AerCap Holdings: Why Mr. Market Is Not Seeing The Value

| About: AerCap Holdings (AER)

Summary

AerCap Holdings is highly undervalued at a price-to-free cash flow ratio of 13.03.

While the price has continued to increase, the P/FCF ratio has not done so in tandem.

Given the increasing trend across the airline industry in opting for leasing services, this company could be in for very high growth in the coming years.

Last February, I had made the argument that AerCap Holdings (NYSE:AER) is highly undervalued, with its share price having taken a tumble after a broad market slowdown and sluggish sales across China. However, we have since seen a rebound from a price of $29 on February 18 to $37.07 at the time of writing.

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However, those who read my articles will know that I always favor free cash flow over earnings as a measure of growth since high earnings do not mean much if debt significantly erodes cash flow. In this regard, the intention of this article is to quantify the business-based reasons for growth that I outlined in my previous analysis, and analyzing the free cash flow metrics of AerCap Holdings reveals an interesting insight. While the price has subsequently risen, the firm's price-to-free cash flow metric has not done the same.

Instead, we see that P/FCF has remained at the 10 to 13 range seen after the company's price drop. This indicates that while price is increasing, free cash flow is also increasing and price has not risen significantly to reflect the company's value.

In my opinion, this mispricing of AerCap Holdings certainly implies that Mr. Market has a hand in keeping the price down. For whatever reason, price is being dictated by investor reluctance rather than a rational estimate of intrinsic value. In terms of the business model, I remain confident that AerCap Holdings will continue to thrive as a result of increasing demand for narrow-body aircraft across Asia and developed markets, along with the further increase in demand for aircraft leasing characteristic of this market segment.

In this regard, I see AerCap Holdings as being highly mispriced given that the P/FCF ratio has not adjusted upwards along with price.

Free Cash Flow Per Share Forecast
Year 1 Year 2 Year 3 Year 4 Year 5
Projected Free Cash Flow Growth 3.14 3.45 3.80 4.18 4.59
Growth given discount rate 2.85 2.85 2.85 2.85 2.85
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Assuming a 10% discount rate (as a required rate of return and expected eventual long-term performance on the S&P 500 given a market lag since 2015), along with a 10% annual forecasted growth in free cash flow per share, varying the P/FCF ratio yields us the following target prices over a five-year timeline:

P/FCF ratio = 15; Target price = $42.78

Terminal Price to FCF Ratio (which is the current one) 15
Terminal Price to FCF Ratio * Estimated Year 5 Free Cash Flow 42.78
Present Value of Dividends Per Share Through to Year 5 0
Target Price in Year 5 42.78
Upside from price of $37.07 15.40%
5-Year Annualised Rate of Return 3.08%
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P/FCF ratio = 30; Target price = $85.56

Terminal Price to FCF Ratio (which is the current one) 30
Terminal Price to FCF Ratio * Estimated Year 5 Free Cash Flow 85.56
Present Value of Dividends Per Share Through to Year 5 0
Target Price in Year 5 85.56
Upside from price of $37.07 130.81%
5-Year Annualised Rate of Return 26.16%
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P/FCF ratio = 45; Target price = $128.34

Terminal Price to FCF Ratio (which is the current one) 45
Terminal Price to FCF Ratio * Estimated Year 5 Free Cash Flow 128.34
Present Value of Dividends Per Share Through to Year 5 0
Target Price in Year 5 128.34
Upside from price of $37.07 246.21%
5-Year Annualised Rate of Return 49.24%
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P/FCF ratio = 60; Target price = $171.12

Terminal Price to FCF Ratio (which is the current one) 60
Terminal Price to FCF Ratio * Estimated Year 5 Free Cash Flow 171.12
Present Value of Dividends Per Share Through to Year 5 0
Target Price in Year 5 171.12
Upside from price of $37.07 361.61%
5-Year Annualised Rate of Return 72.32%
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By my own admission, these targets are not conservative. However, I see AerCap Holdings as a company with potentially very high growth given that the airline industry increasingly adopts a leasing model and AER is coming to dominate this industry. Moreover, we have seen previously high growth in the company in a short period, such as when shares jumped 30% in December 2013 after the company acquired AIG's (NYSE:AIG) aircraft leasing arm.

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To conclude, I see AerCap Holdings as a high-growth stock with a lot of potential. While a price target of $100 is highly unlikely to be achieved in the short to medium term, I certainly see it possible that a mark-up of the P/FCF ratio could result in the company trading in the $70-80 range should current growth trends continue.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.