AerCap (NYSE:AER) will report Q4 earnings on February 23. Consensus view expects revenue and adjusted EPS to be $1.27B and $1.50 (reported EPS: $1.38). After plunging 50% from its 52-week high in June 2015, share price has recovered slightly since early February but remains the worst industry performer on year to date basis. Heading into the earnings, investors should focus on the following topics.
One of the market's key concerns for aircraft lessors is the value of their aircraft portfolio, particularly for wide-body aircraft that have smaller installed base and therefore less liquidity. For the company's 2 primary wide-bodies - Boeing 777 and A330, management disclosed that 75% of its expiring wide-bodies through 2017 have already been placed through re-leasing or lease extension as of Q3 and there remained 10 Boeing 777 and 6 A330 to be placed during the period. Given the market's heightened focus on wide-bodies' residual value risk, sentiment would be improved if the company can demonstrate progress in placing these remaining wide-bodies. Nonetheless, I believe the concern for AER's wide-body exposure is overdone given the fact that these wide-bodies coming off leases in near term represent only 1.4% of the company's total owned fleet (1,124 as of Q3).
Over the next few years through 2018, the company targets an EPS CAGR in the range from 7% to 9% with the primary growth drivers being aircraft portfolio growth and allocation of excess capital. As shown in the chart below, the portfolio growth includes $5B-$6B annual aircraft purchases, which are partially offset by scheduled depreciation and aircraft sales. The aircraft purchases will come from 3 sources - OEM orders, sale and lease-back transactions, and portfolio acquisitions. In terms of OEM orders, the company has committed to order 205 aircraft through 2018 as of Q3 2015 and 80% of this commitment has already been placed with leases. Investors should pay attention to latest update on the OEM order pipeline and percentage commitment being placed. A higher percentage will provide greater visibility into future growth, which is loved by the market. Investors should also focus on management's commentary on future sale and lease-back as well as portfolio acquisitions, which would help fill in the gap between OEM orders and the annual purchase target. Click to enlarge
The remaining EPS growth is expected to be driven by allocation of excess capital. According to management's plan, the company should be able to generate at least $1.5B excess capital in the period from 2016 to 2018. Depending on market condition, management could allocate this capital toward further aircraft purchases or return the capital to shareholders through buyback and/or dividend. On Investor Day in September 2015, management considered share buyback would be the most accretive option if share price stays at the level at that time ($42-$44). Given the price has fallen by more than 25% since then, a share repurchase program is likely to be announced in near term - a positive catalyst for stock valuation.
Another near-term catalyst would be the company regaining its investment grade rating. AER lost its investment grade as it incurred significant debt to finance the merger with International Lease Finance Corporation ("ILFC") in mid-2014 (i.e. debt to equity ratio rose from 2.5x to 4.3x post the transaction). Since then, the company continued to de-lever by limiting its debt financing on aircraft acquisitions. This has led to decrease in total debt to fleet book value ratio from 98% in Q2 2014 to 90% in Q3 2015 and corresponding decline in debt to equity ratio to 3.6x (or 3.1x on adjusted basis) (see chart below). Given management's target range from 2.7x to 3.0x on adjusted basis and the company's strong operating cash flow generation, I believe investors should see the leverage ratio dropping below 3.0x as of Q4. A credit upgrade may happen by mid-2016 if the company stays on track with the deleverage plan (indeed the company's Q3 leverage ratio of 3.1x exceeds the plan of 3.2x). As a reference, AER's leverage ratio was 2.7x at the time of receiving investment grade ratings from both S&P and Fitch in early 2012 and the company's fleet net book value is now 4x larger (scale is a critical credit consideration for aircraft lessors).
The stock now trades at 0.78x book value, compared to comps average of 0.82x and historical average of 1.14x post the ILFC merger (see chart below). Given AER's large scale, conservative leverage, and well diversified aircraft portfolio and that the company continued to grow in size, reduce leverage, and generate higher ROE since the merger, the current valuation relative to comps and historical levels does not look reasonable to me. AER is a BUY.
All the data presented in the above charts and the article is sourced from Capital IQ as well as company filings and presentations, unless otherwise noted.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in AER over the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.