market. Airlines prefer lease payments instead of having this debt on their balance sheets. Long-term lease agreements support the revenue certainty for AerCap. The company has stated that all the forward lease payments are correlated to the rise in interest rates, i.e. hike in interest rates will increase the lease rates keeping the margin buffer intact.
The company was able to pay the debt even during a recession. The debt to equity ratio was lowered from 3.6 in 2009 to 2.49 in 2014 which is an industry average. The company had to take on more debt when it acquired ILFC at less than its book value. The adjusted debt to equity ratio has been going down since June 2014, and favorable risk ratings have been getting better since March 2016. The net income has been consistently growing since 2008. However, capital-intensive nature of the business has made it difficult to keep any positive cash flows as the company has to keep on buying new airplanes or pay the debt to meet the demand and maintain the liquidity respectively.
- Being the largest independent lessor grants greater visibility over the global demand which helps in portfolio optimization.
- AerCap’s scale not only improves operating leverage, but also helps access capital, and some airlines only want to do the bulk of their business with large players that they know will always be there to meet their needs.
- AerCap is able to purchase aircraft at discounted prices due to large orders. At the same time, older aircraft are being sold at a premium to book value due to high demand.
- Diversified customer base (200) over 80 countries. No single customer contracted more than 7% of aircraft with 99% utilization rate of the fleet.
- AerCap’s assets are mobile which can be moved from anywhere in the world. This insulates the company against country-specific economic recession.
- Low probability of disruption – It is very unlikely that anyone would want to be a part of such capital-intensive business without enough experience.
Industry speaks very highly of Aengus Kelly as an excellent manager who has been with the company since 2005 and joined as CEO in 2011. Since then, he has shown remarkable capital allocation skills with his share buyback programs.
AerCap seeks to maximize their return on investment over the life of an aircraft. This is done by managing lease rates, utilization rates, financing, maintenance costs, and the timing of eventual sales. They have been maintaining a portfolio of in-demand aircraft by acquiring new aircraft directly from manufacturers. Management’s experience allows them to identify the most attractive assets that will increase in value or demand. This has been proven by their record 99% utilization rate.
The company targets compensation heavily towards equity-based awards for performance targets. Key executives, including the CEO, CFO, and COO, are required to independently purchase and own shares worth 10 times their base salary within five years of starting their job. The CEO especially seems to have a big stake in the company.
AerCap is the second largest player in the industry with GECAS being the first one. GECAS is a subsidiary of General Electric and has not been doing so well. It includes a variety of aircraft type that AerCap doesn’t focus on such as helicopters, regional jets, and freighters. Air Lease Corporation is the next strongest contender in the market with great experience in the industry. Air Lease has been growing rapidly. However, the size of AerCap allows operating leverage to expand and capture the demand much better than Air Lease.
The capital-intensive business has no free cash flow due to high capital expenditures are driven by debt payments and aircraft orders. Delays in aircraft deliveries can likely impact future earnings over the short term. The cyclical nature of business due to global recession is a concern.
Understanding Mohnish Pabrai’s perspective
Mohnish is a fan of companies that he calls ‘Uber Cannibals’, i.e. enterprises that are undervalued and exercise strong share buyback programs. The best part about buying back shares instead of paying a larger dividend is we can avoid double taxation. In other words, the company is taxed on their earnings and then you are taxed on the dividend they pay out to you. With buybacks, taxes can be deferred to a later date avoiding the upfront double taxation of a dividend. Share buyback at lower valuation increases all the metrics per share for the company. Mohnish had an article about an Uber Canibal portfolio which has produced amazing returns of %15 CAGR since 1992. Do check out this article here.
After Anegus Kelly joined as CEO in 2011, the company repurchased 24% of its shares for an outstanding average of less than $12 a share in first two years. ILFC acquisition caused the issuance of more shares, still, buybacks have now resumed with a vengeance. The company has repurchased 30% of its shares worth $2.5 Billion since 2014. The company has exercised $200 Million share repurchases in February 2018, and also announced another $200 Million share buyback through June 2018. Moreover, these buybacks have been funded from selling of aircraft at a premium to their book value. This has enriched value for its shareholders by increasing book value per share at 16% CAGR since 2014.
There is no free cash flow coming from the core business. Thus, discounted cash flow method is not applicable here. However, management has been funding share buyback via selling of older aircraft. Uber Cannibal assumption works with book value per share evaluation. Assuming the book value per share keeps on increasing at 17% with the continued share buyback and increase in revenue for next 3 years. It brings the book value per share at $88. Giving management a credit for their skills, if the market decides to price the company at 1.2 times book value, then its intrinsic value becomes $102. Discounting $102 at 11% rate of return brings today’s price at 75$. The stock is trading at 50$ a share with 33% margin of safety.
Bottom line –
I liked Mohnish’s approach to uber cannibals. It has beaten the market historically by some good amount. However, I am little skeptical about AerCap. The company can always re market default aircraft during times of low demand to maintain future cash flows. This is something they are good at. However, during 2009-10, company revenue had dropped by 50% due to a global recession. The company was still in profit due to lower interest and depreciation costs. Now that the size of the company has tripled, so are the debt and depreciation costs. I don’t see them buying back more shares if the top line (revenue) drops by another 40-50% in future. Moreover, I can’t see the stock being multi-bagger at this price point. The deal breaker question that I always ask myself is if I am willing to put 25% of my net worth in this company. If the answer is yes, I would probably make a position not more than 10% of my funds but if the answer is no, I wouldn’t buy a single share. In this case, the answer is no and thus, it is a pass for me.
Please share your comments.
AerCap 2017 Annual reports