AerCap Is A Bond, Not A Stock

March 25, 2020

AerCap Holdings is the largest publicly traded aircraft leasing company in the world. As of December 31, 2019, the company owned 939 aircraft and managed 96 aircraft.

 

The business model is acquiring in demand aircraft, utilizing the company's solid financial position and leasing network to get superior pricing. This pricing is evidenced by the fact that the company always managed to sell aircraft above book value for the past 15 years, at around 8% average premium. It also highlights that stated book values are somewhat conservative.

 

The aircraft is then leased to airlines for around 12 years initially, then released or sold as the useful life of aircraft is generally 25 years. The leasing terms are very strict, and the company may quickly repossess the aircraft in case of a default as they retain the title (unlike a bank). The company has so far repossessed over 125 aircraft from over 40 airlines. Credit losses have generally been fairly minimal, even in extremely stressed times. To illustrate, below are the 2010 financial statements of the company:

 

 

 

One would expect heavy losses from what effectively is a levered financial institution in the airline industry. However, impairments were less than 0.5% of assets per year, while the company was still recording significant gains on asset sales.

 

The company has a clever fleet management strategy, as the assets fall into two categories: 55% new technology aircraft with low average age, and 45% of old technology aircraft with high average age, presumably to accelerate the old tech fleet disposition ahead of the competition.

 

 

Turning to utilization, the company has 97% of its fleet contracted through 2022. Current utilization is well over 99%, and historically it only went briefly under 98% during the financial crisis with extremely high oil prices at the time. As a result of the combination high utilization, long contracts and low credit losses, the business is an extremely predictable one through the cycle.

 

One would expect such a business to trade well over book value, which it did for a time. This ended in 2014 when the company acquired IFLC from AIG. The deal was made at a bargain price, nearly doubling book value per share. However, AIG received shares of AerCap in the deal, which they proceeded to sell into the market in the years to come, artificially depressing the share price.

 

However, AerCap saw the opportunity and made significant stock repurchases, lowering the share count from over 200M to 130M in the past 5 years. This had the effect of increasing EPS by almost 50% while the company also deleveraged significantly. This was boosted by arbitrage between selling airplanes above book, and buying stock below book.

 

The reason for this impressive performance seems to be a good corporate culture of preparation, action, and leadership by CEO Aengus Kelly. Management places an emphasis on being ready for the bankruptcies in advance to repossess assets quickly if necessary, always maintaining significant liquidity in the business, and returning cash to shareholders.

 

Liquidity

 

The company currently has 8.2B$ in liquidity, of which over 5B$ is in cash, of which 4B$ has been recently drawn on its 2024 credit line, and the rest still available.

 

The company is also generating 3B$ per year in operating cash flow, and around 1.5B$ in annual assets sales. Finally, there are 28B$ in unsecured assets on the balance sheet.

 

On the other side of the equation, the company has 3.5B$ in aircraft purchase obligations in 2020 and a similar amount in 2021. Debt amortisation is 3.5B$ in 2020 and 4.5B$ in 2021. However, most of this debt can be refinanced as the company has many unsecured assets and relatively nonrestrictive covenants on the unsecured debt.

 

Leverage is 2.7:1, which is not very high as far as financial institutions go.

So in summary, Aercap has sufficient liquidity for times of crisis, such as we are experiencing today.

 

What the market is missing

 

When looking at the airline industry, one could build a cash flow waterfall and consider investing in either the lower or upper part of the capital structure.

The secured debt must be made whole before the unsecured gets paid, then the unsecured must be made whole before the equity gets paid.

 

AerCap's equity is wholly contained within the secured debt portion of the airline industry:

 

 

 

The reason is simple - All of AerCap's assets are owned and leased planes. Payments on these planes must be made unless the airline is bankrupt, and even then either the airline retains the aircraft in a restructuring and keeps paying, or sends the aircraft back to AerCap which then re-leases it.

 

As long global air traffic does not permanently and significantly drop (historically unprecedented), the assets are worth about the same even if many airlines go bust and restructure. Historically global air traffic doubles every 15 years, and rebounds every time after pandemics, natural disasters or acts of terrorism.

 

 

Given that, Aercap is effectively a diversified portfolio of senior secured bonds, and investing in the stock is the a junior tranche in this portfolio - as seen in the chart above.

 

The corona virus crisis is in full swing now. However, considering the current trajectory of the pandemic in Italy and China, and looking at previous pandemics of similar nature, the panic will be short lived.

 

In some countries it could last a few more months, and in some it could take another year for life to go back to normal. Unlike a financial crisis which could last for years depending primarily on human action, viruses are natural phenomena and as such are much more predictable in their trajectory and severity.

 

Given all of the above, the 70% drop in the company's stock is unjustified, and the stock should be generally priced at a yield commensurate with its position in the capital stack - and not on par with airline equities. Anything between 1.2 and 1.5 book value should be a reasonable number in my view, compared with 0.25 as of today.

 

For further reference:

AerCap March 11, 2020 presentation at The JP Morgan Virtual Industrials Conference

Greenlight Capital April 7, 2015 presentation at Grant's investment conference

 

 

Disclosure: I am/we are long AER.

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