Having spent much of the last two years living in a frontier economy, I've learned a thing or two about how to succeed in business in a less-developed market. In particular, two traits of successful businessmen stand out. To start with, a healthy dose of common sense is needed. I'm not talking about the book learning that you get at a fancy business school -- I'm talking about common sense about practical matters. The other trait is that you need access to capital -- lots of it -- at rates lower than your competitors. In the U.S., people fight over basis points -- a full percent difference in cost of capital is the difference between life and death. In most emerging economies, just having access to capital -- at any price -- is the secret to success. If you can borrow at anything approaching Western rates, you will win the game.
We all know that airlines are one of the worst businesses of all time. No one wants to invest in them -- fewer people want to lend to them. If the average emerging market business is starved for capital, the airlines are even worse off. At the same time, emerging markets are seeing rapid growth of seat miles as more people enter the middle class and begin to travel. Additionally, many of these emerging market airlines face less competition and generate reasonably good economic returns, allowing them to reinvest and grow. They just need the capital for new planes. Enter Aircastle Ltd. (AYR).
Aircastle is an owner and lessor of cargo and commercial aircraft to companies who either cannot borrow to buy their own planes or do not want to make long-term financial commitments by buying their own planes. At the end of the second quarter, these were some of their lease commitments out of 155 planes:
|Airline||Country||Number Of Planes|
|South African Airlines||South Africa||4|
|Hainan Airlines Co.||China||9|
|SriLankan Airlines||Sri Lanka||5|
|Iberia Airlines||Spain (Essentially a frontier economy at this point)||6|
Aircastle makes money by leasing out the planes at a higher yield than what they borrow the money at to buy the planes. For a while, that has been a good business. Lately, it has even gotten better as more airlines are having difficulty getting financing at attractive terms, yet Aircastle has been able to lower its cost of capital recently. At current rates, Aircastle borrows at a blended cost of 5% and leases the planes out at approximately 14%. Keep in mind that this doesn't include depreciation or management expenses. Still, it's a very good business to be in. Remember that as with most leasing companies, the balance sheet is a bit leveraged, so your actual returns on equity are in the mid-teens. As the company gets larger, they should be able to continue to lower their cost of capital compared to competitors and broaden the diversification of their airline clients, which creates something of a moat in what shouldn't be a business with a moat.
Here's where it gets interesting. Aircastle recently ordered additional aircraft for $200 million, which will serve to continue to grow their earnings. In the first half of 2012 it earned $0.68 a share, but that also includes a $10 million impairment on an aircraft. Add that back, and earnings come to around 80 cents a share for the first half before minor adjustments for tax. I should point out that this annualizes to $1.60 a share for the full year, but this is deceptive for two reasons. First, there will be more planes in the second half of the year -- those added in the first half that haven't had the benefit of being in the portfolio at the beginning of the year, and also new planes to be purchased in the third quarter. Second, the company just refinanced its debt in a way that will save it approximately 50 cents a share each year. Add it all up, and I figure that run-rate earnings are better than $2.00 a share, and you're not paying much more than six times earnings for the shares.
I should naturally point out that it is difficult and unwise to try and get too precise on the earnings forecast because of the volatility in earnings caused by impairments, gains on sale, and maintenance revenues. In any case, you can buy the shares for a bit more than half of the liquidation value of the company if you sold off the planes and paid off all the debt. At quarter end, book value was $20.50 a share compared to the current share quote at $11.76. You don't have to be all that precise when you have that sort of margin of safety.
I've been of the opinion that in an inflationary environment like we are witnessing, the replacement value of tangible assets will continue to increase. I would certainly put an aircraft into the category of things that will cost more to produce in five years than they cost today. Meanwhile, Aircastle has been able to secure financing against these planes at very advantageous rates, allowing the company to get the advantage of inflation. Clearly, depreciation will offset much of the benefit of the increased cost to replicate a plane, but I think that over time, depreciation will substantially exceed the true decline in residual value of the planes. This is important because Aircastle continually sells off older planes so that it can purchase newer aircraft with better leasing economics.
As I see it, with Aircastle you get a play on the growth of air travel in emerging markets, and also a play on the view that economic uncertainty will continue to price more companies out of the debt market and force them to use companies like Aircastle. I think that both of these are trends that you can count on continuing for quite some time. For that right, you're buying the planes for half of their value and the company pays you roughly 5% a year in dividends while you wait for the market to recognize the attractive nature of the business. The company is scheduled to grow at a double-digit rate over the next year, with earnings per share at an even more rapid pace and I would expect this growth rate to continue.
I have been following this company for a few years, and it has always seemed cheap, but I have waited to talk about it until after the Fortress group of hedge funds finally sold their remaining stake, which had been an overhang on the shares for a very long time. Three weeks ago, Fortress finally exited their position and Aircastle repurchased 2.5 million of those shares as part of its ongoing buyback. In the past year, the company has repurchased 6.5 million shares, which has shrunk the share count by 9%. When you buy back shares at a massive discount to fair value, you create a lot of value for existing shareholders. Following this repurchase, Aircastle will still have $21.5 million remaining on its buyback. I would expect it to continue to repurchase shares and create substantial value for shareholders while growing the business.
Of course, I should mention risks. The biggest risk that I see is that something happens to substantially reduce global air travel. In the same line of thinking, any time that you have a leveraged financial entity, you always have to worry about the duration on the debt (manageable) and if the planes are correctly valued. The global aircraft market is quite liquid. You can sell a plane with a few phone calls. I have to think that its auditor has looked over the fair values of the planes and thought that it was accurate. I get further confidence on aircraft valuations, based on the fact that Aircastle usually seems to sell its planes for a bit more than carrying value when it sells older planes. However, these are my concerns. That said, my fund owns some shares.
Additional disclosure: I am the CEO and chairman of Mongolia Growth Group MNGGF, a publicly traded company.
Disclaimer: Funds owned and managed by Harris Kupperman are currently long shares of AYR. He has no further obligation to notify you if he chooses to buy more shares or sell them. Do your own due diligence, caveat emptor.