Frank Constantinople – SVP, IR
Ron Wainshal – CEO
Dave Walton – General Counsel, COO and Secretary
Roy Chandran – EVP, Capital Markets
Mike Inglese – CFO
John Godyn – Morgan Stanley
Mike Linenberg – Deutsche Bank
Paul Bornstein – Black Diamond
Mark Streeter – JP Morgan
Justine Fisher – Goldman Sachs
Howard Rubel – Jefferies
Andrew Light – Citi
Aircastle Limited (AYR) Investor Day Conference Call April 11, 2013 12:00 PM ET
Good afternoon everyone and welcome to Aircastle’s 2013 Investor Day. I’m Frank Constantinople, the Senior Vice President of Investor Relations. We have a pretty full agenda which we hope you will find useful. Our presentation today will be broken into four parts. Ron Wainshal, Aircastle’s Chief Executive will begin by discussing our business strategy and providing an industry update. Ron will be followed by Dave Walton, our Chief Operating Officer, Dave will review Aircastle’s aircraft portfolio management process. Roy Chandran, our EVP of Capital Markets will then provide an update on the financing markets and Mike Inglese, Aircastle’s CFO will provide a review and update of the company’s financial profile.
We’ll begin the presentation shortly, but I would like to mention that this meeting is being webcast and afterwards the webcast replay will be available on our website at www.aircastle.com along with the PowerPoint materials that we’re presenting here today. A quick reminder, please turn off all cellphones. I would like to point out that the 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 facts that could cause actual results to differ materially from Aircastle Limited’s expectations are detailed in our SEC filings which can also be found on our website.
I will direct you to Page 2 of today’s presentation for the full forward-looking statement legend. And I’ll now turn the presentation over to Ron.
Thanks everybody, welcome. I appreciate you guys coming and making the time. This is the one opportunity here where we have a chance to not only talk about what we’ve been doing recently but also to give you a broader perspective on how we see the market, where we see the opportunities and how we’re actually transacting on those.
We’ll start up by talking a little bit about the market but I think the long-term story here about the positive industry fundamentals holds true. We’ve built a large modern portfolio that’s diverse and reflects a broad spread of risks. Dave will talk about this but our portfolio management is really top tier. We’ve got an organization in-house that’s scalable and has done a terrific job matching our fleet over time. And through this, and through our investments we’ve generated very stable cash flows and we’ve been able to tie that into very conservative long-term oriented capital structure.
We’re disciplined investor we don’t necessarily follow the pack. But we’re focused on the shareholder value and to that end we’ve delivered dividends 27 consecutive quarters. And the management team is really top notch.
So, let me talk a little bit about some of our corporate goals and your return and I’ll tie those in, we’ll all tie those in together during the course of our presentation. We’re trying to focus on improving our return on equity, and I think the current investment environment offers that. We’re targeting aircraft investments that provide cash ROE in excess of 15%. And what makes that particularly interesting right now is that the capital markets – the cost of financing is so attractive. It’s rare that you find an environment where it’s good to invest and it’s also good to finance at the same time.
Now, to get this done, we’ve got to do a good job of picking assets and managing them. Our goals for this year in terms of growth, is about $350 million similar to last year. And I think that’s something we can do and continue to do with the same platform that we have.
Last year was a very important year in terms of capital structure evolution. We’ve really reshaped it, it’s much more capital markets oriented, it’s much more flexible and secured. And as we’ve been developing this, the costs keep going down. And as we do this and as we increase our profitability we would continue to return capital to our shareholders.
Now, it’s a big business, it’s a playing field and opportunity setup $400 billion to $500 billion. And every year it seems like the production increases are continuing. Right now it’s over $100 billion of production every year. So the big opportunity is that there is lot of ways to play, lot of ways to play successfully. We choose to do it in a particular way and I’ll talk about why in a little bit. But first a little bit on the market.
On page 8, you’ll see the time series that shows for 40 or so years how the growth of the passenger market has been stronger – quite a bit stronger than the growth in world GDP. And fundamentally this business is driven by economic activities. However what you see is that there is little more volatility here. We live in a business that’s growing its being propelled by increased travel around the world. But it is subject to the economic bumps along the road. And recognizing that is an important part of the business.
Now, what’s driving the growth? It’s growth in the emerging economies. If you see today, Asia Pacific is roughly the same size as Europe, roughly the same size as North America. But if we look forward you’ll see that the growth is really happening in those areas in the world where the economies are growing faster. And that’s where you see higher operating less work penetration, that’s where you see higher investment opportunities. And as Dave will describe, our portfolio reflects that.
Now, in addition to the market being a growing market, when it grows to 1.5 or 2 times GDP, the share of the market that’s occupied by lessors has also grown. And it’s grown to almost – roughly 40% right now. Lessors have funded a large portion of the expansion in the world fleet.
And I think that will still continue to grow and here is why. Most top lessors and I’ll include ourselves in this category have lower funding cost in most airlines. Leasing provides airlines with flexibility over time in terms of their fleet. We’re better at lessors in dealing with residual values in airlines. And fundamentally, airlines just do not do a very good job of capital management. It’s a low margin, cyclical business that’s extremely capital intensive, and the chart on page 11 shows you that they just haven’t done a good job of covering their cost of capital. That’s a key element that’s driving the lessors market share growth.
So, a little bit about the supply side of our market. Production levels are going up as I mentioned before. They’re going up in particular in the narrow body side. The current generation narrow bodies have basically doubled in production levels since about 10 years ago. And there has certainly been market growth but that’s something that we’re concerned about.
Having said that, there are order backlogs for the current generation airplanes they extend for several years. So, on one hand I can’t fall to manufacturers for building something which people are ready to pay for today. But as a long term investor something we have to take notice of.
I did not include by the way the next generation aircraft because it’s hard to predict what the backlog would be until you know how many airplanes they intend to produce. But those are sold off for quite a number of years as well.
And the wide body sides, it’s a little bit better story. And it’s because you had delays in the introduction of the 787 that go far, many years before the lithium ion battery issue, this program is four, five plus years behind schedule and that in turn means that the 777 replacement is behind schedule as well, the A350 is not immune to it as well. And so the existing technology aircraft benefit from that. And we take note of that from an investor perspective. So, longer an aircraft is going to remain in production, we think the longer it will hold its value.
So, one of the biggest questions that we get asked about is the freight market. Freight market is a market that accounts for about 29% of the book value of our portfolio. I think it’s one of the most misunderstood aspects of our business and so I’d like to spend a few moments talking through this with you guys.
The freight market for sure has suffered along with the global economy. Now what is it that goes by air? It’s high value, and it’s time sensitive. It’s not bulk commodities. That will always go by shape or by land or through some other mode. So, the market has actually grown, it’s just that it’s slowed down over the last few years. In the past two years, it shrunk about 2% to 3%, which is not good news but it’s not a disaster.
The one thing about this market is it’s a very economically sensitive market. If you see on page 14, you’ll see that it moves up and down with the economy a lot more so than the passenger market, it’s a business to business activity. Now we’re in a down-slope right now, I don’t think it’s a permanent down-slope and I’ll explain why.
So, first, what is that flies by air? First of all, it’s a $3 billion market. And it accounts to provide value at 35% of what gets traded around the world. Now, global economic trade flows are growing at a much slower rate than it historically did. Last year it was about 1% to 2%, this year it’s to the 3%, a little bit better.
It is a market though that has lots of distinct components to it, for example the express component where FedEx and ups play is a distinct market where leasing companies like Aircastle don’t play. So when you read the news about what FedEx has to say, it’s an important economic parameter but it does not affect our business. And in any case it accounts for 8.5% of the market.
Now what we did here is we showed you two pie charts, one by tonnage, and one by value. And so, let me give you a little bit of color on what some of these categories consist of. By value, the biggest part by far is what I’ll call high technology that include semi-conductors, laptops, tablets, PCs, network hardware, flat panel screens, all sorts of hi-tech equipment.
And in terms of dollars per pound that’s the biggest most value part of it there. And so you’ll see all sorts of movements in that market. There is a move away from PCs to tablets there is a lot more smartphones floating around today. That market if you look at the International Semiconductor Association, it’s actually kind of leveled out its fine. There is new product introductions and surges and the likes.
Another important here is capital equipment that includes auto-parts and includes oil and drilling equipment, there is a lot of things that need to get some place fast, they’re high value, there is no other way to go. Of course there is the perishable things like Sushi and flowers, there are things like on the consumer side, fashion apparel, that’s the one area where you see a little more of a cross-over into other modes. There has been, and particularly when you talk to somebody like a FedEx, the ship towards less rapid movement of goods. But that I think it will develop in a few minutes is a lesser effect on what we own and what we lease.
So, a couple of comments about supply and demand. The industry is definitely scalped to pinch. But we have two charts here, one it shows the freight ton kilometers which is the measure of demand. And you can see that it’s economically sensitive, in the last two years, down 2% or 3%. As I said, that’s not a good story but it’s not calamity. The big news here is that the supply has increased.
The supply has increased a lot more than demand and why, it’s because you’ve had a bunch of new aircraft programs come online, the 777 and the 747, the shape freighters have come online just at the wrong time, that it’s a fact of life. And this is the big driver in the market more so than demand side.
So what is that we own? The air freight market like passenger market consists of lots of different pieces and parts. We own large freighters, meaning MD11, 747-400 freighters account for almost all of our freighter fleet. And those operate very differently than say a 727 or 757 that FedEx has.
What I’m showing you on this chart here on page 17 is where trade flows happen. So, trade flows are most important for larger freighters like what we have trans-pacific from Asia to the North America market or from Asia to Europe. There is also a fair bit of activity going to the Middle-East now is the large Gulf carrier start behaving as hub and spoke carriers, and there is a lot more activity to follow the industrial activity in South East Asia.
Now what this chart shows you is available capacity, not actual used capacity but available capacity. And the industry statistics is to be clear include belly capacity and passenger aircraft. Okay, let me talk about that a little bit more.
Now, sorry wrong slide, the belly capacity is something that is important trend, I think a lot of people view that as the killer aspect of the sector. It’s important but to put it in context, the available capacity worldwide on the belly space over the last five years has grown from 41% to about 45%. That’s available.
Now in terms of actual use capacity, it’s 23% to 27%, that’s the change, the magnitude of the change. And when you put that in context, there has been a bit of a market share redistribution, it’s important but it’s not of the scale that I think most people understand. The fact of the matter is that belly capacity is increasing but it’s not utilized highly because passenger networks are optimized around passengers as opposed to cargo. So bear that in mind.
Now as I said before business confidence is the big driver here, there is tremendous correlation between freight time activity, freight time kilometers and how people feel about the world. When people want to restock and they want to do it quickly, they’re going to do it by air.
And when you stratify business confidence levels, the weak point in the world right now is in Europe understandably. The weaker trade lanes right now have been Asia to Europe. The luxury goods, the hi-tech equipments that would have otherwise been consumed that shortfall is felt in Europe. And so when you look at this business and you say, well, what are the catalysts, business confidence number one and I think in particular business confidence in Europe. So that’s a little bit on the freight market. We’ll be happy to address more questions at the end of the presentation.
Now a little bit about the outlook in general. As a general matter, a lot of different organizations have been revisiting their forecasts over the last few months. I audited the trade organizations, the world’s airlines, International Transport Association, they had a quarterly forecast, they just upgraded the profitability $10 billion or so for the whole industry which is still a paltry margin. But they’ve also fund that to reflect a little bit of a more optimistic perspective in terms of growth in the world economy.
So, you can see the change in the December forecast versus the most recent March forecast in page 20, and you can see positive numbers. At this point there is an increase in the freight market that’s projected for this year of almost 3%, very strong passenger growth continues in ‘13 as well. And you see a few other important variables the yield is stabilizing in the freighter side.
Okay, now that’s a one year forecast put about a little bit longer, this is where the crystal ball comes out. I audited showing kind of a current to more long term trends in terms of both passenger and freight. The passenger growth rate is still in the 4%, 5% level, very healthy, still a multiple global GDP. Freight comes back after a sort of a missing few years worth of growth.
Now I audited in the most reliable organization in the world, it’s a tough job. We’ve also been working with Seabury on advising us on the freight market. And their perspective is probably a little more aligned with ours. They are showing a slightly more conservative 4% growth over this five year horizon.
So, what do we do with this? I think there is a few things that we all put together including interest rates, I’ll talk about that for a second. First of all, interest rates are at all-time lows, I think everybody here knows that. There is a few impacts here. One is that the good thing for aircraft values and we’re seeing that. Second thing is, it reduces financing costs and the capital market in particular have been a beneficiary of this and as one of the few aircraft leasing companies that plays there, we’ve benefited in that as well.
Now there are some different mixed affects here as new aircrafts get financed, as resale lease back take place, it brings the lease rates down and that put pressures on older aircrafts. That’s sort of an underappreciated phenomenon and if you have availability caused by the production increases that does cut against the lease rates in general.
But having said that I think we are still optimistic. And the other thing is when you look at the used aircraft below interest rates means break funding costs are much higher. And last year was the second lowest year for used aircrafts transactions ever. This year looks a little bit better though.
So, looking ahead, we’re seeing a modest recovery in rents, we’re seeing a little bit better tone in demand, a little bit more in the way of competition from lesser use for aircraft as they come off lease. It is not uniformly across aircrafts, wide bodies a little bit better story than the narrow bodies. The newer aircrafts will be better than older aircrafts.
But I think the other impact is on prices. The prices have gone up but I still think it’s a good time to buy. Basically what happens over a course of the cycle is the when prices are at the very best, the business flow, the transaction flow is very low. So, there is not as much opportunity to work to – to put money to work. This year prices are little higher but the debt costs are even lower and the yield flow is certainly better.
The other thing is I think because of this the trading activity in the secondary market will improve but not the extent we’ve seen in the past. The high book values for lot of sellers are a problem, part of that is a currency issue, part of that the depreciation issue, part of it the break funding issue. And I think the other problem is there is just not much of a bank market to fund that, that’s where our capital market strategy comes into play.
So, let me talk a little bit about the investment approach. We hear a lot of questions about depreciation, it’s something we think about a lot as well. How do you measure depreciation? That’s the big crystal ball item in our business. Well, how long does an aircraft last from a design perspective? It lasts a lot longer than actually flies. What do people do from an accounting perspective? Generally speaking, we use the same approach as starting point as everybody else in the industry which is 25-year life to 15% residual which is supposed equate the craft’s value.
Now, the economic life, the real economic life is first of all, just a number and its very contact specific. Aircrafts, the way we look at it is, as long as an aircraft can justify its reinvestment it will remain flying. And the minute it stops then it gets broken apart. So, our investment thesis is this, and I’ll demonstrate why in the next few pages.
Aircrafts in the early to middle part of a production life will hold a life better it depreciates solely from an economic perspective. And the corollary to that is the last offline aircraft that depreciates faster. The other part of it is that since the residual, the scrap value at the economic life is mostly engines you’ve got to take that into consideration. The values of these engines, is most when the user base is the biggest, which means, earlier on, once the production has reached maturity.
Years and years out, the engines won’t hold their values much because you’ll be competing with a bigger group of cannibalized aircrafts and then at the same time the operator base will shrink. So, let me demonstrate that with an example.
We charted the values this is using send values by the way, over – the current market values over many years for different vintages of airplanes. And we can show you the same exact pattern for 737-300 for example. More of the story is that this shows you that an aircraft bought at the end of the line is going to depreciate twice as fast at the beginning of the line. And that’s a really important thesis in terms of how we approach life.
I’ll take you through the airplane example in a minute. But there is a couple of other things I wanted to point out in this chart. You’ll see that these current market values which are kind of desktop appraisal numbers, they’re not specifically tied to a lease but they do reflect the business cycle. And there are sometimes you may want to buy and sometimes you may want to sell. And your entry point has the big impact on how you do at the end of the day in terms of returns. So, we recognized that the cycle of investor we say, we can’t fight it, let’s embrace it.
Okay, so those slopes were going down to a certain point, what is that point. That point is the residual value at the end of useful life of the aircraft. And when you look at an aircraft production run it’s quite long, in fact this generation of aircraft, these A320, CEO and 737 NGs are – they’re going to be 20-year run. And it’s going to be the first time that we’ve ever seen one technology of airplane, replace itself.
In the past if you look at the classics at the bottom of this page, page 27, you see that the 9 or 15 year production run and much smaller of course. So by the time the NEO or the MAX shows that you’ll have 6,000 – 5,000, 6,000 each Boeing and Airbus model in service, it’s a really big number.
Now when you look at engine values, as I said before, the maximum demand for those airplanes will be when there is a lot of airplanes flying around. As the NEO comes along and as people start attiring aircrafts then that demand will gradually shift. Now it’s important to remember when you talk to people about the value of an engine, nobody asked when was it built. It’s hours or cycle tin flash shop visit. Now that’s a really important determiner in terms of how you think about value.
So, whether I bought the engine off of a 2012 airplane or 2002 airplane doesn’t change per say the value’s condition. And so let me put that into some sort of context here.
I wanted to talk about how we think about maintenance and useful life, and sort of operationalize – it was sort of a very simple kind of one component example. These elements are all very maintenance intensive engines are probably the most expensive thing to maintain in an aircraft. The airframe is the next most important thing and they get maintained on different cycles.
The way it works is that lessees are responsible for the maintenance and to the extent that they give you something that’s less than the full life at the end of a lease, they’d give you a cash adjustment or they’ll pay you cash means along the way. So the chart at the bottom of page 28 shows you the difference between run-out value and full value. And in the case of an engine, it could be $5 million for narrow-body engine. And if you’re doing your job right you’ll be collecting cash along the way to compensate with them.
Okay, so during the aircraft’s lease, during the engine’s life you’re going to see a number of shop visits and at some point the lease will come to an end, you’ll have to decide, okay, do I want to release this aircraft. When you do, the next lessee is going to say okay, thank you very much but for all the time that was burned off before I want you to compensate me for that when I take you to the shop visit.
And so then you have to make a decision, do I want to make a commitment to take this cash I’m holding today and reinvest it in the aircraft or do I keep it and just get out. And that’s what’s driving our decisions on the older aircrafts in our fleet. It’s really simple economics. There is the net pressing value of the future cash flows exceed what I can realize today.
Okay, so having established that let’s talk about an example. So, we took some appraisal numbers here. This is an average of a few different appraisers I think. No, actually its cent value I’m sorry. So the general rule of thumb, general wisdom is new is good and old is bad, okay, I think price matters, okay. So, let’s – and announcing – the other thing that comes up is old is risky and new is not, but that’s also functioning what you intuit for and what your expectations are.
So, let’s take an example. Now I should say first, every owner of an aircraft whether it’s new or used has residual value risk. This is not a full payout financing business. And so the margin matters along the way but the residual matters too. So if I were to buy a brand new A320 today and I used the conventional depreciation method of 25 years or 15% residual, in 12 years which is kind of a good long first lease, if you can get it, that airplane would be worth a little bit under 60% of what you paid for, so in this case a little under $24 million. Okay, so that’s a starting point.
Now, let’s compare that to a used mid-age aircraft, 12-years old, okay. When we look at values by the way, talked about the difference between full-life and run-out, the difference between full-life and half-life, half-life has got most appraiser’s reference, in this case its $5 million or $6 million an airplane, it’s a lot of money. These are all full-life values to give you apples-to-apples.
So, if I was buying a full-life A320 today it would probably be $20 million, a little bit less than half of the value of the cost of a new airplane, okay. That neither good nor bad it’s just the fact of the market. Now in 12 years, appraisers will tell you that without any inflation that the new A320 will be worth more than the current A320 that’s 12 years old. To me that doesn’t sound right. You’re going to have lots of new others, you’re going to have lots of additional CEOs, and when we – like I said before depreciation is the big guest in our business and we don’t outsource our depreciation – economic decisions, we form our own view.
My view is that the aircraft is 12 years old today, probably should have a better value than an aircraft in the dual inflation environment that’s 12 years old in 12 years. Now in contrast, my 12-year old aircraft today in 12 years would be part off value. And we’ve been transacting at these levels so I’m pretty confident about it.
So, I ask you which do you think is higher risk? Rhetorical question. So our investment approach isn’t meant to say it’s good – it’s old as good and new as bad, it’s a value question, it’s a value proposition question where you have to ask yourself do the assumptions make sense? And so, this informs our investment decisions and let me take you through what we’ve been doing in our respect.
So fundamentally, we view ourselves as a value investor. There is a lot of different models out there but almost everybody seems – large seems to be focused on new narrow bodies. The airplanes are functional, they are great, they are efficient, there is nothing wrong with it, but the question is is it a good investment. In some cases, it might be, in some cases, it’s not. I happened to think that right now there is too many people chasing after the same things, I am worried about the production levels, so we hadn’t been competitive out there and I will show you why in terms of our view of returns. But we look around the space and we say what’s the best way to plan our space. If you are a bond investor, an equity investor and you look at a five-year horizon, what you think of it is a good value may change, it probably did and we do too. And we have the platform in the financial structure that gives us that flexibility.
So we’ve always tried to focus on access from financing, from different sources, we’ve got a great platform that’s very scalable, very flexible and we also sell aircrafts. So because there is a cycle, sometimes you want to sell aircraft and (inaudible) the capital – invested a different way or return to shareholders.
So let me take you through how we see returns. Now this is a subjective view and this is a snapshot of four different points in time. The returns here on the assets are, obviously a function of what you think of its residual values. So the first layer here shows you the interest rates have really dropped, we already know that then we compare new narrow bodies, these are unlevered cash returns, not book returns, cash returns. To new wide bodies the mid-age aircraft that are mid-aged narrow bodies.
And what we see in the market today based on our view of residuals is really low returns on narrow bodies. It’s a function of competition, it’s a function of – many of the players here have access to debt that we don’t, Japanese banks, Chinese banks, and electric you name it, and that’s okay. Wide bodies, we have a more constructed view on residuals I’ll just put that out right now, simply for supply reasons.
Then on the mid-aged side, I think that’s where we have the best risk return trade-off frankly. And what makes this competitive there is the fact that we don’t have to go to the bank market no longer to finance these aircrafts. So for us it’s at the end of the day it’s an investment decision, where we can make a good return for our capital shares.
So, that translates into four different buckets that we have kind of shown on a number of different occasions. Dave Walton will take you through the specifics of what we’ve actually done. But the high quality wide bodies has actually surprised me enough in the biggest part done over the last two years, even after A330 was mandated .
Mid-age aircraft I would like to do more, but there is not enough volume at the price levels that we find interesting. The freight market is a market that’s got its issues right now. It won’t be a big part of what I expect we’ll do. But I think there may be terrific returns versus risk values there. And each acts a small new part of what we’ve done, we’ve bought our first freighter in the Q4 of last year.
So, just a couple of last points and then I’ll turn it over the Dave. In consistent with our approach to being a valued investor, we’ll look at investments every which way we can find them. We’re not limited to just buying in bulks to the manufacturers, in fact buying in bulks from manufacturer scares me. We’ve done it, you’ve got to be comfortable with funding and taking risk on financing over many years, you’ve got to take – be comfortable in taking risk on what the leases will be. We are not owned by insurance company or bank – we’re independent. And we take that as a little bit of a different risk profile than perhaps other people.
Now having said that we’ve done it, but it’s something that we may do it again but it’s something that – it’s a harder thing for us, to kind of swallow given who we are. We bought aircraft almost every different way from governments, from lessors, from investors, from airlines, 60 different sellers, 95 transactions.
Now how are we doing this year? We talked before about a goal of around $850 million as of our. As of our earnings call for the year end results, we had $220 million from commitments for this year, almost $60 million for early next year. We made very good progress for more than half way there. We’ll talk to you a lot more about that in terms of specifics when we get to our earnings call in about three weeks.
And so, with that I’m going to turn it over to Dave, and Dave will take you through our operations and our portfolio.
Thank you Ron. I’d like to start on slide 37, and talk about how our new investments are transforming the portfolio mix.
We invested $1.8 billion over the last two years. And this may be a little known fact which hopefully won’t be a little known fact for long but we invested almost two thirds of that in aircrafts that were less than five years old.
Those newer aircraft investments were weighted towards high quality wide body aircrafts on lease – on long-term leases with good customers. But as Ron said, we’re also continuing to focus on the mid-age narrow body part of the market. That’s where our unsecured capital market’s access really helps us.
I think it’s really useful to look at a snapshot, year-end 2009 and compare that to year-end 2012 to get a sense for how this portfolio mix is changing. You can see the A330s are a much bigger part of the portfolio and moving up from 17% to 30%. In the narrow body part of the market, again, we’re continuing to play there but we’re seeing much better values in the 737-800s. The percentage of the portfolio by net book-value in A320s declined from 17% in ‘09 to 12% in 2012.
We’re also taking steps to prune the portfolio and we’ll talk a little bit more about that later but you can see the 737 and A320 Classics as a percentage of the portfolio has declined from 4% to 1%. And we’re also starting to sell off some of our older 767s and 757s.
The portfolio is broadly diversified by customer and by geography. On the customer side you can see our top 10 customer list, we feel pretty good about that. Our biggest exposure is the South African Airways, that’s the government owned flight carrier of South Africa. That represents 7% of the portfolio by net book value.
Also on the list, US Airways, that’s our biggest exposure in the US. As you know they are planning a merger with American Airlines. And the other name I’d mention is Airbridge Cargo, Airbridge Cargo is part of and it’s guaranteed by the Volga-Dnepr Group, that’s the dominant cargo carrier in Russia.
Again comparing 2009 to 2012, you can see how the geographic mix of the portfolio has changed. Most notably Asia now represents 34% of the portfolio by net book value, that’s up from 20% in ‘09. And during that same period of time, our exposure to Europe declined from 46% down to 35%. And that reflects both our investment decisions and our placement decisions and also some of the market dynamics that Ron mentioned earlier with much more robust growth in Asia.
Moving on to the portfolio performance, we’d like to call ourselves active asset managers and what that means to me is first of all we take a very close look at our customers before we make a placement or an investment decision. We look at their financials, we evaluate the management team, we meet the management team and we get to know them.
Going forward, we monitor our customers very carefully. And we’re not afraid to take aircrafts back if we see a problem developing that we don’t feel good – that’s going to resolve itself. And we found over the years that getting out a potentially dicey situation early is a much better way to go, you definitely do not want to be the last leasing company out of a difficult situation.
And what that leads to is very good portfolio performance. Our utilization in 2012 was 99%, and the rental yield was 13.8% which is pretty consistent with what we’ve delivered across the portfolio over the last six years. You may have heard one or two people say that mid-aged aircraft or maturing aircraft are tougher to manage, well, I don’t disagree with that. But the fact of the matter is that we’re very good at it and we’ve delivered the results over the years.
Just taking a look at the freighter part of the portfolio, you can see our utilization and our yield statistics are quite comparable to the rest of the portfolio. And what that reflects really is the investment decisions and the placement decisions that we’ve made. If you take a look at our top five customers, these customers include some of the biggest names in the industry. And they’ve performed quite well for us over the years.
Ron mentioned that the cargo part of the market can be much more sensitive to economic shots, well that’s true. But we have to remember that our freighter leases don’t re-price every year. And we’ve had good success with these customers.
Turning to placements, I’ll start with 2013, we told you on our earnings call for Q4 that we had seven AOGs. Well, I’m very happy to report that we’ve taken care of all seven of those, in fact, after this presentation we went to the printer and we signed an LOI on the freighter that’s mentioned here. So we’ve done our work on the AOGs. Now our job turns to firming those up and getting them back on lease and we’ll report on that progress on our earnings call for Q1.
Looking at the schedule of these expirations, we had – we have 16 left to place. About half of those we expect to be part out dispositions, the other half is mainly consisting of 737-800s that are rolling off lease in Q4. So, we’ve done a good job of taking care of the AOGs. We’ve got a very manageable past for 2013 on the scheduled lease expiries and we’ll report on our progress on the next earnings call.
As Ron mentioned, every leasing company owns residual risk. And so, one of the things that we consider one of our core competencies is selling aircraft and we’ve been very successful across the cycle, we’ve sold almost $1 billion worth of aircraft since 2006.
And we’re able to shift our focus depending on market conditions. So by way of example in 2011, we saw a very robust market for selling aircraft opportunistically. We sold almost $0.5 billion of aircrafts and the average – the weighted average age of those aircraft was about six years. It was a different market in 2012, 2012 we focused more on buying, we think of it as a good time to buy and we were successful on our investment – in our investments.
And we focused our sales efforts more on pruning the portfolio. You can see we generated gross sales proceeds of $79 million. The weighted average age of the aircraft we sold was closer to 17 years.
What we built in terms of the team over the years is a very good engine management and trading function within our company. And as Ron said, as aircrafts mature, engines become a much more important part of the residual value risk. And that’s being brought to bear on some of these exit strategies that we use and that we will continue to use as we prune the portfolio.
I’d like to finish by just going through one quick case study with you. And this particular case study has to do with a 1998 vintage A320 that we sold for part out in Q4 2012. And this really demonstrates how we approach a lease placement opportunity versus – which as Ron noted include a decision to reinvest in an aircraft versus an exit.
So this particular aircraft was coming back to us off of the normal lease expiry. And while it was in good condition and we could have delivered it to a new customer it was in a condition where the major components were a little bit tired. So the trade-off for that is we received a large maintenance compensation payment from the exiting less fee. We received $6.5 million.
Now the other factor here is when you – as Ron said, when you take those large maintenance payments, we know you are going to have to reinvest in the aircraft in the next lease. And so when we took a look at the lease rates that were available in the market we decided it’s really not a good proposition. And so we brought our engine trading and engine management team and our airplane sales people in and we were able to sell one engine into a very strong B2500 used engine market. We used one engine internally to replace an engine that was due for a shop visit and needed a big investment and we sold the airplane very well.
So ultimately if you package those components of the metals sales together with the maintenance payment, we turn to small profit on the investment in Q4. But you have to bear in mind we owned that asset for six years, we collected $24 million worth of rent. And overall the investment period return on that for us on an unlevered basis was close to 10%.
But basically what I wanted to demonstrate with this is number one, when we come to a decision point and a transition point with an aircraft, we approach it like investors. We ask ourselves what’s the best use of our capital. Do we want to release and reinvest or do we want to exit. And then secondly if we decide we’re going to exit, we’ve got the team to execute on that.
And with that, I’ll turn it over to Roy.
Thank Dave. I just want to spend a couple of minutes talking about the financing market. And I mean, I think that’s probably one of the most IT – I’m sorry, there we go.
So, in terms of the financing market, the financing market I think is in great shape. So if we think of the financing market that we would touch, the capital market, the bank market, as well as the ECA markets, all three of those markets in a relative basis have improved significantly relative to the period following the financial crises, when essentially the bank market and the capital markets were closed.
But I think the driver in all those markets really has been the capital markets, the capital markets have really led the way and really the consequence of a confluence of very, very low interest rates and partly a recognition by issuers that they can no longer be reliant on one particular market, particularly the bank market.
So, with that you’ve seen record issuance in the capital markets, I think lessors in total issued about $37 billion in financing. The airlines too have played very, very aggressively with a number of very attractive WTCs being done, one done for US Airways, lowest ever coupon, Emirates, tap the US capital markets in a WTC type structure within re-pricings of term-loan transactions. So, a number of transactions that have really showed the how strong of the capital markets are.
Turning to kind of the demand side, the Boeing chart there shows you in terms of delivery dollars what the requirement is. So going from 2012 to 2015, roughly about a 30 increase in dollar refinements, and I think it’s our view that the dollar refinements are all – it cannot be matched by whether DC markets or the bank markets because those markets are as robust they are have constraints. And we think the capital markets will drive the growth.
This chart just gives you a very quick view on the various products within the capital market. And you can see with the broader market across all products, issuance have grown dramatically. But I think the thing to note is there has been really a shift from mainly secured financing to unsecured financing and roughly in terms of our mix, roughly about a 50% mix between airline issuance and lessor issuance which is very, very different from how the markets looked three or four years ago.
And think lastly the other observation I wanted to point out is, we’re starting to observe some sort of cannibalization of the bank markets as more and more issuers consider the capital markets as a more optimum may of appraising finance.
A number of you have already probably seen a similar chart, high yield market – and the high-yield index continues to move down to record new lows. Deals done six months ago seems to be done almost seem to have done one two wide basis, and I think the message here is the market continues to be strong. And probably as a good time as ever do to tap the markets.
This chart here, we prefer to highlight a number of different securities. These are from us and our peers. The dotted lines represent secured notes and the full lines, unsecured notes consistent with the broader market trends, deals have decreased. But I think the key point here is that the delta between unsecured and secured bonds, have dramatically increased. And post that that’s very, very relevant because we’ve relied on the capital markets to raise very, very flexible financing. And the fact that we usually don’t have to offer security to raise efficient financing is a big bonus for us.
Here, we’ve laid out – kind of a basic credit metric between us and our peers. And there is couple of things I want to highlight is, we continue to operate a very, very conservative capital structure. Debt to capital – debt to equity is 2.6%. We’ve also drawn deadlines to try and grow on an incumbent base. And so asset coverage is roughly 1.5% and I think as the philosophy we’re going to try and continue to maintain that sort of a level – to grow that level in order to keep our assets to the capital markets.
The last point I wanted to note was, in terms of an order book, we don’t have an order book. And we view an order book as really as in-built operating leverage. So from our perspective, keeping our credit metrics from and maintaining access to the capital market is one of the key going forward.
Now turning to the corporate market, ECA markets gone through somewhat of a change, some of you may know this year marked the change in the pricing regime so this is the price that an issuer has to pay to the ECA and roughly by order of magnitude the premium paid to the ECA is roughly doubled. And in today, that payment ranges anywhere from 6% to 15% depending on your credit ratings.
And the original rationale for the increase in price was to try and curtail the usage of ECA financing. But I think what we were starting to observe is that really hasn’t taken forward. And part of the rationale for that I think is the fact that you can actually finance your increased premium. So, regardless of the fact that you might be paying 8 or 10 points upfront of the ECA you can fund that. And given where our funding levels have stayed, on an amortized basis, it doesn’t really translate to a substantial increase in pricing the issuer if you’re holding the asset until the end.
The other driver in the ECA market is really the advent of the ECA bond. Typically the ECA market or traditionally the ECA market has been a bank funded market. But the ECA bond has come into pull and what’s been happening is USA impact bonds is roughly about $11 billion of issuance. And that in turn obviously has helped to drive financing down.
COFACE which is the French agency had the first back bond issued primarily this year. But there still remains a pricing difference between European and US export, therefore and the pricing difference is roughly about 70 basis points.
In terms of the bank market, I think the bank markets generally have been better. I think the big change in the bank market is – the bank market has really no longer just historically been a very asset based market and it’s really transformed into a real credit market.
The remains some of the key players, some of the Germans are still there. You see some of the Australian banks playing. And then we do see from the Japanese Bank coming into the market but by and large, these deals are still pretty much credit driven deals. And ultimately the banks are looking for good security, they are looking for a strong credit and obviously in terms of term, they’re limited in a month’s term that they can lend again. The lending envelop is still pretty much sort of 10 to 12 years, 70% to 75% loan to value.
The other big change in the bank market is the implication of Basel III, which is really the amount of risk rate capital that banks have to allocate towards loans. And by and large the key implication is – Basel III doesn’t promote or doesn’t exist long-term financing. It’s disincentive to a non-recourse transactions. And that’s why you’re seeing a greater number of transactions getting done purely on a secured basis or shorter term financing as opposed to historically long-term recourse – non-recourse transactions.
Finally, in terms of what’s happening with us and relative to our peers. I think the big change with us and our peers is, we compare just based on net earning assets. A number of peers compared to GE and LFC, the top two guys have decreased in size. And part of the leveling of the playing field I think is driven by the fact that all of our peers have access to capital. The capital markets have been a good level of the playing field. And I think from our perspective what we will continue to do is marry up our acquisition strategy with our funding strategy and work hard towards making sure that we can access the capital market and the bank markets efficiently going forward.
I’ll turn it over to Mike now to take you through the financials.
Thanks Roy. I wanted to just talk a little bit about our thoughts on capital allocation and a balanced approach to that subject as we have been implying it over the last three years.
Since the beginning of 2009, we’ve been very focused on adding incremental assets and pruning all their assets to increase the ROE of the business and on a net basis we’ve invested $1.6 billion net of asset sales which is about just under $1 billion in growth of flight equipment across that timeframe. We’ve also been a regular and consistent dividend payer over our history and we’ve paid $121 million in dividends over that three year time period. And I’ve also used about $140 million in the context of stock buybacks given where the price to book of the stock and our peers have been since the financial crises.
In the context of stock buyback, sort of hitting these in reverse order, as I said, we purchased 11.7 million shares at an average cost of 11.87 since the beginning of 2011 and we currently have $30 million remaining under our existing stock buyback authorization. In the context of dividend, the stock base is very attractive dividend yield and has since the crises and we’ve been paying dividends in the context of $428 million since our IPO in August of 2006 for 27 consecutive quarters.
Looking at the sort of accounting vagaries of aircraft leasing and what GAAP results produced in the context of ROE, we thought it would be instructive to help understand what maintenance revenues, the effects of non-cash interest expense, lease incentive and amortization and other non-cash charges, due to that volatility.
So, if you look at GAAP ROE, which is the blue bars here, and then you take a step back and say, what is the cash flow from operations in this business, add in some audit collections and financially subtract depreciation. I think you see a much more consistent and truer picture of what is the underlying business model in this business. And you see a cash based ROE that’s very consistent and very strong through the financial crises and starting to creep back towards 12% in the context of what we’ve been doing with the business over the last three years.
Going back a little further and thinking about where we’ve been since 2007, which was our largest year of acquisitions over this timeframe you can see, operating cash flow growth is significantly outstripped the growth in the flight equipment that we used to generate lease revenues, little bit under 5% growth in assets is translated into about 12% growth in operating cash flow across the six-year period.
When you think about the business model, five-year average lease term, very consistent, strong lease rental revenue drives that cash flow. And at the end of last year we ended the year with $650 million run rate portfolio of leases, almost $300 million of which comes from our large unencumbered asset base.
Our capital structure, we’ve always been amongst the most conservative in the industry and we feel comfortable operating this business in that construct. We have no significant debt maturities until 2017. As Roy mentioned we don’t have a forward order book. Our unsecured debt, that’s the total debt has increased to 49% up from 15% at the end of 2011 and we have $2.1 billion of unencumbered aircraft representing 72 aircrafts at the end of 2012.
Looking at our year end numbers, we ended the year with unrestricted cash of over $618 million. We have a $115 million un-drawn revolving credit facility. Our net debt to equity ratio is 2.1 times, net debt to total cap just under 60%. And year-over-year our sort of cash pay weighted average interest rate went down from 5.8% to 5.22%. And our highest coupon unsecured notes which were the first ones we issued in 2010, the nine and three quarters are callable in August of next year.
And finally, just to note from one of our friends in the audience here, just to sort of give you some comparison across some simplistic layouts of metrics, given the different accounting treatments that people use in this business, I think this is just an instructive illustration of what we believe and why we believe being a value investor mix. And we do produce the highest adjusted net interest margin amongst our peers. In the 2012 timeframe we do operate one of the most efficient overhead structures. You can the cash SG&A at about 7.1% of rents. And as I mentioned very strong cash based ROE in the context of the underlying fundamentals of this business.
So, we feel very comfortable with where we are with the strong cash and liquidity position we have with the investment environment we see. We think we’re very well positioned to capitalize on our very disciplined and differentiated approach to value investment.
And with that, we’ll be happy to open up the floor to questions.
John, go ahead.
I think we may have a microphone coming to you.
John Godyn – Morgan Stanley
Hi, thank you for the presentations, John Godyn at Morgan Stanley. I was hoping that you could just elaborate on some of the cargo comments that you offered on a few points. First of all just, sort of what are you kind of feeling from customers on margins right now in the cargo market?
Second of all, as we think about your cargo exposure on a go-forward basis, it seems like you are certainly committed to it. But if we thought just sort of three years out and not sort of as a guidance metric, but just sort of thinking about where could fright be on percentage of the book, how should we think about it from here?
And the third question is just on the supply overhang that you highlighted, as you kind of think about how that might evolve going forward. It doesn’t strike me as something that’s going away immediately but I don’t know if you have a different perspective on supply overhang and freight?
I’m not sure if I understand what you meant by margins John?
John Godyn – Morgan Stanley
Sorry, say it again.
Your first part – your first part of your question, was it about margins?
John Godyn – Morgan Stanley
No, I’m sorry, I asked for what you’re hearing on cargo from customers on the margin?
Okay. Cargo customers right now are, mix-story depending where you are in the world, still weak. And this is not a good – I think there is still a concern about the overhang on the supply side, that’s kind of the biggest thing you hear. And actually when you look at the orders that have been made recently, they’ve all involved trade-ins which tells you this is kind of push marketing on the part of the manufacturers. It will take a while for that to get worked out and as for having a good marketing organization helps a lot.
As Dave mentioned, we’ve faced, we got a letter of intent signed for the one aircraft we had coming off lease this year, that’s it. Last year we had four aircrafts that we put back on lease as well. So, it’s not a great market but it’s not dead. That’s the main thing.
I think the supply overhang is how fast that last depends on number one, how fast is demand recovery. And we talked during the presentation about what might stimulate that. It’s a business confidence thing and I think Europe is particularly depressed and that’s where the upside exists.
Now I think it’s also important just to amplify something I mentioned before as to take into context where are some of the sources that you hear externally about the market come into play, coming back to FedEx. If you look at what flies domestically for example, it’s very little large freighters, 747 don’t fly around the US. Okay, so if demand is weak, and that’s where belly space is by the way at its maximum. There is the share of belly space domestically is like 70%.
So, it’s not a even picture around the world. I’m more optimistic about the recovery in the long-haul trade flows. And but I am concerned about the supply side. Our freighter portfolio has a weighted average remaining lease from the five years. So, I expect there will some aircrafts that don’t get released on good terms and some will do just fine. But I think the main point is I think the freight market will come back, it may take a little while but it’s not dead.
John Godyn – Morgan Stanley
So, just a follow-up on that. Should we expect your freighter exposure as a percent of your book value to stay constant from current levels or come down or just directionally how are you thinking about it?
You’ll probably see it come down simply because we’ve been finding a lot of good value elsewhere. And as I said before, I’m not shying away from the freight market per say but we need to find good value. And there is very few deals to be done. So if there is a super-duper deal to do in the freight market, we’ll do it. We can manage through it, we’ll bear in mind the riskiness of the business as we have historically.
So, I think you’ll see a trend down but we don’t have a specific target. It’s based on what the opportunities are. I think the danger in this business is we set targets without regard to what’s going on around you.
John Godyn – Morgan Stanley
And if I could just ask one more on cargo. How is your underwriting standard in sort of incremental cargo capital compared to the underwriting standard that you’re using for passenger request?
Well, in general I think we’re looking for more conservative residual values and higher returns it’s a bit of a balancing act here. But don’t think – it’s very situation specific. If you said to me here is a 777 I’d probably have a different perspective on it and somebody saying here is an older 747.
With older 747s I wouldn’t turn my back on that, I can deal with the engines at the end and rotate them around my fleet is fine. So, it’s a question of what the big proposition is and simplifying it too much starts losing value. Other questions? Yes, up front, up here, yeah.
Mike Linenberg – Deutsche Bank
Yeah Ron, two questions, Mike Linenberg with Deutsche Bank. First, you talked about the seven aircraft on ground and how they’re being dealt with. The ones that you have disposed of is it reasonable to assume that they’ve been disposed at below book value?
When you net out the maintenance revenue, they’ve been a small gain certainly.
Mike Linenberg – Deutsche Bank
Okay, very good. And then, second question and maybe this is more of a clarification. You talked about low interest rates and how that’s helped boost the value of aircraft and conceptually I get that in the vacuum. But when I think about aircraft values, would you be better off or would aircraft values be a lot higher in an environment of much higher inflation which typically comes with much higher interest rates. What are your thoughts on that?
High inflation is a good thing for the sector, simply we put, yes. But the correlation between the two matters too. Other questions? In the back, yes.
Paul Bornstein – Black Diamond
Paul Bornstein, Black Diamond. I’m just curious, you have a lot of money to put to work and obviously lot of investors want to get high yields. But my question is on the competitiveness today versus three or four years ago to finding the deals that meet your investment criteria. Is it taking a lot longer to be heads out there or it’s – I just want to get your opinion on what you’re seeing out there?
Okay. Could you all hear that question? Yes, okay. Well, a couple of things. One is, I wish we had the capital structure and the access cap to capital markets today that we did – that we do today three or four years ago. Three or four years ago was one of the best times to invest probably in every which way you could, whether it’s order new aircraft at that point, three or four years ago, the world was going to end. If I showed up at Boeing and Airbuses doorstep they would gladly take my money. It’s gotten a little bit more robust. And the deals that are available are not the same.
Same is true on sale lease back basis. And I think that’s – when I talk about in the order streams, at that time we had a A330 order stream for about $1 billion, it all worked out well in the end, but we had no aircrafts placed in ‘09, we had no financing lined up. And we had a lot of money down with Airbus so it’s sort of a – a bit of a hand-count situation. So there is an opportunity cost element to that end.
The number of deals that were available in that market were probably in terms of immediately putting money to work were probably more limited than they are today. It’s the same thing, it’s what I mentioned before about – in the deepest times that only the people that have to sell aircrafts do sell it at the weakest times. Otherwise you wait.
So the amount of deals photo was available in ‘09 was the world’s – was the lowest ever in terms of transaction volume. Last year was the second lowest in terms of secondary market. But the deals that were available were terrific.
So, part of our capital structure strategy and our investment strategy to stable powder – stable capacity for if and when those times come. If you go back 10 years, there have been a couple of three times that had been really, really interesting time to put money to work. And since we don’t have the deposit that we can go to it at the moment’s notice, we like to have some dry powder. Question in the back.
Mark Streeter – JP Morgan
Hi Ron, Mark Streeter, JP Morgan. I’m wondering if you can talk a little bit about I know your cost of capital was obviously very important to you with the rating agencies and well, in the bond market. I looked at some of your credit metrics they seem better than many of your peers, you don’t have an order book yet you are still rated below some of your peers that have been able to get to investment grade. I’m wondering what the hang-up is with the rating agencies, are they more concerned about mid-life aircraft, is it size, what are those points that are going to get you a higher credit ratings so you can get that funding cost even lower?
Mike or Roy, do you want to take that.
First of all, yes, we agree with you, our credit metrics are better than a lot of our peers. I think there are different views from the different agencies. Moody’s with its new specialty financed philosophy and framework it’s not clear to me that there will ever be a mono-line or anything that investment grade again in their framework.
S&P I think has a more constructive and transparent view of the world. And I think in their view we’re still a little bit small in size in terms of total assets in the context of being an investment grade. And we’re only a step away with them. And I think that’s the goal in the construct of changing and migrating the capital structure to a larger unsecured mix that is something that is achievable over the coming years with S&P.
And we’ve just begun discussions with Fed too based on looking at what they’ve published on our peers and what they’ve published on the sector in general. We also seem to have a more constructive view of the space and of the merits of this business model in the context of their ratings framework.
So, in summary, it’s still something we think can be achieved. I think I’m not sure that will be achieved. But Moody’s as part of the shell ultimately. But I think in the context of Fitch and S&P, those are things that we are working on and we think can be accomplished in a not so far away future.
And one thing I’d add just to that point is when you look at the layer bonds trade, we’re trading pretty comparably to the guys that have nudge on us in terms of ratings.
Mark Streeter – JP Morgan
Great. And then just one quick follow-up just on the freights books disconnected has narrowed. You’ve made some disclosure about your call it your watch-list of assets and so forth. Can you give us anymore color or granularity on how confident we should be with the book value of those assets?
I think the best we can say is, as Ron just mentioned, we parted out a few plans in the first quarter, we expect to report modest gains on parting our plans. So when you’re disposing of things that are 23 years old that are classics and net of all your balance sheet elements, you’re at book value or above. I’m not sure what else you can do to help demonstrate that your assets or workbook.
Thanks. Justine, over there.
Justine Fisher – Goldman Sachs
I have a few questions the first is another one on the capital structure. If I look at the capital structure breakdown that you had here, you’ve obviously refinanced a lot of your secured debt with unsecured. Do you view your secured to unsecured ratio as appropriate now, would you like to move more unsecured. I mean, it doesn’t seem to me that there are obvious candidates to refinance more secured with unsecured but what do you think the right ratio is?
I don’t think we have a hard and fast rule that we’re going to be this percent this or that percent that. I think we’re comfortable where we are, I think over time and given the strength of the capital markets it’s likely. We will do some refinancing in the coming year and we’ll probably have a higher proportion of unsecured to secured and to get to investment grade I think we will need to maintain a higher proportion of unsecured to total debt than we currently enjoy.
Justine Fisher – Goldman Sachs
Okay. So, well, the big glue callable in 2014, what caught my eyes, when you say refinancing it could be that and more, it’s not just necessarily that bond?
Yeah, I think that’s a safe way to think about it.
Justine Fisher – Goldman Sachs
Okay, okay. And then the other question is, on ECA bonds, some of the other lessors have done them and this is something that you guys would consider doing I mean, I know I guess there well, they are well off secured, so. How would you..?
Yeah, in the context of new deliveries, it’s certainly something we would consider – if that – if we think that makes sense. And to us in thinking about whether ECA makes sense now that we’re in the new regime where the upfront fee is basically double to what it used to be. Ultimately it just comes down to a view about holding period. If you think it’s an asset that you want to flip in two or three years, you don’t want to pay 10 points upfront and flush that down the toilet when you turn around sell an asset.
If you think it’s an asset you’re going to hold, it probably can make sense still even with a higher upfront. ECA is still a very cost effective financing. And I think as Roy touched on, even though the fee is doubled people can still borrow the fee. So the idea that it’s going to dramatically mute people showing up at the door of XM and ECA is financing new claims. And I think it’s going to take a little bit more than that or more time before that’s going to really meet the appetite for that kind of debt.
Justine Fisher – Goldman Sachs
Do you think that something does meet that eventually, do you think that people will see weight in these new ages those aren’t really working, unless do something else or do you think that’s okay, they’re not really working it proves that maybe people are happy with the way the market is and we don’t need to take any more action to try and level the playing field?
I think it will over time. I think the ECA is in action, they’re not – they didn’t defeat doubling is only one step. They’ve also been pushing back on people and who historically may have shown up with a 12-plane order book and financed it and they said okay in the financial crises. I think in today’s world there is a saying, that’s very nice, well do stick to those, you should go find someone else to do the others there. So, I think they are working their own portfolio, their own exposure and trying to gently nudge people back into the commercial market just the extent that it makes sense.
Justine Fisher – Goldman Sachs
Okay. Now I have a question on geography. You pointed on your slides that you have more exposure to Asia now I think that’s probably the trend with most of the lessors that we’re seeing. There is a large lessor market that our depending deal was potentially Asian buyer that have. And my question to you is, do you think that it makes a difference who the owner is of a particular leasing company or where they may be domiciled as far as getting that Asia business? I mean, maybe on the financing side it does make a difference maybe if you buy an Asian bank obviously.
But do you think it matters on asset side as far as who you can lead to and do you get business with certain airlines or can you increase your market share there depending on who the owner is. Does it matter or I mean, with most lessors based in Ireland anyway, it doesn’t really matter so much?
It does matter to some degree. And it matter in certain markets not across the board. It matters in China, it matters in China because there is pact issues to the folding tax exemption that might have been available in the past isn’t anymore. And so you have the basic set-up in Zhenjiang or someplace like that to be as effective as you can from a tax perspective when you lease in the Chinese Airlines. That’s a home-field advantage.
It’s probably a little bit more subtle but there is a home-field advantage and it has been for long time. But I think those are more of the exceptions in the rule, they are big exceptions but they are exceptions on the left. Most of the other folks around the world realized that it’s in their best interest to look as broadly as they possibly can for the best deal they can.
Howard Rubel – Jefferies
Ron, Howard Rubel with Jefferies. How have your degrees of freedom changed as more and more of the engine manufacturers are going towards power by the hour and they’re trying to control the parts within the marketplace?
It’s a good question. It’s a longer term question and I’m not sure if you could all hear it. I think to paraphrase it, it was how have our use on engines, our strategy on engines changed as more and more of the manufacturers control the aftermarket if you will?
And the approach there is particularly notable when you look at Rolls Royce or they detailed to an important degree too where they’re tried to have the majority of the servicing arrangements under their control. Engines are a little bit like the razor blade model where you kind of give them away and you hope you make your money and the spare parts.
And as other providers of spare parts, DNA parts for example have popped up that eats into the business model of the engine manufacture. So, some of the approach has been to get more direct control over the shops so they can – therefore can protect their business model. It worries us because the options that you have in terms of matching residual values are more limited when you have more of a monopoly on the servicing and then ultimately matching the spare-parts ultimately.
We’ve been a little bit more conservative to be honest on situations where those types of arrangements are in place. But it’s really tough to project out most of those involved engines that will be years out and it’s something that will also be something worth noting for the NEO and the MAX, as how will those play out. So the traditional view of residual values needs to be thought about but it’s little bit early to kind of quantify that in a real accurate way. Question in the back over there?
You can get rate of returns by taking greater risk in going after from your credits. Can you just talk about whether there is value in the by trading down in credits more or less and how does that move over cycle? I guess the second question is you mentioned something about how European exports financing was about 70 basis points more expensive than US, and if that one factor is causing Airbus values to be lagging behind the Boeing side?
I’m not sure if I completely heard the second part of the question. Can you repeat that?
There was a slide showing that it caught 70 basis points more to export financing for Europe than US?
All right, okay.
Is that had an effect on Airbus values?
Okay. So, the first part is should we trade freighter exposure for higher yielding – lower credit passenger exposure, it depends. It’s not – each opportunity is valued on its own. And the cost of the stepping into a bad lessee is not small and it’s an unknown thing to be honest.
When we approve deals, we do a sensitivity analysis not just a base case return assuming everything goes according to contract. Of course we sensitized the residual value in a lot of different ways. But we also look at what is the biggest exposure points from a credit perspective, for example if somebody’s got a lot of debt due at a certain point in time. And we also look at it from a maintenance perspective. Were we most exposed if the lessees not paying maintenance reserves and we’ve got a problem?
Those exposures can be huge. And what we do in those context is make sure that either we per say note of the deal and price it accordingly. The freighter risk is just because it’s a freighter per say doesn’t mean it’s a bad investment. I mean, it’s a question of do we properly assess that risk. Freighters by the way from the markets week, we’ve all covered that. But as we redeployed freighters it’s been a lot easier to redeploy a freighter than say a narrow body because you don’t have all those lessee specific drags.
When you take a wide body an A330 for example, the new customer is probably going to want a whole new front section of the airplane, different seats and flight entertainment system etcetera that’s millions of dollars of downtime as well. Freighter is pretty easy to redeploy because you pass it back and we put it back on lease. I want to get away from the notion that freight is bad. It’s an investment. There is a freight merit, the price merit profile to transaction.
I was really trying to come to – you could lease to Singapore, you could lease to Air Berlin, you get low return on Singapore than Air Berlin, would you take the risk?
And sometimes the markets will really reward you for going to Air Berlin and sometimes the markets don’t reward you very much for going to an Airbus via Air Berlin. But a weaker credit and I would like to know right now, is the market rewarding you by taking generally weaker credits or is the market not really hanging that much of premium weaker credits versus better credits?
Okay. If I was directly financing the transaction, there would be a very dramatic stock difference between Air Berlin. I probably couldn’t finance Air Berlin today, not very easily, Singapore, all day long. So that’s one way of looking at it.
Now we have the flexibility of not going to the bank market and doing a mortgage debt financing like a lot of our peers do. And then it’s a question for us of relative value. We don’t consult with the market on individual aircraft acquisitions and it’s indiscernible anyway. For us it’s a more complicated process of saying well, there is a 5% yield on Singapore looks good compared to 12% yield on Air Berlin, maybe it does maybe it doesn’t. When you look at the bond market there is different risk trade-off there and just making a black-end comment is, it’s got to be quantitative to answer to some degree.
Now, in terms of your question about the price on Airbus versus the ECA cost differential, I don’t think that’s a real driver. It’s kind of a secondary or tertiary factor at best. There are so many things that get into a decision about an airplane and how you finance that whether its Airbus or Boeing, it’s probably – the ECA versus accent thing is a small part of the equation. Hi Doug.
Your bet on the A330 at one point was out of consensus and turned out to be pretty prescient. I’m wondering with impending competitors on the line, 787-10 about to be launched. At what point do you turn a little bit more cautious on the matter of aircraft because it’s so massive that it’s okay going forward?
Well, the 787-10 is many years off, it’s still not an official airplane. I think the 787-9 is real airplane, at least I expect it will be soon. And I’ll have just as much of an impact on the A330 market. I think the dash-10 might be more of a 777 killer and we start encroaching on the A350 part of the world.
It’s a fact of life that you’re going to have a new technology coming online. And the key for us is making sure that we’ve priced the residual expectation accordingly. I guarantee you that every lessor that makes a residual expectation to be wrong, hopefully you were right, we’re wrong in the right direction. So we’re trying to factor that in.
Now, on the margin I probably a little bit more oriented in the A330 family to the 300s, because they’re more commercial aircraft and with the improvement to the thrust and range it’s able to do more missions. Not everybody needs an aircraft that can fly 7,000 to 8,000 nautical miles, that’s a very small percentage of the number of roots that a 787 could do versus an A330. A330 is actually pretty versatile and the capital cost would be pretty cheap. And for some operators it will make sense.
And a follow-up question on freight, your graph showed quite a few 777 freighters coming on over the next few years. I’m wondering if there is some potential upside there for you in that – there is very strong demand for 777-300ERs they come off the same line is Boeing potentially turning the dial down on freight versus more passengers?
The 777 freighter first of all I think is the freighter, the work horse large freighter of the future. It’s versatile and efficient enough to do almost all the tasks. So we’re very bullish on that. We haven’t bought one yet, mostly because there has been an opportunity that we can make sense financially. So it’s not just a good airplane, it’s a good airplane at a good price.
The popularity of the 737-300 and we’re big fan of the 300ER, it’s the same production line and so it’s popularity does cut into the amount of 777s that are produced. And when for example FedEx decided to differ some 777s, I suspected some of those airplanes may have become passenger airplanes. I don’t know that for sure but that’s my suspicion. So yeah, that on the margin every bit that we can help the supply side and the freighter side is good. The big question to me is more than 777s is what happens to the 747-8. Hi Andrew.
Andrew Light – Citi
Hi, its Andrew Light from Citi. Kind of specific questions about India and it was originally going to be very large knock in the lessors, it turned sour you pulled out I think literally early. And there have been a few judgments recently to do with Indian Aviation and to the release. And do you think that’s a market that could yield future opportunities? And also are there any kind of problematic if you like emerging market jurisdictions out there that they limit the emerging market upside that’s works for you, that will feel great?
So, let me divide your question in two parts, one is just kind of some commentary about India and then how do we deal with kind of the emerging markets, it’s not just only the emerging markets but I’ll talk as Dave said, how do we manage use – more problematic situations and maybe you can touch on what we did in India specifically but, India is worrisome. I mean, there are Cape Town signatory that isn’t abiding by the rules.
Look, any legal system is only as good as – how it’s enforced and that’s a risk across the board. And it actually goes beyond that – it also goes to lessee behavior. Now our exposure in India, just to quantify is, six aircrafts with one carrier, its jet, and two of those come off lease next year. So it’s actually pretty underweighted in – in the scheme of our portfolio. We did have aircrafts with Kingfisher which we removed early in 2009, it was a mutual decision and I think we’re both happy we did that.
So, Dave, maybe you want to cover the other part.
Sure. Maybe I’d just comment one thing about India. I think it’s important to note that the transactions that are in question and the ones the aircraft that got stuck at Kingfisher, I don’t believe any of those were actually Cape Town transactions. And I know there has been a lot of pressure from governments for manufacturers, and from industry generally to work with the Indian government and make sure that even now those weren’t Cape Town transactions but they are being released eventually.
So, I actually – I think in time, I have a little bit greater confidence maybe on them than the people who are writing the stories that are in the newspaper about what’s going to happen in the future in India. And I do think the government is going to honor Cape Town for the Cape Town transaction.
And just in terms of how we manage our exposure, we go into a new jurisdiction, emerging markets or otherwise, we do a very thorough analysis of the jurisdiction, we hire local council on the legal side to help us figure out how the rules work. Obviously, if you have a problem in that jurisdiction, resorting to the legal system is not your first choice so you also want to understand practically how things work and we do a good job, I think we’re doing that. But we understand as part of our credit analysis both the customer credit and the legal risks in a jurisdiction before we go in.
Hi, up here, oh you got one back here.
Yeah, I have two perhaps naïve questions. One, given your importance for engine life, what is the sensitivity to oil price increases, in other words could you get caught if there were an oil price spike under-depreciating? The second question is simple question are all your contracts in dollars or are they in yen and euros and so on?
First one is easy everything in our business is in dollars. So, we don’t have direct currency exposure though we have indirect currency exposure through our customers. Because if you look at an airline around the world, about half of what they – half their P&L is ownership cost between dollars and few which isn’t dollars. Rest of it is maybe other currencies and the revenue mix might be a totally different currency so we pay attention to the whole picture. But as far as the direct exposure, it’s all dollars.
As far as engines and fuel costs, the question when you see fuel costs is what’s going on around and what are the alternatives? We saw fuel cost spike in few different instances, few years ago. And what that does is it takes the most marginal aircraft and makes them unattractive. And so, usually it’s the preceding technology that – that’s most vulnerable. And I think that’s what kind of acted as the catalyst for the demise of the 737 and A320 Classic aircraft.
So, fuel cost did go down and however the greens fairly follow. And the issue for an airline that might lease an airplane like that isn’t necessarily just the cost of the volatility, when you step into a lease you’re making a long-term commitment. And well, there would be a period of time where you get hurt.
So, if you look at our fleet, as Dave pointed out we’ve got 1% in our – of our exposure in classics and that’s going to go away in short order. The bulk of what we have is in the current technology aircraft. So the question, my answer is – what’s available is the alternative.
Now when you look at a brand new airplane, it’s going to be as most efficient. There is not a better technology available today and maybe there will be in three or four years, that will be a step change better by the way.
When you look at an engine’s efficiency, it degrades over the course of its maintenance cycle and then you put it through the shop and you get most of it back. So the question about efficiency isn’t a question only about the engine, but at what stage is it in its maintenance life, that’s the part of the equation here I think a lot of people have overlooked.
But the bigger driver is technology and what’s available is an alternative. If you were to forecast a massive spike in 2015 or ‘16 when the NEO and MAX comes out, I don’t think that per say foretells the end of the current technology airplanes because there is nothing available, there is going to be 11,000 to 12,000 of these airplanes and they’ll take the manufacturers close to a decade with no growth to fill that. Other questions?
Just a question on residual value. Based on your historical experience or just your general forward thoughts, what factors will you more likely be wrong, for example is it that you over-estimated demand or is it that a technology that you thought would come later came sooner? What sorts of factors?
First of all, just a couple of things. When we estimate residual values, accounting is conservative. And where we think we’ve really aired, you’ll see that show up in the form of impairment. The only way we can get to the other side of the equation is to sort for gain. And when you make a determination of residual policy, you can’t aim too high, you can’t aim too low, so long story short, I think the question of residuals, if you’re doing your job absolutely right, there is going to be dispersion around the main and there is going to be some impairment in some point in life.
Having said that its really been all over the map. If you ask me to gage residual value on our wide bodies I would have probably guessed, first of all that the 787 would have been not only flying today but they would have been producing in the release of 10 to 12 a month. And that has been a tremendous good positive for the wide bodies that exist today.
Look, the rule of thumb seems to have been that, if you have a new technology, it’s not going to come on time. And it’s not because the manufacturer is a bad guy, they are doing some pretty innovative things and it’s hard to put a timeline on inventions.
Supply is another story. I wouldn’t have guessed, if I look back at my – not residual but rental rates, and I can look back at our all pricing models, we’ve probably missed on the released rates, on the narrow body side, and that’s function number one of interest rates and number two, mandatory in order of the production increases. I think the production increases on narrow body side are pretty strong. So, it really depends on what you’re talking about. And in the end, it’s really not even a question of residual, in the end the residual of the engines.
And what matters is well, I think – we have a pretty good view about what those training values would be for the most part question is when did that happen did it happen earlier or later? Other questions? Last chance. Thank you.
Okay. Well, thank you all for joining us today. We hope you found this session helpful. Feel free to reach out if you have any questions afterwards. And pay attention, we’ll be issuing our press release shortly regarding the first quarter earnings call. We look forward to seeing you then. Thanks.
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