Aircastle Limited Q3 2008 (Qtr End 9/30/08) Earnings Call Transcript

Aircastle Limited (AYR)

Q3 2008 Earnings Call

November 7, 2008 12:00 pm ET

Executives

Julia Hallisey - Investor Relations

Ron Wainshal - Chief Executive Officer

Michael J. Inglese - Chief Financial Officer

Analysts

Analyst for Jamie Baker - J.P. Morgan

Richard Shane - Jefferies & Co.

Andrew Light - Citigroup

Presentation

Operator

My name is Ashley and I will be your conference operator today. At this time I would like to welcome everyone to the Aircastle third quarter earnings conference call. All lines have been place on mute to prevent any background noise. After the speakers’ remarks there will be a question and answer session. (Operator Instructions) Ms. Hallisey, you may begin your conference.

Julia Hallisey

I’d like to welcome all of you to the third quarter 2008 earnings call for Aircastle Limited. Joining us today are Ron Wainshal, our Chief Executive Officer, and Mike Inglese, our Chief Financial Officer.

Before I turn the call over to Ron, I would like to mention that this call is being recorded and the replay number is 800-642-1687 from within the US or 706-645-9291 from outside of the US with a replay pass code of 68123844. This call will also be available via webcast on our website www.aircastle.com.

I would also like to point out that statements today which are not historical facts may be deemed forward-looking statements. Actual results may differ materially from the estimates or expectations expressed in those statements and certain factors that could cause actual results to differ materially from Aircastle Limited’s expectations are detailed in our SEC reports. I direct you to Aircastle Limited’s earnings release for the full forward-looking statement legend.

Now I’d like to turn the call over to Ron.

Ron Wainshal

Before I start with my remarks for the quarter, I wanted to comment briefly on the 8K we filed this morning. In connection with the regular SEC review process related to our 2007 10K, we determined that our previously filed consolidated statements of cash flows should be restated to eliminate certain noncash activities and to reclassify certain maintenance payments and security deposits from operating activities to financing activities.

Let me underscore that none of this will change our previously reported consolidated balance sheets or consolidated statements of income including net income, earnings per share or shareholders’ equity for all periods. This will not change our cash balances. Mike will elaborate on this later in the call when he covers our financial results.

Turning to the market, it’s clear that the current market conditions are having a negative effect on share prices. In my view the current trading levels of our shares reflect a steep discount by almost any metric that does not even come close to reflecting our consistently strong financial and operating performance, the value of our assets and our platform, and the prospects for business. For example, during the third quarter our adjusted net income plus depreciation was $87 million. This measure of cash flow works out to be $4.48 per share on an annualized basis. Relative to yesterday’s closing stock price returning in a multiple of only 1.26 times.

Both management and our Board are focused on continuing to execute operationally and on finding ways to deliver value to shareholders over time.

As we built this company from the ground up during the past four years we’ve always been mindful that our industry is cyclical. Conditions periodically get difficult and then they get eventually better again. However we’ve prepared for the tough times.

Our portfolio of 133 aircraft is modern and well diversified with 58 lessees in 33 countries. Our business generates strong cash flows from leases that have an average remaining term of 5.4 years and our portfolio utilization was 99% during the last quarter. Our fleet is term financed through at least 2013 in financings that are not recourse Aircastle and they employ a conservative 60% to 65% loan-to-value leverage, or put another way a debt-to-equity structure of roughly 2 to 1. Finally, we built an in-house team consisting of experienced top notch professionals.

I’d like to now discuss the highlights from the third quarter. Adjusted net income was $35 million and as I mentioned adjusted net income plus depreciation was $87 million. Both metrics are on PAR with last quarter’s strong results.

Our leasing performance was very good. We had already secured commitments for all of our scheduled 2008 lease expirations and all but four of our 2009 placement requirements. The placements were completed on attractive terms. More specifically, same-store rents for 2008 placements were up 12% and for 2009 they’re up between 5% and 10%, and the new lease terms average more than six years. To put this in perspective these placements cover 29 aircraft or about a fifth of our fleet and they also represent about 16% of our revenues.

On the lease restructuring side we placed the three aircraft returned last quarter. Those were two 737-300s and one 757 and they were back in service in September.

Additionally, Futura a Spanish charter carrier leasing two of our 737 classics ceased operations in early September. One of these aircraft was already scheduled to go to a new lessee starting in January next year and we’re looking to potentially start to lease earlier. At the beginning of this week we signed a letter of intent to lease the second aircraft, the 737-400, with the aim of putting it in service by year end. In aggregate, the rents on the new leases for these restructurings are comparable to the previous leases; a very good result.

More significantly last week Sterling Airlines of Denmark ceased operations. Sterling leased seven of our new generation Boeing 737-700 narrow bodies. These represented about 4% of our revenues. The airline’s financial problems are not a surprise to us and we had already put in place a swat team to get ready in case things didn’t work out. Our goal is to have lease commitments in place for all these aircraft before year end and I believe the net annualized effect of repositioning these aircraft is going to be about 1% of revenues. While this isn’t the outcome we would have liked, it shows the resilience of our revenue stream and the focus and capabilities of our team.

In any case, the unfortunate failure of Sterling and if you toured a number of other airlines over the past several months highlights the difficult business environment we discussed earlier. We’ve always diligently monitored all of our customers bringing the team’s experiences in managing through several cyclical downturns. We’re being very proactive. If there are signs of trouble, we’re leveraging the strength of our in-house credit, technical, legal, remarketing and resources, etc.

We’re also working on placing the remaining of our 2009 lease roll-off and our new order A-330s. Our four remaining 2009 placements all have second half 2009 expirations and the aircraft consist of three new generation narrow bodies and one 737 classic. We’re making good progress on these aircraft and we’re seeing healthy demands still.

With regards to the A-330s we have 12 new order aircraft coming from Airbus with deliveries starting during the second half of 2010 and they run through the early part of 2012. Three of our early positions are subject to long-term lease commitments and we’re working actively on several high-quality placement opportunities. We believe this order provides the company with very well priced built-in growth.

Demand for 330s remains good given its operating cost and technology advantages relative to older generation aircraft and the continuing 787 delays also help. The highest interest we’re getting is from airlines focusing on re-fleeting rather than growth and in general for many airlines leasing is looking a lot better now than buying new aircraft given limited capital availability. Our goal is to have the majority of the Airbus order placed by the middle of next year.

Mike will discuss the funding program for the A-330s in more detail but I’d like to point out that even assuming a very modest level of debt well below the 60% to 65% loan-to-value we’ve employed and achieved in the recent market, we expect to fund the equity portion of this program internally; that is from cash from the business, not from any public equity sale. For 2009 the total pre-delivery payments due to Airbus during the aircrafts construction are approximately $120 million. While we are starting to work on a pre-delivery payment facility, we do not need any of this to cover these pre-delivery payments.

In the area of asset sales we completed a sale of two 757s profitably during the third quarter. These aircraft were subject to sale agreements when we acquired them and the gain represents our technical team’s ability to renegotiate in win-win solutions in working out their delivery conditions between the previous operator and the buyer.

We also expect to close during the course of this quarter two sales transactions that will generate net gains as well. One is a 747-400 aircraft financed in our warehouse facility. This aircraft recently came off lease from Air India and we’re in the process of delivering it to a Western European operator who will purchase it. The other is a 767-300 ER being sold to an Eastern European buyer.

Before I wrap up I’d like to briefly cover my perspective on the market. We’re seeing weakness in Europe which has many small to medium size airlines who are financially vulnerable and in India which is suffering from overcapacity and infrastructure limitations. On the other hand, we’re seeing relative strength in Turkey, the Middle East and believe it or not the United States where airlines are benefiting from the share drop in jet fuel costs and where capacity reductions announced earlier this year look very impressive.

As airlines around the world grapple with challenging economic conditions, we’re seeing the competitive landscape in some markets getting reshaped considerably. There’s a pretty clear consolidation move afoot in Europe with three groups taking a particularly active role. They are Air France/KLM, Lufthansa and British Airways plus Iberia. Consolidation moves are also playing out elsewhere. We think this is healthy and we see positive affects for Aircastle as some of our customers get acquired by bigger players and as a result become stronger competitors.

For example, Lufthansa’s acquiring a major stake in Brussels Airlines to whom we’re leasing three A-319s. We benefit from having a strong owner here as we do with Swiss, the lessee of two of our A-330s which was also acquired by Lufthansa in 2006. We also understand that Air France/KLM is expected to complete their acquisition of Martin Air, one of our biggest customers, by early next year.

So taking a step back, our basic investment thesis has always been that travel demand will continue to grow as 1 billion people in developed economies continue to fly and as 3 billion people in the rapidly emerging economies such as the Brit countries look to increase their air travel. Our job is to manage through these downturns and do our best first to make sure we position the company’s assets to benefit from better times and then also to look for the best investment opportunities when prices are more attractive.

Currently our focus is on two things. One is managing the portfolio; that means collecting rent, leasing, looking after the aircraft and selling if it makes sense. Two, continue to enhance our liquidity. We’re convinced building cash is the most prudent thing to do in terms of ensuring the company’s on the best possible footing and that doing so will create optionality.

The stock closed yesterday at $5.63 per share and some of our debt securities are trading at significant discounts to PAR. As I mentioned earlier, we’re frustrated by this as we consider these to be extremely cheap. We also believe that attractive purchase opportunities will surface next year as aircraft owners and financiers struggle through the financial market turbulence. That said, we think it’s premature to take action today and we’ll continue to evaluate all these opportunities as we build our cash position.

I believe we’ve got the right team, the right assets, the right capital structure not only to weather the storm but also to prosper and this will ultimately set us apart from other companies during these difficult times.

I’ll now turn it over to Mike Inglese.

Michael J. Inglese

I’d like to spend a few minutes updating you on our financing activities and then cover business results for the quarter.

As Ron mentioned in the beginning, we ended Q3 with $77 million of unrestricted operating cash and we remain focused on building liquidity going forward. During the quarter we completed a $207 million term deal covering nine aircraft, eight of which have transferred into the facility and the remaining aircraft will transfer this month.

The new facility is priced at three month LIBOR + 225 basis points and will have quarterly principal amortization equal to 85% of the cash flows after payment of interest and other fees. The initial loan-to-value ratio for the portfolio is 59% based on current [half wide] market values at closing. This deal and the aircraft sale agreement Ron mentioned for the 747 refinances all the remaining assets on our warehouse facility and completes all our refinancing needs through September 2013.

In addition we currently have no borrowings on our revolver and we do not intend to renew the revolver or the warehouse facility in December. In the event we acquire aircraft we will seek to finance those assets opportunistically at that time.

We now have in place four long-term portfolio financings that are nonrecourse to the parent company and are not cross collateralized. In the first three deals which account for $2.4 billion out of the $6 billion total debt there are no financial tests that could trigger an event of default. Our latest $207 million facility has interest coverage and loan-to-value tests but we believe we have ample cushion against these thresholds and more importantly specific cure rights in the form of additional equity contributions to deal with that possibility if it were to arise in the future.

We built this business on a strong balance sheet and a stable conservative capital structure that takes into account the cyclical nature of the industry.

With respect to our remaining aircraft purchase commitment, the Airbus program, we’ve reduced the overall size of the program as well as the pre-delivery financing requirements for it. We continue discussions with numerous banks to arrange PDP financing for the program but given current capital markets conditions don’t expect to have a facility in place until sometime during the first half of 2009.

Total payments required under the program equal $120 million through the end of 2009 with over half that amount due during the fourth quarter of 2009. We expect to fund around 50% of the pre-delivery payments with the PDP bank facility but as Ron mentioned earlier, we do not necessarily need any financing to cover these pre-delivery payments.

Regarding our financial results, we earned adjusted net income of $35 million or $0.45 per diluted share on revenue of $144.5 million for the third quarter compared to $32.9 million or $0.49 per diluted share on revenues of $105.3 million in the third quarter of 2007. The Q3 figure excludes an $800,000 gain on the sale of the two aircraft Ron mentioned and includes $12.2 million of charges related to interest rate hedges. Similarly, the Q307 figure excludes $0.5 million of charges related to interest rate hedges.

Adjusted net income plus depreciation was $87 million or $1.12 per diluted share, up 28% and 10% respectively over Q307. We use this measure to assess our cash operating performance after taking into account the interest expense on our outstanding indebtedness.

At September 30, 2008 we owned 133 aircraft. For the aircraft owned at quarter end we had contractual aircraft lease rentals on a monthly run rate basis of $45.3 million or $543.3 million on an annualized basis, up 25% from Q307 producing a gross yield on the portfolio of 13.6% or 1.13% per month. Our fleet revenue utilization during the quarter and year-to-date continue to exceed 99%.

For Q308 total SG&A was $11.6 million including noncash share based compensation expense of $1.6 million in the quarter. Our current expectation for full year ’08 cash SG&A continues to be approximately $40 million.

Reported interest expense for Q3 was $54.1 million including hedged charges of $10.5 million. This figure is also net of $1.6 million of interest earned on cash balances and $700,000 of capitalized interest. Gross interest expense excluding the hedge items previously noted on debt facilities was $45.4 million on weighted debt outstanding of approximately $2.7 billion during the quarter for a weighted average cost of funds of 6.76%. At the end of the quarter we had $2.6 billion of debt outstanding with a debt-to-equity ratio of about 2 to 1.

Depreciation expense for Q3 was $52 million compared to $35 million for Q307 reflecting the growth in the portfolio year-over-year and our September 30 run rate for depreciation maintains at about $17 million.

Third quarter we recorded a tax provision of $1.3 million for an effective tax rate of 4.9% year-to-date reflecting the revenue and income sourcing mix from the portfolio.

A quick update on our hedging activities in connection with our most recent term financing. We terminated approximately $200 million of notional value of existing hedge agreements and put new hedges in place. As with our other long-term financings the new hedges for the $207 million term facility do not require any cash collateral posting going forward. Our remaining hedges that require collateral posting have approximately $19 million posted today.

Following up on Ron’s comments on the 8K we filed this morning, we currently expect to file the appropriate amendments in our third quarter Q within the next few weeks. To re-emphasize, the changes only relate to the cash flow statement presentation issues and there’s no impact on the income statement, balance sheet, overall cash position of the company or cash performance.

With that Operator we’d like to proceed to the Q&A portion of the call.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Analyst for Jamie Baker - J.P. Morgan.

Analyst for Jamie Baker - J.P. Morgan

Regarding your new $206 million term loan, can you tell us what the amount of schedule payments are for 2009? I know that in your $786 million term loan there’s a $50 million amortization per year for the first five years. I’m just trying to get a sense on what you’re total debt amortization payments would be for 2009.

Michael J. Inglese

The amortization profile is variable and it’s based on the rents collected in the portfolio after taking into account interest expenses. 85% of that difference will be applied towards principal repayment each year and we haven’t been in the practice of giving forward guidance on that amount. So you’re going to have to watch how that plays out over time but it’ll be substantially less than the amount you see in terms of the [inaudible] portfolio schedule payments on a quarterly basis.

Operator

Our next question comes from Richard Shane - Jefferies & Co.

Richard Shane - Jefferies & Co.

The 737-700s on lease to Sterling, when were they put on lease?

Ron Wainshal

The short answer is the leases were renegotiated in early 2007.

Richard Shane - Jefferies & Co.

Where are the lease rates or where were the lease rates on those seven planes versus the current lease rates or the lease rate on the most recently placed 737-700 within your portfolio? I want to get a sense of what’s going to happen on those seven planes in terms of directionality of revenues.

Ron Wainshal

I’ll just kind of get to some numbers here. The simplest way to look at it is the lease rate monthly was around $300,000 a month under the Sterling leases before. I think we’re going to be 15%-ish, maybe 20% down with the new leases.

Michael J. Inglese

Partly that reflects the fact that we’re getting aircraft back during the winter which is a harder time to get aircraft back. I think had we gotten these in the springtime when the summer season peaks, it would probably be doing quite a bit better than that. When we look at our lease placement options we’re going to have to weigh between more downtime and higher rents and the converse.

Richard Shane - Jefferies & Co.

Out of curiosity, when that happened why not issue an 8K?

Ron Wainshal

Two things. One is it wasn’t material in our estimation and also the information was all public. We actually issued an 8K when we bought the aircraft so the information, back in 2006 I believe, was largely out there and the fact that Sterling was in bankruptcy was also pretty well publicized.

By the way, one other thing. It happened last Wednesday and we figured we’d address it in a lot more detail on a call like this.

Richard Shane - Jefferies & Co.

Looking at your capital allocation strategy, you’re in a situation right now where the stock is trading at 30% of book, give or take. You’re basically preserving capital to acquire the Airbus 330s and you’ve made these pre-delivery payments. Does it make any sense at this point to actually bust the contracts and just buy back stock? I mean, you’re going to buy the planes at PAR or you can go out and effectively buy a portfolio that you’re valuing at X at 0.3X. Isn’t that a better investment at this point?

Ron Wainshal

A couple of things. The contract is one which we think is extremely well priced. We can’t get into the details. Those are subject to confidentiality. But we continue to believe that this is a really really good deal. Number one. Number two, breaking contracts with manufacturers isn’t so easily done. You’ve got to give up your deposits and then you’re probably exposed for actual damages based on whatever they do with the aircraft in lieu of your taking them. So that’s kind of hard to quantify. It also isn’t exactly great corporate policy from being a market player.

I think that the better way to look at it is, what is the best way for us to deploy the capital we have right now and is there a better to reallocate it? As you noted we made a few asset sales. Those all help and we’ll find the best way to re-channel the portfolio. But you also have to take into consideration the world in which we live.

Richard Shane - Jefferies & Co.

I understand that and I respect that, and obviously walking away from a contract there is a long-term implication of that. There’s a social implication of that or an ethical implication of that. But there’s also an economic implication and it just strikes me that you guys may have really good pricing on those contracts but if you take the balance sheet as is, the market is giving you an opportunity to buy 100+ planes that you know well at 30% of the value of those planes.

Ron Wainshal

We’ve considered our options pretty carefully and our decision is not to do that. There’s a basis for doing that.

Operator

Our next question comes from Andrew Light - Citigroup.

Andrew Light - Citigroup

In the quarter was there any charge for the Futura bankrupt in September? Was there any kind of transition or maintenance cost associated with Futura in the third quarter or will that come in the current quarter?

Michael J. Inglese

I think there was a very, very modest charge in the third quarter. I don’t know off the top of my head but it’s probably in the $200,000 or $300,000 ballpark. That kind of relates to write-offs of leases and the like.

There was no revenue discontinuity because during the quarter we had security deposits covering us and actually we did a very good job of getting the aircraft back on lease; they’re about to be anyway. That’s a fourth quarter affect but I think as I said during the script, if you look at all the restructured aircraft that we had to address so far this year, putting Sterling aside, the rents are almost the same one lease versus the other and the repositioning costs were extremely modest. Generally speaking most of the aircraft were taken as is or something very close to that.

Andrew Light - Citigroup

What would you expect the additional cost in the fourth quarter in respect of repainting, reconfiguring and bringing those planes up to scratch, the two Futura ones?

Michael J. Inglese

I think it’s inconsequential. It’s a few hundred thousand I would say at most and I think the bigger story’s going to be on Sterling.

Maybe I should drill into that a little bit because I imagine you’re going to go there as well. Sterling’s seven aircraft, I talked a little bit about the revenue aspects. We have security deposits to cover two months’ rent, around $600,000 per aircraft. That covers us for downtime. I think we’ll have these aircraft back in service sometime during the first quarter. We have good demand; it’s coming from a variety of different places around the world; and I’m pretty optimistic about it.

Redeployment costs are probably going to range I’m going to guess somewhere in the $500,000 to $1 million territory, per aircraft. Some of that are things that are lease specific like paint but a lot of that is going to be things like take-off weight updates that have a lasting value.

One last thing economically. We had agreed with Sterling to install winglets on these aircraft which Sterling did at its cost. Title was passed to us. We gave them a break on rents in exchange for that so I think actually there is a benefit coming to us. By getting the aircraft back early that doesn’t flow through the accounting statements but to [inaudible].

Andrew Light - Citigroup

Does the $500,000 to $1 million per plane flow through the income statement [inaudible]?

Michael J. Inglese

That is not something that’s going to flow through the income statement. It’s just an enhancement in the value of the aircraft.

Andrew Light - Citigroup

So the $600,000 security deposits you have, presumably they were fully paid up until the time they went down so you have full coverage through October and November and then there’s no coverage?

Michael J. Inglese

That’s right.

Andrew Light - Citigroup

A question on the maintenance rent, the $5.4 million you recorded in the quarter. Is there a rule of thumb as to how we can predict that? Is it a set amount per lease expiring [inaudible]?

Michael J. Inglese

The short answer is no. There is no way. That’s a hard one and I think what we’ll try to do going forward from a disclosure perspective is try to separate that stuff out as much as possible, but we can’t predict which airlines are going to go bankrupt when and the maintenance numbers that you’re talking about build up and they change over time. They reach kind of a peak just before an aircraft goes into a shop and then it drops down.

Ron Wainshal

It’s unfortunately very lease specific and it’s not just if someone defaults. It’s when a lease naturally expires. There may be excess that comes through the P&L related to the maintenance reserves collected under that lease. So it’s very hard to predict and virtually impossible for us to guide you around.

Michael J. Inglese

Analytically I would strip that out. From an accounting perspective it’s revenue but I don’t think of it anywhere near the same way as a rent.

Andrew Light - Citigroup

Was it with respect to the Futura then [inaudible] payment or was that across other lease expires as well?

Michael J. Inglese

There were other lease expirations in the quarter that contributed to that number.

Andrew Light - Citigroup

Presumably there’ll be maybe not a similar number but maintenance rent in Q4 with respect to Sterling?

Michael J. Inglese

It’ll be quite a lot bigger.

Operator

This concludes the Q&A portion of the call. I will now turn the conference back over to the presenters for any further remarks.

Julia Hallisey

This concludes the Aircastle third quarter 2008 earnings call. We look forward to speaking with you next quarter.

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