Air Lease Corporation (AL)
Air Lease is a compelling long since it trades around book value and 10X 2013 pre-tax EPS despite 30% Y/Y growth expected through 2014 and a pre-tax ROE that will reach ~20% in a couple of years. Based on our estimates, Air Lease will generate pre-tax EPS of $2.73 in 2013, growing to $4.23 in 2015 with ~111% upside to $59.2 by 2015 (at 14X 2015 pre-tax EPS multiple). As explained below, the company will very likely never pay cash taxes so pre-tax EPS multiples are appropriate for valuation purposes. The company's earnings growth over the next couple of years is highly predictable and managed by one of the best, most experienced and most capable management teams in the industry with a strong track record of creating value. Air Lease benefits from strong tailwinds in an industry growing at 2X GDP with global airline traffic doubling every 15 years.
Air Lease stands out from its peers in aircraft leasing due to its unique, well-defined and defensible earnings growth strategy, focus on long-term lease contracts (8-12 yrs), youngest, highest-quality assets in the business - fuel efficient, high demand, commercial aircraft - first access to best-in-class commercial planes, long-term relationships with over 200 airlines in 40+ countries, 22 yrs+ average industry experience amongst the senior management team, lowest debt funding costs of all peers with potential for investment grade credit rating, highest multi-year earnings growth and the largest order book among public lessors.
Now is a good entry point since the stock pulled back recently due to misunderstandings about the company including perceived interest rate risk and a secondary offering from PE sponsors who sold less than 50% of their overall shares (~8% of total Air Lease stake).
Air Lease Corporation, a unique player in the aircraft leasing industry, launched in 2010 by its founder, Steven Udvar-Hazy, a pioneer in airline leasing with over 40 years of experience. The company is run by him and his experienced management team from International Lease Finance Corporation (ILFC), a subdivision of American International Group (AIG). Air Lease purchases new commercial aircraft directly from manufacturers at significant discounts and leases its planes under long-term, 8-12 yr, triple-net lease contracts to 70+ airlines in 40+ countries. Currently, ~45% of its planes are used, under five years of age, and ~55% are new, highest-demand, most widely distributed, fuel efficient, and modern planes on the market. Currently, the Company has binding purchase commitments to acquire a total of 325 new aircraft for delivery through 2023. Most of these aircraft have already been placed with customers via binding contracts, which is why EPS growth for the next couple of years is so predictable. Its customers include Blue Chip airlines, United Continental (UAL), British Airways, KLM (KLMR.PK), Emirates, Korean Air, Air New Zealand (ANZFY.PK) and Ethiopian Airlines, amongst others. 90% of Air Lease's business is conducted abroad with balanced geographic exposure and limited customer concentration - no customer accounts for greater than 10% of revenue. The company's focus is on high-growth markets including Asia, the Pacific Rim, Latin America, The Middle East and E. Europe. In addition to leasing aircraft, the company also provides consulting services to both airlines and aircraft manufacturers.
Why do airlines lease planes?
· Leasing is common today: In the 1970s, very few if any planes were leased although today, 40% of aircraft are leased and that number is expected to climb to 50% in the next several years.
· Access to capital: Some airlines have limited access to capital, especially in emerging markets where many airlines lack a long operating history.
· Asset management: Airlines have traditionally not been good asset managers since owning planes is not their core competency. Airlines are not well positioned to buy or sell planes to rival airlines and they tend to sell at distressed times at distressed prices.
· Fleet flexibility: Airlines also prefer fleet flexibility by keeping a portion of planes leased so they can easily manage their capacity up and down to add or reduce routes.
· Cost of capital: Aircraft lease companies generally have a lower cost of capital and benefit from wholesale purchase prices, which they can pass on to airlines. And many airlines cannot afford the pre-delivery payments, which can cost 30% of aircraft value.
· Delivery access: If smaller airlines bought planes directly, they would be last in line for new planes, would have to pay full retail price, and would end up waiting a long time for the planes. For example, manufacturer backlogs can stretch out for 7 years or longer.
· Tax benefits: US tax laws allow accelerated depreciation on taxes, which are cost savings the US-based lessors can pass through to their international airline customers.
· According to our estimates, Air Lease will generate pre-tax EPS of $2.73 in 2013, growing to $4.23 in 2015 with ~111% upside of $59.2 by 2015 (at 14X 2015 pre-tax EPS multiple). This represents an estimated ~1.8X P/BV multiple at year-end 2015 compared to ~1.1X P/BV today. ROC will remain high with ROE nearly doubling from '12 to '15. We value using pre-tax EPS because, as explained below, Air Lease benefits from a tax shield and will not have to pay taxes until the mid 2030s or later.
· We believe these target multiples are conservative. Pre-tax ROE will be greater than 20% in a couple of years and EPS growth should continue to be at least in the high teens long term.
Air Lease trades cheaply because it is misunderstood and underfollowed by investors:
· Not in the commodity finance business: Air Lease is not a commoditized financing business like many of its peers who mainly engage in "sale lease backs." Air Lease provides a value-add service by utilizing its in-depth industry knowledge and relationships to help airlines improve efficiency. Because of Air Lease's expertise, it can help airlines offload less efficient planes and lease new aircraft that better match their customer and business needs. For example, Mr. Udvar-Hazy commented on the Q412 earnings call that for mergers like the U.S. Airways-American merger, "we work very closely with the airlines that are coming together in the new marriage, and we work with them on their fleet-planning alternatives. And usually, it involves a rationalizing of the fleet, reducing the number of fleet types, disposing of obsolete aircraft or airplane types that don't fit in to the new strategy of the combined carrier. And so there will be opportunities for Air Lease to provide our aircraft from our order book to these new consolidated carriers on a very efficient basis." Air Lease is unique because its competitors do not want to take on the risk of delivering planes a couple of years out.
· Does not incur significant interest rate risk:
a. Some investors mistakenly assume that because Air Lease has debt, interest rate hikes will lead to increased interest expense. However, according to a recent report by Morgan Stanley, "Air Lease's interest rate risk at face value is offset in large part by contractual escalators." In other words, its interest rate risk is mitigated because exposure is passed through to the customer, acting as a natural hedge. Embedded in customer contracts are index-based rates so if rates go up, airline's lease rates go up correspondingly. For example, if interest rates went up 1% on Air Lease's ~$2bn in variable-rate debt, Air Lease would pay ~$20mm in additional interest expense. Correspondingly, though, its ~$2bn worth of plane deliveries in '13 would generate an additional ~$20mm in revenue, offsetting the additional interest rate expense. The company consciously balances its debt and asset value to hedge out interest expense risk in this way.
b. Additionally, Air Lease pays high spreads on debt because it does not yet have a credit rating from any of the major credit rating agencies who typically require a 3-yr operating history. According to a recent credit research note by JPMorgan, we should "expect Air Lease to receive a low BBB rating soon from either Fitch or S&P. Once rated, we see Air Lease spreads eventually tightening by ~100bp."
· Underfollowed: Not only is Air Lease misunderstood by many analysts who do follow it, the company itself is generally underfollowed for 4 main reasons: (1) The company falls between sectors so few buy-side analysts cover it well; (2) The company launched its IPO two years ago and broke the price which initially reduced interest in the company; (3) Investors assume that Air Lease is a complex finance business but in actuality it is a straightforward value creator. And lastly, (4) secondary offerings put downward pressure on the stock, further reducing interest, as Ares, Leonard Green and WL Ross reduced 50% of their investments after being invested with the company for several years.
Well-run business with significant advantages and robust, competitive moat
· Long-term revenue / growth is unusually transparent, predictable and sustainable
a. Forward revenue visibility: According to AL management, it knows its financial model three years ahead because it places buy orders with manufacturers and leases contracts with airlines several years in advance.
b. Room for growth: Growth potential remains high for AL because by 2015, its ~$10bn of aircraft will equal only ~3% of global leased planes.
· Benefit from industry tailwinds, including:
a. Leasing trend increasing: Airlines are trending away from owning planes to leasing them. Operating leases as a % of fleet are expected to rise from ~40% today to ~50% within the next several years.
b. Rising emerging market aircraft demand: Boeing's Market Outlook for 2011-2030 indicates that emerging economies are likely to be the primary source of growth for aircraft demand going forward and Air Lease is aggressively targeting these markets. Airlines in these geographies are generally attracted to Air Lease's business model because the airline's cost of capital is much higher than Air Lease's.
c. Strong replacement demand: Aircraft replacement demand remains strong, especially in the US with the oldest and largest fleet in the world.
d. Global air traffic rising: Global airline traffic doubling every 15 yrs with average annual passenger growth equal to 5.1% (~2X global GDP).
· Experienced management team with skin in the game and a track record of success
a. Experienced: The CEO of Air Lease, Steven Udvar-Hazy, brings 40+ years of aviation industry experience and a strong track record of creating value. He co-founded and led ILFC in 1973 to its IPO in 1983 and through its sale to AIG in 1990. During the recession at ILFC, Mr. Udvar-Hazy managed to increase pre-tax income from 1.1 billion in 2008 to 1.4 billion in 2010. In 2011, Forbes ranked him as the world's 409th richest person (net worth of US $3.2 billion).
b. Skin in the game: Each member of the management team had to write a personal check to get an elevator key to the business and collectively they committed over $90m of the initial investment in the company.
c. Proven and robust business model: Prior to forming Air Lease, the current management team gained deep industry experience working together at ILFC. Even in the wake of 911 - the worst disaster in the history of airlines with 10% of airlines risking bankruptcy - the Air Lease team (while at ILFC) leveraged its deep industry knowledge to avoid any credit losses. It helped its struggling customers reduce their lease liabilities by repossessing and redeploying planes. It assisted Boeing (BA) and Airbus by buying their entire supply of fleets when they had zero buyers and managed to gain significant discounts and generous buying terms going forward. We are confident that the company could survive or potentially benefit from a future disaster due to its expertise, relationships, flexibility and proven ability to execute.
· Strategic advantages / sustainable arbitrage opportunities
a. Embedded relationships with OEMs lead to discounts: Air Lease benefits from substantial discounts on aircraft purchases because of its manufacturer relationships and large, advanced, wholesale purchases. For example, it has low-cost access to $17.2bn worth of aircraft through delivery slots with Boeing and Airbus beyond 2015, adding ~$2bn of further revenues. Delivery slots are also at key times (March/April/May time frame) when cyclical demand for aircraft is highest. And historically, Air Lease has been able to sell its planes for 10-12% above book value.
b. Knowledge and relationships: For new aircraft deliveries, Air Lease is able to leverage its knowledge and relationships to separately source aircraft components, including seats, safety equipment, avionics, cabin equipment, etc., and have the manufacturers install them during final assembly for significant cost savings.
c. Seat at the table: Air Lease's management team holds exclusive seats on aircraft design and planning committees giving them visibility into future industry trends and providing them 1st-level access to new planes. For example, Air Lease has the first 8 of 12 B787-9 orders.
d. Tax shelter: Benefit from tax shelter due to accelerated depreciation over 12 years for tax purposes (versus book value depreciation of 25yrs to 15% residual value). Like real estate investments, Air Lease does not pay taxes on gains when it sells aircraft as long as it reinvests profits in new aircraft. As a result, Air Lease will not have to pay taxes until 2030 if at all. And if the company is sold, the buyer will be able to write off the deferred tax liability under a 338 HT election. We expect that just like with ILFC, the CEO, Steven Udvar-Hazy, will eventually sell the company in order to permanently shield the company from tax expense. Furthermore, the CEO is 68 yrs-old and may be motivated to sell prior to his retirement.
e. Strong FCF: The company generates strong FCF because of negative working capital and the benefits of a tax shelter.
f. Largest and fastest growing order book: The company has the largest order book for Western build jets in the public leasing industry with ~3x current fleet on order between 2013 and 2023. The second largest order book in the industry represents just ~20% of its competitor's fleet.
g. Younger planes: Because Air Lease has a very young fleet with fewer planes coming up for lease renewal in the next few years, it faces fewer revenue headwinds than its competitors.
· Responsible asset and balance sheet management and strong FCF generation
a. Smart book ordering: Management limits new aircraft orders to half of what it thinks it can place in the marketplace. This enables the company to remain flexible and well positioned if the market turns or strategic opportunities arise.
b. Low financial leverage: Keep financial leverage to 2-2.5x, notably the lowest among all the lessors, compared to 4x for ILFC when it was under AIG.
c. Healthy debt mix: 58% of current debt is fixed with the goal of 70:30 fixed/floating mix
d. Access to capital and lending options: Access to 40 member banking group (largest of peers) with $2.3bn of equity, $4.4bn of unsecured and $2.4bn of secured debt.
e. Low overall debt: Maintain low debt/equity so it is not forced to sell its planes.
f. Self-financed growth: The company can self-finance its growth because of increasing debt capacity by leveraging increasing equity and strong FCF.
g. Strong operating leverage: Its 52 employees can support growth from the ~160 planes today to ~300 aircraft.
RISKS AND MITIGATING FACTORS
· Risk of continued selling from PE firms. We believe this risk is minimal since:
o Collectively, all 3 PE firms - Ares, Leonard Green, and WL Ross - have only ~8% of stake in the company.
o One of the directors recently bought over 11k shares in March and April suggesting that insiders still believe the company is undervalued.
· Air Lease is currently under litigation from ILFC who allege breach of fiduciary duty, misappropriation of trade secrets, wrongful recruitment of ILFC employees, and the wrongful diversion of potential ILFC leasing opportunities. Air Lease does not appear to be concerned about the litigation because it has no reserves against it and have not altered any part of its business as a result of the lawsuit. Furthermore, Air Lease claims there are no trade secrets in their industry and that no employees at ILFC were bound by any employment contracts.
· Liquidation risk: We believe this is minimized for three reasons:
o Air Lease trades very close to liquidation value based on figures reported by sell side research.
o The company's asset value is likely higher than stated book value given its young, 3.5 yr avg fleet age and the fact that within the first few years of a plane's life, the market value is higher than depreciation value.
o The company buys its aircraft at substantial discounts and historically makes 10-12% on aircraft sales, suggesting that a liquidation may result in recouped investment.
· New generations of cheaper, fuel-efficient aircraft could depress resale value of Air Lease's current fleet of plans. We think this risk is minor for three reasons:
o Air Lease's rising mix of new (up to 8 yrs-old), fuel-efficient, narrow body aircraft tend to hold their residual value.
o Air Lease purchases its planes at significant discounts with historical sales of 10-12% above book value providing them a healthy cushion.
o Aircraft valuations have not yet rebounded since 2009 and further downside appears limited. According to research by Morgan Stanley, "a significant step down in values is unlikely without a major negative, incremental macro shock."
· Customer default risk: Smart management and operational choices reduces this risk for 3 reasons:
o Customers pay their leases from 1 to 3 months in advance with maintenance reserves, which enables Air Lease sufficient time to repossess and deploy planes before incurring a loss. And order cancellation risk is minimized because of non-refundable security deposits.
o AL prefers to purchase high demand aircraft, including Boeing's B737-700 and 777-300ERs and Airbus's A330-200, that are young, fuel-efficient, planes that can easily be reallocated and redeployed to other airlines.
o Because the asset is mobile, if a payment is missed, Air Lease can reposes the plane and relocate it within 1-7 days. To date, Air Lease has only had to repossess two planes and it booked profits on both repossessions.
· Geographic interest rate differential: Higher domestic borrowing costs could be a risk if international interest rates remain flat or decline, thereby reducing Air Lease's spread. This risk is mitigated for two reasons:
o Air Lease's returns are already so high that even with a reduced spread, the ROE is still likely to be attractive.
o The management team has managed through many difficult macro-environments in the past and can leverage its experience to minimize the impact of reduced spreads.
· Government risk: Despite the aircraft industry being highly regulated, Air Lease does not operate any aircraft and are therefore not directly subject to many industry laws and regulations. Changes in international environmental regulations may benefit AL because of their increasing mix of new, fuel-efficient planes.
· ~65% of fleet book is in eurozone and Asia Pacific: Worsening eurozone crisis or geopolitical issues could pose a risk to Air Lease. This risk is mitigated by a diverse range of customers with no more than 10% customer concentration and what appears to be a healthy airline industry in China.