"The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down."
At first glance, Aircastle (AYR) would seem to be too good to be true. The company is selling at 55% of net asset value, pays a 6% dividend and is rapidly repurchasing stock. What is the catch? The company is involved in the airline industry, more specifically in the business of leasing aircraft to airliners. In a slowing global economy what could be riskier than owning an airliner? Answer: Owning a company that these airliners owe money to. However, using a broad stroked pen to label entire industries as unworthy of investment is not a great way to make money. The markets' automatic discounting of Aircastle could create opportunity for the discerning investor.
Note: (The following analysis will be mainly qualitative in nature. For an excellent quantitative- based analysis of the company, please see the article published recently by SA contributor Thomas Lott)
Aircastle was founded in 2004 by the private equity firm Fortress Investment Group and it IPOd in 2006, right as the era of cheap credit was hitting a crescendo. Aircraft leasing outfits were popping up left and right as we had reached a point where there was such an avalanche of cheap money, money managers were looking skyward to juice up their returns. Unfortunately for Aircastle, the music was about to stop just as it entered the scene.
One useful exercise to do when analyzing a new company is read the CEO letters from the annual reports starting in the early to mid 2000s. Not only is it entertaining to watch how the letters change tonally from exuberant to grim as the recession unfolded, but it gives an important window into how competent management is. Did management understand the radical shifts that were taking place in its markets? Was it being active or reactive in the actions it was taking to preserve the company's positioning?
Reading the past annual reports from Aircastle, one starts to get an idea of the tectonic shifts that have occurred in the industry. Unfortunately, you cannot simply call up a bank to secure a mortgage, buy a new plane and lease it out to an airliner for an easy profit anymore. For one thing, a lot of the banks that you would call have collapsed and the ones that have survived are not eager to finance inherently risky assets like airplanes.
Even if you can secure financing to purchase an airplane, the leasing market has changed from the frothy days of the mid 2000s when airlines were more concerned about expanding their fleets to satisfy a rapidly growing market rather than securing the best lease price. In the current slow-growth environment, lessors have to increasingly compete on price to close deals.
Given the new economic realities of the aircraft leasing market, Aircastle has positioned itself as a "value investor," purchasing used aircraft in the resale market and leasing the aircraft out. It will never be able to compete with the ILFCs of the world as its cost of funds will never be as low as a company with a parent-company backing. Therefore, the company needs to approach the market from a different angle.
For small- to mid-sized independent aircraft lessors such as Aircastle, there are three main factors that will determine the success of the enterprise:
- Capital Market Access
- Exposure to Technology Risk
Having success in these three main areas does not necessarily mean that a company will survive in the long run but failing in any of these core competencies will ensure a rapid decline. It is for this reason that I will focus my analysis on Aircastle around these three factors.
Capital markets are the lifeblood of the aircraft lessor much like any finance company. If no one will lend you money at a sufficiently low rate, then it is impossible to even gain traction in the industry. The reason an aircraft lessor exists is that it is able to borrow at lower rates than airlines; if access to the capital markets is restricted then the lessor is unable to offer competitive lease rates, which will quickly lead to failure.
As discussed earlier, traditional bank lending in the aircraft leasing industry has all but dried up in the aftermath of the 08/09 credit crisis. As a result of this, Aircastle has acted proactively to shift its debt composition from secured to unsecured. At the end of 2011, 15% of the company's debt was unsecured. As of its Q3 '12 filing, this number had jumped to 41% due to refinancings done in April 2012.
The net effect of this refinancing was to extend the maturities of Aircastle's long-term debt and give it greater capital allocation flexibility. Secured lending generally brings with it restrictive covenants that require the borrowers to maintain large amounts of restricted cash that earn effectively no return. For example, by refinancing from secured to unsecured debt, Aircastle was able to free up $80M of restricted cash ($51M of which was used to close out the interest rate swaps on the secured financing).
Aircastle believes that its proven access to the U.S. unsecured debt markets will be a key differentiator in the upcoming years. I believe that by opportunistically refinancing its debt from secured to unsecured, Aircastle has not only strengthened its capital structure but given itself greater flexibility to capitalize on deals it uncovers in the resale market. With balloon payments on its debt now extended to 2015 at the earliest, refinancing risk for the company should be greatly reduced.
New technology is a constant threat in the air leasing space as it directly affects the working life of current equipment. As a general rule of thumb, airplanes are expected to have an average life of 25 years but this can vary substantially depending on when in the production run it was manufactured and when a new production run is slated to begin.
For example if a lessor were to take delivery of one of the first Airbus A320s to roll off the production line in 1988, the plane would have a very strong chance of having a 25-year plus operating life. However, an A320 delivered in 2012 has a much weaker chance due to technological advancements in the industry.
Aircastle believes it is unique in the industry in that it not only analyzes the age of a plane but also when it was produced relative to the total production cycle with a preference for planes released in the early to middle stages. Therefore, even though the company's above-average fleet age of 11 years would seem to be a negative, one has to consider that company management is managing age through a different metric that goes beyond simply number of years in service. Remember, Aircastle needs to be able to find value where others do not to succeed and the only way to do this is to look at aircraft valuations in ways that its competitors do not.
At present, the biggest technology changes on the horizon are the New Engine Option (NEO) and 737 MAX being developed by Airbus and Boeing respectively. These developments will result in each airline offering more advanced, fuel efficient narrow bodies over the next few years. This of course will affect the depreciation rates and estimated salvage values for existing narrow bodies owned by lessors as airlines gravitate to the more advanced aircraft. As a response to this, Aircastle is moving its portfolio away from narrow bodies and toward wide bodies to mitigate some of this obsolescence risk.
To be successful, a lessor has to be cognizant of how future technological developments will affect its portfolio and position itself accordingly. This requires an effective and experienced management team, which Aircastle believes to be its key differentiator.
Ron Wainshal has been the chief executive of Aircastle since 2005 and has 14 years of experience in the industry. The other company executives have a minimum of five years with the company and the majority have industry experience prior to joining the company.
Having an experienced management team and the extensive industry network that comes with it is an essential to a successful lessor. A deep network is necessary to create enough liquidity in the market to allow a company to buy and sell assets on a regular basis. To give you an idea of the number of players in the market, Aircastle has consummated more than 80 transactions with over 60 counterparties over its relatively short company life.
Beyond networking, a strong commitment to risk management is needed to ensure that the company can maintain strong, steady cash flows under a variety of market conditions. Just a few examples of the types of risk an aircraft lessor faces are as follows:
- Geographic Risk
- Repricing Risk
- Obsolescence Risk
- Counterparty Risk
Aircastle manages this risk by minimizing its exposure to any one element be it geography, aircraft type or customer. This risk diversification is exhibited in the tables below:
As you can see, Aircastle has diversified its portfolio of assets to ensure that a sudden shock in the industry should not substantially hurt the company. It is also worth noting that the company goes through rigorous evaluation of every plane in its portfolio at least once a year. This is one of the benefits of having a relatively smaller portfolio and speaks to the value investing nature of the company.
In conclusion, I believe Aircastle is a very well run company that operates in an industry that has yet to recover from the Great Recession. While company management has made mistakes in the past, namely over-expansion during the boom years, I find it very unlikely that they will be repeated.
The company has effectively found its niche as the value player in the industry and while investors wait for the market to recognize Aircastle's intrinsic value, they are paid to wait with an attractive 6% dividend.