Aircastle LTD (NYSE:AYR)
Limited Analyst Meeting Call
April 12, 2012 12:15 pm ET
Frank Constantinople - SVP, IR
Ron Wainshal - CEO
Dave Walton - COO, General Counsel
Roy Chandran - EVP, Capital Markets
Mike Inglese - CFO
Good afternoon everyone and welcome to Aircastle's 2012 Investor Day. For those of you I have not had the opportunity to meet I am Frank Constantinople, I am Aircastle's Senior Vice President of Investor Relations. We have an interesting agenda which we hope you will find useful. The presentation today will be broken into four parts. Ron Wainshal, Aircastle's Chief Executive Officer will begin by discussing our business strategy and providing an industry update. Ron will be followed by Dave Walton, our COO and General Counsel and Dave will review Aircastle's aircraft portfolio and credit process. Roy Chandran, our EVP of Capital Markets will then provide an update on the financing markets which we think you will find interesting and Mike Inglese, Aircastle's CFO will provide a financial review and update of the company's financial profile.
We will 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 accompanying PowerPoint presentation materials that we're presenting here today. I would also like to point out that the statements today which are not historical facts may be deemed forward-looking statements and 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 Ltd'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 therein. And I will now turn the presentation over to Ron.
Thanks Frank. Welcome everybody. A lot of new faces and some familiar ones. I'll step back and give you a brief overview of the company which we have started from scratch basically seven years ago and over that period of time we have built I think a very distinctive top shelf aircraft lessor that we are the first of our breed to go public back in 2006 and we have been sort of on a frontend of a lot of things in terms of the industry. Our approach to the markets is unique I think both in terms of the investment strategy and also in terms of the capital structure.
We will spend a lot of time talking about both, but I think it's important to note that they are integrated and what we do and how we finance it, has to go hand-in-hand, it's a financing business at the end of the day and I don't think that carries through throughout business. In any case we have had a very eventful last 12 months or so, we have invested $1 billion during 2011. We've continued that this year and I'll cover that in greater detail and we have been very active in terms of the capital market.
During the course of the presentation I'm really going to focus not only in terms of trying to give you a sense for what we are doing and why, but how we are different as well. So taking a step back, we are in a business that's growing, the commercial aircraft is a $400 billion to $500 billion space and it's growing. It is growing basically with GDP across the world and as that pie grows, the share that aircraft lessors occupy is bigger. Our portfolio is modern, it is in demand, it is diverse. In terms of our maturity profile, it is pretty well spaced out.
What are the things that makes us different, we will cover this in some depth is our cargo market strategy and we are the leader in that space. Throughout the business' life and we live in a cyclical industry, we have done an exceptionally good job of keeping our planes flying. I think in general the sector is probably underappreciated in that respect, but I think within our space we are among the best if not the best. What are the other things that's worth noting is our approach of acquiring aircraft.
We buy aircraft wherever we see good value. It's not a one-dimensional strategy of buying only from the OEMs or from airlines who sell leasebacks. We have acquired aircraft just about whatever which way you can imagine, more than 80 transactions with more than 60 counterparties. Through the last several years which have been economically a little bit more sensitive than we would have preferred. We have managed to keep our earnings and our cash flows very strong and that's continuing and one of the underpinnings to that is our capital structure.
We have got a very conservative capital structure which we are continuing to improve on. The bond yield that we just completed a few weeks ago is another big step in the direction, we have created a huge unencumbered asset base and that asset base in turn throws off a very strong revenue stream.
Finally, the management team is top notch, we have gone and cherry picked from the very best out there. We have got real scalability, in fact I think we can double our portfolio of size and still keep basically the same overhead structure and we are all very focused on making sure that we are accruing to shareholder value. We improved our ROE, we have improved the payout in terms of our dividends and we were very mindful of stock price movements and stock buyback programs. So it's all bit of a balance here.
So with that let me turn in and go and address the general marketplace. As I mentioned Air Traffic's long-term growth, time series, in fact if you go and look at passenger traffic since 1970, there has only been three years where traffic contracted. One of those years was in 2009, so we have recovered very nicely from that and we are continuing on the same historical trajectory of around 1.5 times GDP growth in terms of Air traffic growth. Air freight which I mentioned is an important part of our business is a little bit more volatile.
And that sector tends to lead the economy or the passenger market a little more economically sensitive. In my view we have seen the corner turned and as we look at the projections from IATA, the International Transport Association calls for growth of around 4% to 5% over the next several years. And that pretty much marries up with 1.5 times of GDP type of growth rate.
What’s driving that growth rate, primarily, is the emerging economies. China, India, Brazil, Turkey, Russia, there is a number of others but those countries in particular now account for almost a third of the deliveries. And that's going to continue to grow. That's where our market is growing and that's where our portfolio is shifting.
And, in fact, if you look at the world fleet, the 17,000 or so aircrafts that are flying around today will probably double over the next 20 years. Now, that's a long period of time but if you look at the deliveries that are coming this year, it’s nearly $100 billion worth of equipment.
The growth is one aspect but re-fleeting, replacing older and perhaps not so efficient aircraft is another important dynamic. Fuel prices are high. We will cover that. Environmental pressures are growing and those who purvey aircraft with a more efficient and acceptable technology will do well.
One important thing to talk about. It seems really self-evident but aircrafts are portable and what makes them even more portable economically speaking is there is only two manufacturers. That's very different than if you look at other long life assets, and that makes the punchability of aircraft quite strong.
So let me try to illustrate one of the comments I made before. I talked a little bit about the growth in the market. Now let me talk about the growth in the market share. Aircraft leasing effectively was started in the early mid-70s and grew pretty steadily. There's been a few little bumps along the way, but it’s now more than a third of the world’s fleet, and I see that continuing. Why airlines don't reliably make money if you will see below, and these are very expensive, capital intensive businesses, having flexibility over a cycle is an important thing. And frankly, I think we are better group of companies in terms of batching residual risk.
Now it’s also happening and my colleagues will talk about some more. Is it the funding market for airlines is involving in shifting in a very profound way with a demise of traditional assets base lending banks.
Many of the top European banks that would fund small to mid-size airlines just simply getting out of the business or just going out of business all together, and that’s one of the important things they were trying to do strategically.
Now if you look at the bottom, you’ll see aircraft work force make money. They make the money pretty reliably and our customers don’t.
And I don’t see that changing. That’s just going to be one of the reasons why that share of the pie is going to continue to grow my opinion.
So I’ll now take a different tack and talk about aircraft programs. Aircrafts are -- 2011 was actually very interesting and important year in many respect. We saw the launch of several new platforms, a shifting of resources by Boeing and Airbus and also increases in production. I’ll talk about the production first.
If you look at Airbus narrow bodies and Boeing narrow bodies, the production rate is going up 20% to 25% versus say three or four years ago. And that’s continued -- that’s expected to continue. Aircraft production is a long lead time process. There is a 18 to 24 month process, and so even if somebody wanted to increase or decrease production today, if they push the button you have to wait almost till the end of the next year -- I am sorry, the beginning of the falling year to see much of an impact.
I think this increase in production rate is actually what’s driving lease rates being little bit softer particularly in the airbus side today. I’ll talk about that more. Now there is, as I said, a new technology coming down the road. That’s particularly important in the context of understanding, you know, what the residual value performance would be. The Airbus NEO or new engine option was announced last year and has got a lot of momentum.
I think there is a general view among industry participants that this is going to be a reasonably successful aircraft. It’s not a particularly new aircraft. This is the second time Airbus is taking the same fuselage which has been around since 1988 and put a new engine on it.
It is definite step change in efficiency, and, you know, it seems to have gotten good customer interest. The Boeing reengineered aircraft, the MAX as it called, looks to me a little bit more of a challenge technologically. It is little bit further behind in terms of the calendar and there are more things that need to be sorted out. They are taking steps that way. I think there has been some good airline interest there but the thing that’s common to both of these aircraft is they are reengineered planes as oppose to a clean sheet of a paper aircraft.
When we think about aircraft, we think about a long life investment. We think about the investment being one where the life of the aircraft is actually longer than the current production run. Aircrafts are typically made for about 15 years. Actually if you look at the A320 and 737 new generations, they will be twenty years. So that’s good in relative terms. The MAX and the NEO were surely on our side anticipated in some form of fashion for many years now. The fact that it’s more tangible is not a shock.
Anything you can say that the residual value implications would have been more profound if there was a brand new technology as oppose to reengineering. My view is that the MAX and the NEO has zero impacts on the rates today. What affects interest rentals today is current supply demand. And that will be produced in five or six or ten years.
Now, there are number of very important side effects of the decision to re-engine the narrow-bodies. In the case of Boeing and in the case of Airbus, you have to begin with programs that are horribly behind schedule and way over budget. 787 finally got launched into service late last year, four years late. That’s important but what's even more important is that the production on that aircraft is way, way far behind in terms of the reclassification and that’s actually what moves the market.
The Airbus new wide-body, A350 XWB was redesigned and it has been tweaked constantly. That’s a year behind as well. So the beneficiaries of all this are existing technology aircraft. And when you look particularly at the 777, also the A380, the fact that there is a shift in resources towards a new generation narrow-body versus the new 777 is a good thing. That means, it will be produced longer and the longer an aircraft is produced, the longer it will stay economically viable. This is one of the underpinnings of our investment strategy.
So let's talk about rental trends. These are numbers that come of shapes if you will. They come from Ascend, one of the appraisal firms that are out in the industry. And you know, you might tend to mute affects and tend to lag a little bit. What it basically shows you here, the shapes are pretty similar. One on the top, you have the Narrow-bodies that are current technology there. The 5-year age is a constant age and then you have the same thing for wide-bodies. You will see the pattern of the cycle here, number one.
And number two, you will see that some aircrafts have done a little bit better than others. In regard to narrow-bodies, you will see that the Boeing fleet has done better than the Airbus fleet in general. You see that there is a recovery after the down turn of 2008, 2009 and ‘10. The recovery hasn't reached the levels that we saw back in 2007 or ‘08 which was last peak. In fact, I think we’re about roughly halfway between the trough and the peak as a generalization.
You will see that there are some aircrafts that have definitely underperformed. The smaller variants of the narrow bodies for example have done worse, particularly the 319, that's the blue line that kind of tails-off in the top chart.
Wide bodies have been a little bit more volatile, but I think there is a much better supply and demand picture there. It’s simply because there has been no 767 production of any sort. There has been no 787 production. So you are basically going with half of the [thicket] turned on.
And on the 777 side, its Airbus competitor has now been discontinued with A340, so I think of that as a much more robust forward-looking picture than for narrow bodies as a generalization and you will see that particularly the 777 has done quite well. And that's kind of an important part of how we think about the investor proposition.
The demand for aircraft is of course not only driven by demand, but how much money you can make off of that and fuel is now for most airlines the single biggest P&L item. Fuel prices have been higher and they have been extremely volatile and when an airline signs up to lease an aircraft, it doesn't do so for one of two years, its too complicated and expensive to induct into a maintenance program and to train its crew and so on.
And so there are longer-term commitments and there is a reluctance to buy airlines to make commitments for aircraft that are not fuel efficient. And by that, I am particularly focused on the technology because you will have ups and downs in terms of the maintenance cycle, more than people understand. But the real step change happens when you move from one technology to the other.
So let me illustrate that with the chart here that shows for different aircraft types what the percentage of the parked fleet is, okay. Starting over on your bottom left, you’ll see the current technology narrow bodies, the A320 family, the 737 family and those are the different colors or the different years starting in 2008. You’ll see that throughout the downturn and to the recovery, there has been extremely low level of parked aircrafts and that’s not surprising given where fuel prices have been.
All the way to far-end, you will see the older technology of narrow bodies and you will see that in the beginning of 2008 it was only 5% of the fleet and by the way, these aircraft are aircraft that have not been in production for about 15 years now, 10 to 15 years, so it’s important to remember that. There was definitely a spike-up during the downturn and there has been no recovery. I think that underlies my point about fuel prices.
Now if you look at the middle, you’ll see basically two different sets of aircrafts that are wide bodies and wide bodies are a little bit, generally a little bit higher percent parked because the cost and that the issues in redeploying them a little more complicated in narrow bodies.
But also the A330 family very, very low levels in fact even lower than the Airbus narrow bodies. 767s are doing okay, better than I would have expected given and it’s all the 787 delays. And you’ll see in the freight market a little bit more of a volatile time period, but that’s actually seemingly improving recently to me in my view, okay.
So what we do with all that? Our approach is to invest and I’ll emphasize, selectively. It means we don’t believe that in a cyclical business you have to put money to work at all times; when you are at the top of the cycle, if you were to buy aircraft in 2008 you probably wouldn’t have done so well versus buying an aircraft in 2009 and our approach is to use discretion, use our market knowledge.
Attractively priced, this is another area where I think a lot of people that will cite. It goes hand-in-hand with economy, but just because something is new for example doesn’t mean that it’s a good investment; we’re very focused on that; and also marrying up the return to how we finance it. So if we see an attractive looking return, but we can’t finance it effectively then that doesn’t look so good at the end.
So the capital structure is what drives the funding cost and we’ve always been fairly nimble in terms of adapting to what was out there. But I think we’ve taken a more strategic approach over the last couple of years realizing the evolution of the bank market and the depths of the capital market. And that’s important to what we do. And a portion of what we do every year is going to be reinvested. We are not intending on becoming on wasting trucks. We’re also are mindful of sometimes the attractive things to do in terms of dividends or buying back your stock. So selling assets is also part of the game here.
Given the cyclicality, we are not fighting it. We sometimes embrace it. Last year we sold $0.5 billion of planes and made a lot of money, so all those things to me are essential elements of being a successful aircraft lessor. We’ve done all those things in the last year or so. We have improved earnings. We have improved our ROE. Mike will talk to you more about that.
On this page I wanted to talk a little bit how we integrate an investment proposition with the funding and the fancy formula in the middle of the page is basically weighted average. And what it says is if I make a return on assets, let’s say 12% and I maintain a capital structure which is consistent with what our long-term goals are which is roughly two-thirds there and I know what my debt cost is, a 12% return, given 7% debt gives me a very attractive ROE. That’s a really simple way to think about our business and I think the integration of the returns and the cost of capital is a fundamental part of how we look at the whole proposition, a lot of people just look at one part of it and I think that’s a big mistake.
And what we do in this regard, how do we source our opportunities? We focus number one on where we think we have a competitive advantage; it’s a financing business, so there is no trademarks to intellectual property, but our approach is different and among the top leasing companies very few people have the diversity of investment sources that we do; very few people have the leadership position we have in the freight market and very few people have the capital market facts that we just demonstrated a few weeks ago.
We also have a different perspective; most of our peers are focused on new narrow bodies; it’s not opposite, just that’s a very proud in feel and in any business where everybody is doing the same thing it’s down returns. We think actually the mid-age aircraft are actually very attractive and in fact I think will hold the value better and we like the new wide bodies because if you look at 777 I think that’s the only aircraft made today that still have shard wing produced at the end of the decade.
So what are the key investment approach? The price and rent matter. This is a finance business. Looking an appraisal is interesting, but if I told you what my bond portfolio was worth without telling you the coupon, it wouldn’t be particularly informative discussion.
Now I think when you look at an aircraft, it’s not a bond, it’s something that will have a long life and if it doesn’t you’ve got a real problem whether you decide to hold it or not. We think of them as aircrafts that will definitely in terms of usability extend beyond the current production level as my example on the classics illustrates, but not all aircrafts are going to be same. Now the utility of the aircraft is very much a function of how many operators there are. And if you have a broad operator base, you will have an ability to generate good rentals, not only this lease but the one after that and the one after that and so on. And that's pretty much been our orientation.
Now we tend and this is what makes us different, not to like the last off the line, a new A320 delivering in 2015, if you are expecting it to last 25 years, that's 2040. Think about it, that's beyond as we are joking it is beyond our economic lives. So we are a lot more focused on the early to middle part of the production run where you tend to actually get the economic, the generic economic value assumptions.
Now one of the things that I think also makes us different is that while we have made orders with the OEMs, it’s a small part of our business. In fact we took delivery of our last A330 just a few days ago. When you look at a new order, you have to wait several years for the aircraft. So typically you won't know who your customer is. You won't know what the rent will be. You won't know how you are going to pay for it. And along the way, you will have to pay some pre-delivery payments to the manufacturer of the aircraft to produce it.
That's dead money and that's a drag. So it isn’t to say we never do that, it is just say for all those things we would want a return premium versus doing something here now. And there maybe opportunities, but typically the manufacturers feel the cycle in the same way that we do. Buying an aircraft last year when the production sold out for years to come probably doesn't lead to a very hungry seller. But in 2009, I would have imagined if you had the courage to make a big order, you would have done very well.
So I think there's a time and a place for such things and having a big order stream in place, right now for example means that your capital is tied up and you may not be able to take advantage of what's the field. So what are we aiming at specifically? This is pretty consistent with what we’ve been talking about over the past year, high quality wide bodies what I mean by that or primarily 777s, 300ERs and also the A330s. I have a much more positive residual value outlook. And those aircraft type versus the narrow bodies, where I know there is going to be a near-term replacement or I know the production rates are going up. And where I know there hasn’t been the same sort of supply pressures in the first place.
With these types of aircraft, they have good customers, it tend to get longer lease terms. There is a lot less competition from other leasing companies and there's good financing availability for the all reasons above. For new narrow bodies I think we’ll sit that out for the most part. We will wait for the new technology to show up, but I think there is great value from the middle-age aircraft that are still the current technology. This has been the kind of the core of fleet and the basis for a very strong performance.
When we look at this, the entry prices are very low because there is no competition. There is no bank financing in this market. And that’s where the bond market is a huge advantage for us. We see great prices, great yields, a very quick payback to a part out value type of equation. So I actually think in contrast to lot of people might believe that this is a less risky proposition, buying a mid-age A320 or 737-800 as supposed to buying a last off the line one, in fact much less so.
And finally the freight market which is as I said before, a core strength of ours, but in a way kind of a combinations of those first two categories. There are definitely new high quality asset plays that we had here, I think the 777-200 freighter is the freighter of the future. That’s going to be the work horse, that’s where there is, that's the right size and payload capability and operator base.
It's a good operating lease asset and one we are very interested in. We also think there is great current technology possibilities, particularly in the sale leaseback market. The freight market has been up and down. It’s a little bit down right now but on the way up and there is a lot of very strong customers that are looking for cash.
So we see this, we see good cash yields on the investment. We see a useful life of 20% to 40% longer then passenger aircraft, better credits, longer lease terms, lower transitions cost. But one thing here is that the freight market is more economically sensitive. However it is a lot less event sensitive. So if you have a flu pandemic, if you have God forbid another 9/11, freight market not so badly affected like the passenger market.
So from a portfolio perspective I mean, I like the aircraft is individual investments from a portfolio perspective, it's one this end market diversification I think is important. So next thing I have here is an example of an aircraft that we bought in 2010. And there is a lot of seemingly, there is a lot of mystery around the math around aircraft purchases. It's actually really simple. We bought this aircraft from a passive investor just as the lease expired. It was an eight-year old 737-800. We bought it for $22 million, well below apprised values and thanks to the team we were able to source at least almost immediately for six years at $245,000 and we also collect maintenance reserves for another $160,000 per month.
So over $400,000 of cash flow per month. Now we had an expectation that the return on the assets would be about 14% in that context. What we did is after we put the lease in place, after we added value to the equation so to speak, we sold the aircraft last year at a price higher than what we actually bought it, after collecting this big fat cash yield of $400,000 a month.
So you can take look at the math here, does not have many moving pieces here. What you see here is actually the 14% kind of expectation and the sales prices as we said in excess of $22 million. This is how you make money. So with that, let me talk about our pipeline. We are opportunistic, that's an overused term, it just means that we are not going to buy if we don’t see good things to buy and we see good things to buy. Last year was one of those markets where we saw great opportunity, particularly during the back half after the bank market softened up.
And when we started to really amplify our efforts. That's starting to pay off in a big way. During the first quarter, we closed an $80 million of investments and we will elaborate that in our Q1 filing in a few weeks, but we expect actually more than $400 million to close during the first half and that could be higher. Included in that as I said our last of our A330 deliveries. This was a twelve-year lease to Virgin Australia.
I think they are taking their second aircraft in the next few days. I think Sir Richard will be there for the big ceremony. More importantly for us is we also got a terrific debt rate. Twelve year fixed debt rate at 3.81%. So we are going to make a very nice return on equity in that deal. That is an ECA back deal by the way and filling out this $400 million in change is confirmed letters of intent to purchase more than $260 million of additional investments.
These investments fall very much within the three buckets that I described before. For the full year and just one thing I had to say, during our earnings call just a few weeks earlier, I talked about $300 million for the first half, so we've definitely raised our expectations by over a $100 million and what I have said back then was 600 million for the full year. We've obviously upped that. I think there's actually more possible than the 700 but that's our current advertise expectation.
So with that, let me turn it over to Dave and he will talk to you about our credit process and our portfolio management.
Thanks Ron. Before I talk about the lessee credit review process and the portfolio, let me just take a minute to refresh everyone’s recollections on the profile of our operating lease portfolio. These leases are triple net leases. Lease terms generally run from 3 to 12 years and you will see at the end of 2011 the weighted average remaining lease term on the portfolio as a whole was about five years.
We get paid rentals in US dollars. Generally, they are fixed for the term and paid monthly in advance. We also collect security deposits and maintenance payments. But one really important thing to remember about these assets is that they are mobile. As Ron was alluding to earlier, we can and we do redeploy them worldwide.
Let's talk a minute about risk management. I guess the first point about risk management and it starts with diversity. And I am going to talk in a couple of slides about portfolio diversification, but it doesn't end there. Each new investment or lease placement is based in part on a detailed credit assessment of the perspective lessee. So we do our due diligence before we make an investment and before we put our assets into an airline.
What we do is we gather historical financial data. We look at projection in business plans where we can, thank you, and we make a site visit. So we’ll have a risk officer who will go out and meet the customer face-to-face. Make sure we can get to know them and get to know the management team before we make an investment decision or lease placement decision.
Once we close the deal and it’s on the books, we stay in touch with our customers. We are looking at their financial performance, and of course their lease compliance during the lease term. And if we see or we anticipate a problem, they may end up on our watch list. Now what happens when they are on the watch list?
First of all, what’s going to happen is our risk officers are going to be talking to them, try to figure out, do we have a valid concern about something, and if so what they are doing about it.
The second thing is our technical team, legal team, marketing team; everybody is going to go into a higher state of readiness. And for example, what that might mean for a technical team is that, you know, they are going to take a look at when did we last inspect the aircraft. You know, do we have a good sense for its current condition, what it might take to redeploy it in terms of costs, and also where do the records stand.
As you probably know, it’s very difficult to redeploy an airplane if you don’t have a good records package. And what that would mean is major historical records, really back to birth on the kind of maintenance that’s been done on the aircraft, where it was done and how it was carried out. So we made a decision that really at the inception of this company that we were going to digitized the main aircraft records for the fleet. And that’s what we undertaking to do.
So for instance, if we have a customer on the watch list, one thing we are going to do is we’re going to take a look at the records we’ve got digitally and make sure that we think they are up to date. If they are not, but again we may go out there, send somebody with a scanner and make sure that we get everything up to date.
Basically, we want to be ready. And I think one of the things that we try very hard to do and I think we’ve been very successful at it is if somebody goes on the watch list, we make a sober assessment of whether they are going to be there in the long run, and if we don’t think that’s going to be the case, then we act quickly.
We found out over the long hall that it’s much better to get out early, take your losses and redeploy the airplane than wait around for a meltdown.
Let me go through one case study with you to try to give you a sense for how we put this into practice. This particular airplane was leased into Tunisia and we put it in there in 2009. The airline performed pretty well for us but as everybody knows, Q1 last year was a pretty tough year in that part of the world. And when the turmoil started, we were almost immediately in contact with this customer to find out how they were doing. One of the things we did pretty early on to, as I mentioned before, and then once we felt it was a safe environment, we sent the technical team in there to take a look at the airplane to make sure that we understood where it stood from a maintenance perspective.
Now this customer came to us as part of its dialogue and basically said, you know, tour market is devastated, we really don’t have a use for this airplane. Now the easy thing to do at that point would have been to put our head in the sand, maybe literally, and just ignore the problem. But in reality that’s not our style. We like to act where we think we need to and so we immediately set about marketing this airplane.
But we told the customer, listen you got to keep paying your rent on time. You have to be ready, when the time comes, to put this airplane into a good technical condition and we will see what we can do for you. Well, fortunately, this was a good story and I think it was a good team effort on our part. We deployed the airplane to a customer in Denmark in Q1 of this year, and again I think it demonstrates the good dialogue with the customer, good team approach and acting where you need to act to be proactive.
Also as part of the story may be as the rent stream continued uninterrupted through that process, which is pretty good story for that part of the world. Now turning to the portfolio, you know as Ron mentioned, we are seeing growth in the portfolio in Asia. It’s up to 28% of the net book value at the end of last year from 23% in 2008. Europe is now at about 41% of the portfolio versus 44% in 2008. And just to pause for a second on Europe, you know, may you should take a look at the top ten customer list. At the bottom right you can see our European exposure on that list.
First of all is Martinair. Martinair is the cargo arm of KLM. They are wholly owned sub of KLM and part of that KLM-Air France Group. The next one on the list within Europe is Airbridge Cargo. They are the largest cargo operator in Russia and part of a bigger group that’s performed traditionally very well, and then there is Iberia. Iberia merged with British Airways in 2011. And again they are a good performer with a valuable South American franchise. Frankly, I don't lose very much sleep over that European exposure on this list.
There is something else to note about our European exposure. You know we've got 41% of the fleet there, but we've also got 35 customers. So beyond this list it’s very well disbursed in Europe.
In terms of the diversification by aircraft type, the way we think about this is about one-third of the portfolio is in current technology narrow body aircraft; about one-third of the portfolio is in current technology wide body or mid-body aircraft and about a third is in freighters and Ron mentioned a little bit earlier why we like freighters.
Turning to lease maturities, let's start with 2012, I mean this slide doesn't really tell the full story on 2012. We did a lot of work in 2011 to place 2012 scheduled lease expiries. So I think we had 10 or 11 aircrafts that were originally expiring in 2012 and we did lease extensions on those. So we are working hard on this roll-out for 2012 last year.
And then in 2012 we've been chipping away at it. Right now we've got about 6% of the total net book value of the fleet to take care of and that's a pretty manageable job for us. We also had a couple of 747-400 converted freighters to market when one of our customers World Airways filed for Chapter 11 protection in the first quarter of this year. We've taken care of both of those airplanes.
We, for one of the aircraft we worked with World and decided to leave that aircraft in there at a reduced lease rate and for the second airplane we took that airplane back from World, we’ve put into maintenance and we have a lease commitment on it. So we expect to deliver that airplane on lease here in the second quarter. So you know as Ron mentioned, the freight market is tough, but we feel pretty good about the fact that we took care both those airplanes pretty quickly.
Looking ahead to 2013, ‘14 and ’15, you can see it’s a pretty world dispersed lease maturity profile here and a very manageable job for us. And then finally, this is actually my favorite slide. This tells a good story I think of the work we’ve been doing. If you look at the blue bars, we think about this as essentially occupancy rate for our aircraft fleet. And you can see for the last five years we’ve been averaging about 98% to 99% occupancy which is pretty good performance.
But if you look at the red line, you can see that we also were able to maintain our yield at around 14%. So we weren’t giving away capacity, just to keep things fine and we’re doing a very good job of maintaining that yield. And I think to me what this demonstrate is first of all we’re making good investment decisions on the front-end. We’re investing in airplanes that we can redeploy at the end of their natural lease terms or mid-stream if we have to.
Secondly, I think it demonstrates that we’re making good judgments, doing our due diligence upfront to make sure we are putting our aircraft into places where the lessees can perform.
And then finally, if we do run into trouble we’re proactive. We don’t wait till the last minute to take a decision. We pull airplanes out where we have to and we redeploy them and that’s how I think we post these kinds for you all.
So with that, I’ll turn it over to Roy.
Thanks Dave. I’ll spend a couple of minutes just talking about the financing environment and it’s impact on us and probably speaking about the lessor community.
Much has been said about the banking market and what’s happening in the banking market. I think if you examine specifically a couple of factors surrounding the bank market, it’s not too surprising to see where the bank market is today. If you look back in terms of regulatory reform, there have been industry wide push towards allocating more capital towards the bank and obviously in a way as it went, it kicks in, so definitely pushed the bank towards less capacity as it relates to aviation financing.
Secondly, in terms of the actual businesses themselves; if you look aviation financing within these various banks, there has been a general refocusing of the businesses and some of them has been designated as non-call leading to reduction in number of players.
And thirdly, I think the biggest impact on the banking sector obviously has been the European debt crisis. The European debt crisis triggered a whole range of rating downgrade which ultimately led to a significant increase in funding cost of the banks. So we put those three factors together, that impact really is a huge reduction in the number of players and capacity and increasing cost.
So looking to kind of the remaining players, if you look across the banking sector, the remaining players really are limited to players who are what I call the banks who are regional. We are pretty much focusing on premium plans. That’s to say that they are focusing on brand name airlines in the particular regions, airlines which they can join for the fees from either ForEx or hedging or cash management services which leaves really the broader international aviation bank numbers much less than they where a couple of years ago.
So the next slide reinforces the point I was making earlier. The lower left chart shows you kind of a universe of European banks in kind of 2000 time period and then fast followed the 10 to 11 years, the right hand side the number of banks left. I would go further and further discount those banks on the right to really to no more than three or four players left within the European banking community.
Outside of this year, it’s still regional banks that are active in Asia, in Japan and Australasia, but all of the institution as I mentioned earlier are pretty much focused on premium clients and name brand airlines. And typically all of these lenders have mopped away from being asset based lenders to be much more credit lenders.
The top part of the slide shows how lending profiles have changed. Historically, airlines typically would lend any where from 80% to 85% loan-to-value; again a wide range of assets and these are assets for term narrow bodies 12 years, wider bodies for 15 and they are typically underwritten and banks would take on fairly larger numbers and then syndicate them because there is a very, very healthy syndication market. That has changed dramatically.
And in today’s world, you would see prices have gone up to compensate for huge increase in funding costs. Terms are much shorter and the actual advance rates have reduced to 65% to 75% loan-to-value and the sweet spot for the banks really have been pretty much majority of the newer narrow bodies and selective wide bodies. The other big factor within the financing market is what's happening in the ECA markets. The export credit markets is directly, have played a very, very big role in normalized kind of pre-credit crisis time, export credit agencies. So this is the US Ex-Im Bank, (inaudible) in Europe all have effectively funded roughly 15% of the order book.
Since 2009 that number has jumped to about 30% of the order book and if you look at data for 2011 and projected for 2012 from Boeing you will see that that trend is likely to continue. The big change really, it's happening within the ECA market is rules are beginning to change and the rationale for that is last year the ECA banks got together and decided that they were going to change the availability of ECA funding, so to bring a more level playing field with the commercial market.
And the net result of that is effectively the premiums charged by the ECA banks are going to roughly double to somewhere between 7% to 13% upfront depending on the credit quality of Obbligo. So that's going to obviously have a big impact on funding of new aircraft. There are also some other changes, for instance the advance rate have reduced. If you're an investment grade Obbligo, you no longer can borrow 85%, your capital is 80% and for sub-investment grade borrowers you can borrow up to 85%.
The other big point, big change really within the financing markets will really be in the role of the capital markets. Since the beginning of 2009, sort of the tailend of the financial crisis, the capital markets have come back in a big way. And both lessors and airlines have kept capital markets in a very aggressive way across a wide range of instruments from WTCs to secured and unsecured bonds and term loan. The lessor themselves have raised about $20 billion in the capital market and you know this trend is likely to continue as the credit markets become much more familiar with the industry.
We believe that you know the access to capital markets is really the strategic differentiator and you know key to access to markets will be obviously credit ratings and the associated financial disclosure and transparency. So given that we think the lessors ultimately really will be a conduit to the credit markets or airlines and other lessors who are unable to access the credit markets on their own.
And finally the last page is just to highlight you know some of the transactions done today, the $20 billion number I mentioned earlier, I think the key point here is that you know this trend is likely to grow. The one point I would like to highlight is the differences in investment strategy between the various lessors, you can see that pretty much some of our peers are pretty much focused on you know sort of the funding a new forward order book or new general leaseback but we are the only lessor who are pretty much focused on mid-age aircraft and the freighter segment.
And I think that's key for us given that we believe those segments are best funded through the unsecured market and we think that you know the unsecured markets will continue to play a very key role in building of our capital structure and growth going forward. And we hope that the recent success of our $800 million (inaudible) section to be able to continue to drive down funding costs with a blended yield of just over 7%, that was a vast improvement from our inaugural 2010 transaction which yielded 10%.
So I think in conclusion I think the takeaway find from our perspective is the banking markets have changed dramatically and I don't think you know that it is going to be a reversion to the bank market conditions of 10 years ago and capital markets you know will remain, will be a key differentiator for us and for some of the other lessors. I will hand you over to Mike now who is going to take you through our financial performance and capital structure.
Thanks Roy. Just a quick runthrough of as you have seen and heard from us and for those of you who've known us for a while and for those of you who are new to us, this business model has performed very well throughout the financial crisis and you can see the recent performance increasing, adjusted EBITDA and profits in this business over the last few years as we resumed investing in aircraft assets.
At the end of the last year we had about 4.4 billion of flight equipment on our books and the yearend release rental run rate from that equipment was about 610 million for the whole portfolio. Before our recent transaction about a 110 million of that came from unencumbered assets. As a result of our recent refinancing of our term loan that 110 turned into about $247 million on a pro forma basis.
A quick sort of lesson for some of you who aren’t so familiar with the business about some of the aspects of the reporting. Here you can see in this chart over the last nine quarters, the growth in lease rental run rate in the business again as a result of the resumption of investing in assets in the sort of second quarter of 2010 and one other item of note for those of you who are less familiar with the business model. Maintenance and other revenue that we record in any period depend upon a number of factors and it's related to the timing of lease expirations, whether they are scheduled or unscheduled.
And so you will see some volatility on a quarterly basis in the maintenance revenue in the business, but fundamentally overtime you know this sort of effect we think smooths out, but it is something just to make note of as you are thinking about looking at quarters against prior quarters. Over the last year we continued to focus on shareholder value. We increased our common dividend in 2011 two times up by 50% over the previous level, which it was reduced to as a result of the financial crisis.
We paid dividends for 23 consecutive quarters since our IPO in August of 2006 and have paid out about $405 million in dividends in our history. Also in 2011 we repurchased 7.6 million shares which is around 9.5% of the prior outstanding at an average cost of $11.92. Our recent transaction, just a few highlights of what we did. This transaction closed in early April and so none of the effects of it will be seen in the first quarter results, we will release in a few weeks.
But in the first week of April we issued 800 million of senior unsecured notes, 500 million of five-year notes at 6.75%, 300 eight year notes at 7.58%, both tranches price at par and we used the proceeds to take out our term loan, number one terminate the swap associated with that deal and free up some restricted cash that was locked up in the transaction.
We think this is a very important step in the migration of the capital structure of this business to fund it more on a corporate basis overtime which we think will give us much more operating flexibility and we think more predictable and improved financial results as well.
It extends the debt maturity of that particular deal we paid off had a hard maturity in May of 2015. It was refunded at essentially a similar interest rate and as I said it continued the migration to more of an unsecured model overtime. That transaction grew the unencumbered asset base from $700 million of net book value to about $1.7 billion on a pro-forma basis. And for us simply put, it was an NPV trade freeing up the cash that we've been paying in amortization, the restricted cash and thinking about what we think we can do with that from an ROA perspective going forward, we think it’s a positive net present value event for the business.
Looking at the numbers here on a pro-forma basis, I put it out earlier step maturity of any size to mid 2017. As I said, growth in the unencumbered asset base of the business and pro-forma for this raise at the end of the year, we had $525 million of unrestricted cash available for deployment in the business.
This set of numbers and you can see the middle column is the pro-forma look for the deal at December 31, 2011 and when you lay that out against our publicly disclosed amortization profile for existing amortizing debt which also includes a reset of an interest rate on our second securitization that occurs in June of this year, you will see our weighted average debt cost on that pro-forma basis looking at the December ‘12 number is a little over 5% overall; we think a very attractive and strong interest rate for this business.
A couple of other housekeeping items in the context of this discussion. As we looked at our reporting and our adjusted net income metric and some of our peers, we’ll be making a change to how we report that in the first quarter to be more consistent with what some of our peers report. We’re no longer going to exclude gains and losses on aircraft sales and related financing charges. We are going to take out stock comp and we will be excluding the heads loss amortization that you will see in our reported results from this term financing repayment and I’ll touch on that in a second.
And you can see in this table here what the prior sort of look of historical adjusted net income was and if you did it on this basis, on a historical basis, you can see how that trend looks and as I said starting in the first quarter we’ll be rolling that out on a quarterly basis for those of you who follow along with that metric.
What does the term financing means? This is a question I’ve gotten from a lot of people, so just to make it clear no good deed goes unpunished when it comes to hedge accounting. Despite the fact that I freed up $80 million of restricted cash that was about 15 days basis points and used some of that money to pay off the hedge on this deal which is roughly $51 million. The accounting for that hedge will pretend that it hasn’t been paid off and it will just continue to amortize overtime as a non-cash charge.
So you can see in this chart on the top half the amortization of that hedge lost for the last three quarters of 2012 and how that will roll through 2015 and then you’ll also see in the second quarter a one-time write off of the some of the non-amortized deferred financing fees associated with this transaction.
On the bottom half of this chart and this is the part that I would spend a lot of time out with people who are looking at the business. I think the most important element of thinking about the fundamentals of our businesses, the cash interest expense I guess paid is very different than the GAAP reported interest expense that you see in our financial statements and we are very focused on what is the cash flow, how are we driving that and what are we doing with that cash flow going forward to create value.
And then finally, just a simple illustration to highlight as Ron mentioned earlier thinking about the $700 million sort of acquisition bogey for 2012, what would that mean on an annual contribution basis setting aside when does it get made a quarter resilient etcetera.
If you think about cash on hand that we have in the last four months net of debt pay-downs, we raised about $375 million of debt that we sort of consider growth capital. So I am thinking about that sort of $700 million as being funded $200 million from cash and cash from operations, $500 million from debt funding outside of our other debt that’s amortizing.
If you take our portfolio lease rate factor of about 13.8% which is 1.15% per month that translates into about $97 million of lease within a year and about a 5% depreciation on that purchase price and 7.4% which is the average cost of our debt rates in December. And two weeks ago, you are looking at about $24 million pre-tax contribution on an annual basis from that sort of investment. And on an equity cash flow basis basically taking up the depreciation, you are looking at about $59 million of equity cash flow produced on those assets.
So finally, as we started out, we think this business operates in an industry that has very strong long-term fundamentals. We have a great team, very focused on value creation for everybody, a great portfolio with a diverse customer base, strong contractual cash flows with long dated liabilities and established capital markets access which is becoming more and more important in this business in terms of growing value and the size of this business. So we think we are very well positioned to move forward from here.
And with that, we’re very happy to open up for the questions.
Hey, thank you for the presentation. Just two quick questions, Ron, you mentioned that you thought freight was turning a corner. I was hoping you could elaborate on that a little bit, are you just looking at IATA data and is this kind of a projection or you guys seeing something in the marketplace right now as you are re-marketing leases and talking to customers that sort of new and timely?
It’s a little bit of both. We look at more than just IATA data. You can look at for example the traffic statistics that come from some of the leading airports like in Hong Kong. The IATA data tends to be a little bit noisy. It comes at out every month and as you know Asia is a very big part of the airfreight sector and Chinese New Year fell in January this year as opposed to in February so it means that January is all for depress.
In general, I would lump the first two months together and call that flat; much of what I am saying is actually coming from more of our customers. And everybody held a different profile of business, but guys flying out of China for example are very excited about that and airplanes were quite full.
If you look at recent results for airlines like EVA and China Cargo and Taiwan you’ll see a definite increase in yield, easy comps, because last year was really beginning a year ago of the softness in the market. You see that in tone of the people in terms of demand for aircraft.
So the example that Dave talked about in regards to aircraft coming out of World back in October, November, I wouldn’t have thought what we have done as well as we have; that’s coming back and I am optimistic about the Republic for the rest of the year, it’s not going to be a fast recovery, but I think it’s good solid recovery. Ultimately, that business is a business confidence type of business and so we’re seeing that kind of solely improved.
And just another question on your capital deployment; when you think about, I mean obviously you guys are seeing a lot of good opportunities in the first half, but when you kind of compare that to maybe the idea of deploying capital in the form of a buyback with the stock trading at levels similar to where you bought back last year. How do you think about those two things and then just as an insight to that dividend as well, how do they back in the equation?
Obviously, we think about all three of those things in the context of capital deployment. We don’t have an existing buyback authorization in place, but that's clearly a topic that will revisit in the context of our board and our governance and I will talk about that topic as we go through the year. We raised our dividend twice last year because we believe having a dividend payment is a good form of discipline in returning regular capital to shareholders and I think it's something that we believe as we can grow the fundamental earnings power of the business that we would expect to be able to grow the dividend with that over time. And in the context of this is the business we are in and finding good investment opportunities that factors into that mix as well. But we are trying to balance all three, but we, there are limitations on what you can do in the context of buybacks and so we are looking at that balance and trying to find the appropriate mix going forward, but we continue to look at it everyday and makes you think a little bit differently.
Right, just a couple of things. And that seemed vain just kind of building on what Mike said we've got an important constituency here with our unsecured bond holders. So I don't think the vast majority of the unsecured bond holder market would be too happy if we took the bond proceeds and bought back stock. Right, so it is a balancing act. I will say this. We do the math pretty carefully. The example that I gave you where we generated an 18% unlevered return is something we did in 2010 when the stock price was depressed. It shows you can make that doesn't count any leverage which is not specific, but shows you an example of what you can do with the asset size and you have to kind of balance it all up. I would say in general the returns are available right now are very attractive and we will talk about that with our board.
Hello, two questions. First on page 41 your new adjusted net income, it would appear that you've got probably 20% uptick in your equipment sales gains on equipment sales, is that typically what can be expected into the future?
No, I think in the context of 2011, we had a focus on and we saw a different dynamics that play in the marketplace in the first half of the year and even as we headed into the second half of the year. we’re always looking at our portfolio in the context of what do I own, what do I think its value is and is it to better own it, release it or is this the time maybe to take some chips off the table on this asset. If I think I can redeploy it in something that has a better yield. So aircraft sales and the gains on sales will be let's call it volatile from year to year over time, but it's part of the fundamental portfolio management of being in this business.
On a long-term basis would that be 10%, 15% of your total net income or adjusted income. What was the expected number, have you ever had a loss in any?
We’ve never had a loss on sale in any particular year. I think in 30 aircraft we’ve sold in our life we had a couple of $100,000 loss on one of them. So our history consistently has produced gains on sales and thinking about a percent of number over time is very hard to do unfortunately to sort of say it is going to be 10% or 15%.
One other question. Would you expand eventually into other large mobile equipment, call it locomotors and trains or things like that?
We do a step back strategic look every year with our board and we did a particularly big one in 2010 when after all the craziness in 2009 and we asked ourselves what are we really good at and commercial aircraft is a specialty. We don’t see any lack of opportunity in the commercial market and we won’t expand this for the sake of it. There are things that we have re-oriented around. So if you look at the investment strategy, we have decided particularly after Boeing made the shift to re-engine the 737 instead of a 777 redo. That new wide bodies will be a better asset to invest in and it taps into our skill effect. Another example would be as we did in our early years, we recently bought, this was one of our first quarter transactions, from a couple of banks in Europe, a secured loan backed by 777-200 ER. So that’s the same. We know the asset inside and out. We will be very happy to own the aircraft at the balloon value for whatever reason the airline didn’t pay it back. We know what to do it with it and we are making in that context a return debt is pretty similar unlevered to what we can make on a lease.
So we keep, this is part and parcel of keeping an open mind. I think to sort of answer to your question now is if we get to the day where we are kind of running out of things to do in our space that we know really well, that we will look out for it, but right now it’s a very attractive opportunity set.
So two questions. If you are not amortizing the hedge loss going forward, does that mean you are taking on the adjusted numbers of $50 million writeup in the second quarter?
All I am saying is, I am excluding that effect when it is going to appear in my reported basis. The cash has been paid. As I said I freed up $80 million of restricted cash associated with that facility. That was earning me about 15 basis points in the bank. So the economic trade for me is done but the accounting logic is I've got to amortize that amount as if the loan still existed.
And in our net income and just in our adjusted net income we are seeing the cash is already done, so it is not as good of a representation of future earnings target in our view
And shouldn’t you be upset by a charge somewhere?
Yes on an adjusted basis.
To be honest I didn’t talk about the adjusted charge but it is sort of not, it is kind of irrelevant to my thinking about where I am taking the business.
And second question when you gave the competitive landscape who you are competing with when you look at a lease when someone comes to you in a mid-aged lease of all the major players in that net market?
Well let me divide the market into two pieces, there is the placement market, you know re-leasing the aircraft itself and then there is a buying part. In the re-leasing side, everybody is competing with everybody else and nobody has a particular leg up. I mean this maybe overstating and if you got a good team and a good set of customer relationships around the world, you will be competing with other people who are similarly situated whether they are big or small.
It will be a question of who has got what aircraft available at a particular time. On the buy side is where you have the real per pound differences. We used to compete back in our early days against them, really well capitalized and formidable players, people like CIT and AWAS and AirCap and Babcock and Brown, that is during the days when bank debt was available and today none of the people that I mentioned are people that I see when I look to buy mid-age aircraft. Now it doesn’t mean we don’t have the competition, but the guys tend to be smaller people, you probably wouldn’t have heard and in some cases hedge funds, but I think without exception people that don’t have buy market access.
Right now when we look at newer wide bodies, we do have a different competition base and that frankly is more competitive, but it's a big enough market and one where we still see good opportunities.
Given the opportunities that you see and the fact that there has been such a pullback in the available capacity, particularly with bank lending, why aren't you trying to expand more aggressively, particularly since you do have access to the capital markets? Can you help me understand what the limiting factors are, and why you aren't pursuing it more aggressively?
We are trying to. The simplest way I can illustrate it is our pipeline is building quite a lot. I mean what I’ve told you relative to what I, my expectation for first half of the business is $400 million. Three weeks ago I thought it was $300 million. And the pipeline is very, very full. Now as a fact of the matter, I have to make sure that I don't get ahead of myself. That's a very important thing for us, both in regards to cash, but also fundamentally in regards to our credit metric.
So we have to be disciplined, if we have to have allocated capital or allocate it. But right now I am as optimistic as I have been in several years in regards of the pipeline. But the thing I would mention in that regard is that there are ways to grow that are faster and more kind of immediate, hard to buy a very big portfolio in one lump sum. I could do that, and we've done that before. We bought a (inaudible) portfolio back in 2007.
The issue of the portfolio is that on the good side you have a lot to work all at once. On the bad side is you are probably buying a few things you probably wouldn't have picked on your own. And I am finding things that I wanted to on a kind of a plane-by-plane basis. Just fine right now. Not to say that we wouldn't look at the portfolio. We kind of look at everything. Right now the pipeline is good as ever seen.
Yeah, in this environment, seems like there is a lot of opportunities for aircraft leasing companies. I am just wondering the entry barriers. Are you seeing a lot of new competition, new leasing companies coming into the field over the next couple of years?
I’ll talk about that little bit. Maybe, also I’ll let Roy elaborate too. We had a lot of -- and look, the various entry in this business are not huge. It’s a financing business. But I think it’s a matter of ticking were you want to play. Three years ago, we saw a huge inflow of private equity money. And that private equity money went in two directions. One is either to brand new aircraft or to the end of life play. And of course the return expectations where you execute were different. We saw nobody go in the middle. Reason is there is no debt.
Right now, and this is, there is nothing permanent in the financing industry, but there is no availability of debt from each aircraft. There is a no availability of debt for kind of niche aircraft by and large like freight. And I think the amount of new money that’s coming has slowed down. It’s not hard to start an aircraft leasing company but it’s hard to operate in certain spaces within the leasing world.
And looks like your debt-to-capitalization ratio you are keeping it around 62%-63%, is that your more or less your goal?
Yeah, when we look at our debt-to-total cap or debt-to-equity in the context of our ratings and what we think is a reason to have to maybe getting higher ratings overtime as we increase the size of the business and the size our encumbered funding base, staying around where we are, which is always been sort of within shouting distance of 2:1 debt-to-equity or sub-70% debt-to-total capital, we think it’s prudent in the context of that sort of march forward.
And then finally, the new accounting that you are doing, right now are you going to restate previous quarters as recorded by the Accounting Standards Boards?
No. There is nothing clear. That’s a bad word. There is no restating going out here. We are re-publishing how we calculated adjusted net income, which is the non-GAAP number in the context of how we see other people on our space talking it. And yes, this is the annual representation if you will in the context of rolling out quarters in our queue and in our press release and PowerPoint. We will be doing the quarterly bridge for everybody so everyone can see what it means.
As the leasing share of the market grows larger and larger, it would seem like there is going to be more and more planes having to be remarketed on a short term than there was in the past and you are saying they are just fewer players. Is this going to create a further challenge for these mid-age assets? And should depreciation rates change, if we are going to start seeing, again, a more turnover from less sources?
Look at this way, the fundamental demand for the airplane, I mean the number of airplanes isn’t changing and number of flights, revenue, passenger kilometers isn’t changed. They are all growing, right? So it’s a reallocation. So there will be some kind of technical market shifts for sure. But fundamentally, I don’t think the lease rates will shift simply because of the market share shift because the demand is still the same little demand.
Okay. Now in terms of where do I see softness and where do I see strength, I think of that and much more in terms of production level issues. The number of parked aircraft as you see is quite low, right? I mean, supply here comes from two places. What’s the part and what is going to be produced? And I am worried about, relatively speaking, about the production level increases on the narrow-bodies.
And I think it will be harder and harder, particularly if you are buying something new, to get not just that first lease done but the second, third, fourth and fifth lease because whether you intend to hold the aircraft for the first lease only or for its whole life, you are exposed to that residual value realization. And I think that part people miss totally.
We tend, for the narrow-bodies so for, to focus on the mid-age aircraft. All these guys that are clustered around a new aircraft will one day own aircraft that are not new. Then the question is what then, right? I mean we will still be able to release those aircraft. The question is have they valued their evaluation analysis proper, and I am the only guy buying aircraft that are mid-age aircraft. I am going to have my pick, I would.
Give me some examples of making high teens to low 20 ROE but when you look at your quoted results, some are very, less considerably lower than that. Can you reconcile that?
Yeah. I think there is two things. One of the examples that we have are not burdened by overhead, and they are purely incremental. We have made investments that were less profitable in the past. Simple as that. The portfolio that we put on in the last three years, I think, very much fits the profile that we described here.
But again the opportunity to spend the ROE to increase for further in all.
Yeah. I mean, it’s going to be a proportionate type of a thing, and you also have to remember the ROE is a function of the debt that’s in place, and you know what's being put on incrementally. I think we showed you a snapshot of that but you also have to deconstruct a little bit there in the first place.
And your cost of equity?
I think our cost of equity you know if I go to the traditional capital asset pricing model, it’s a function of the market return premium times the data. The data of our stock is ridiculous.
Let me go back to the chart where we looked at the stability of aircraft lessors versus airlines. Our data is an airline data. Its wrong. I mean statistically it is what it is, but I think our sector has been, in fact its us, its our peers; our sector has been viewed, maybe its too many airlines I would say.
And I think it’s a much more fundamentally stable business that if you go back in time and think about how many big aircraft lessor blow ups there has been, its only been one and that happened about 25 years ago. So I think it’s a sector that's not fully understood yet and I think of the data of our business as not being a whole lot more than one.
You’ve had only complementary things to say about the 777 freighters; what should I therefore interpret relative to the 400s that you have in your fleet and the 747-8 that are coming out? And as you look to position your fleet over the next several years how is the composition on the freighter side going to change?
The 777 freighter is being cranked out at a very, very slow rate and I think whatever is flying around today will fly around for an awfully long time. Its not just the 777 freighter is popular, the 777-300ER is popular, same production line. And if you were to pick one production line that's hottest in terms of demand, there is one where there is a kind of most robustness there that’s the one.
So the difficulty that Boeing has into high-class is how do you keeping everybody happy. I think the 777 is a 100 ton capacity aircraft similar to the 747-400, that’s proven to be a good size; its got better efficiency; its basically doing the same mission with two less engines, it’s a lot of fuel efficient, a lot more fuel efficient rather. But I think it will take years and years for the freighters to their flying today to be replaced, in fact more like decades.
As it relates to 747-8 that’s a stress version 747, it’s got new wing, its got new engines. It’s an interesting aircraft for a very small handful of people. And I think it’s a bad airplane in general, it’s not a good aircraft for leasing airplane. One of the main investments pieces that I laid out for you is that there needs to be big operator base. And if you’ve got literally a handful customers you are putting yourself at a bad place when that lease is over.
Now it is a lot better than buying an A380 because your deployment cost on the 747-8 is not going to be very high, 380s could be $25 million. But in both case you have a small operator base, but we like workhorse airplanes; workhorses meaning aircraft we can go to large number of customers and say, would you like this and hopefully get a good answer.
Ron, (inaudible) a couple of questions; one is your thesis which is pan out clearly that core airline profitability and high oil prices are good for your business. So would it be fair to say that if oil prices come down and airline profitability goes up that would be bad for you guys?
I am actually hoping for that day to be honest, but I think the reason for leasing isn’t just because oil prices are high. I think it’s good to have customers that are strong enough to pay the bills for that.
Fuel prices have an impact and I am not talking about fuel price movements in terms of one or two year shift, but long-term fuel price movements have an impact on the long range attractiveness in an investment.
Our basic thesis is that fuel prices are going to keep going up and environmental pressures will keep going up as well. They are both inter-related issues. And that anything that they could include classic technology will not do very well. Our fleet today just to be more specific consist of 2% classic passenger for 737, 300s, 400s and the over engine 320s.
So it’s not a very big part of what we have and relative to sales question, we have been chipping away that. We have made very good returns on those by the way and anecdotal our oldest airplane is about to be sold in few months; it’s 1985 aircraft leased to Southwest. Its the 737-300 and god knows how many cycles it has, but we will probably do just fine with that as far as residual values and profitability.
But our focus is going to be where there is most stable demand. And so maybe just I would address just for a moment as you talked about that for a second, when you look at current technology narrow body and I’ll distinguish that very much from NEO or MAX, but if I look at the fuel efficiency of the current aircraft, it’s largely driven by the engines. When an engine is new it is at its most efficient. And typically an engine overhaul cycle will last from the all say five to seven years, it varies.
By the time it’s about to go into the shop it’s particularly inefficient plus a 10% may be less in terms of fuel consumption. After it goes out of the shop it gets almost all that fuel efficiency back; it does the part that people don’t appreciate. Now it’s true that as aircraft gets older it get more expensive to maintain, but the fuel efficiency which is the big thing we are talking about over here is really following a cyclic soft type of the pattern and where you see the big step changes is when you go from one generation to the next.
So when the NEOs and the MAXs show up, that will be a step change. But looking ahead, lets say we are in 2016 and the first NEO is rolling off, the NEO is going to be entering a world where there are about 4,500 current technology A320s; if I look at current production rates that’s like nine or 10 years of production assuming no growth.
So even if you wanted a NEO you have a long wait, so that isn’t to say that depreciation in all those things factor. Our focus is going to be -- is conditioned on fuel prices going up and the generational thing is the other part that kind of overlays on that.
So let me just follow-up on your answer on the NEO and the MAX, because the history is as you point out is that when you go to a kind of game changing the fuel efficiency move, you know that this is probably 15% efficiency; it generally does have a pretty big impact on the current generation planes and you mentioned that you feel that the current residual values reflect that; can you give us some idea kind of what your assumption is on that?
Well, I am going to give my stock accounting answer and I’ll give you how we actually do it economically and there are some intersection of course. Most lessors assume that aircraft last 25 years and will have a residual value of around 15% at the end. That's our basic accounting assumption too, but let me contrast that. Let's say we look at 1997 A320 that we will buy for $30 million to pick a number. That aircraft probably costs I guess that 30 million bucks, so my 15% precision residual value is $4.5 million. Now what's residual value. At the end of the life it's going to be and this is an aircraft that we are projecting will stop flying in 2022.
Of course we don't know for sure but the value at that point will be largely for the engines. Okay what is it that gives rise to engine demand? Its spare parts. Now if you have a huge installed base of 4000 something aircraft, the current technology aircraft or 8000 engines you will have a lot of demand for spare parts. If I buy that last off the line $50 million A320 in 2015, the residual value assumption if I follow that formula its going to be 7.5 billion bucks.
It's not worth 7.5 million bucks because by the time you're ready to scrap that aircraft and if you are right about that 25-year life in 2040 you're going to have no installed base. So what happens with residual value is they tend to collapse as your platform ends its life and so this is another reason why we like the frontend. Now when we do our economic analysis, we will underwrite specifically to the condition of the aircraft, what are we projecting forward in regards to the maintenance cycle for something.
It gets a little bit more complicated if you're buying a mid-age aircraft like buying used car. If you have got a nice mechanic to go with, you will do very well. If you don't know what you're doing you will lose your shirt. But I think the part that people forget is that economic lives are to a large degree driven by where in the production life that aircraft will be. And empirically, the stuff that comes off first will fight the longest.
You spoke earlier about the fact that lease rates were coming down a bit and you explained why that is not a function of the MAX and the NEO coming online in two years, can you if you can why lease rates are coming down in those narrow bodies?
Let me be more specific. Lease rates I would say are flat. Okay now two things. One is as an aircraft gets older, lease rates go down. That's like the gravitational, it's the law of nature. I would like to think otherwise but that's what we assume. Now if I look at lease rates today for a new, call it a 10-year old 737-800. Today it's probably about the same level it was a year ago. Okay now what sets the price of anything, it is the supply and demand. Right now, supply and demand right now because somebody who says your lease rates is too high, they're not saying to me I'm going to lease in 2017 a MAX. So you are going to say I'm going to lease it from some other leasing company with the same airplane. Right so I think the confusion here is I'm not talking about the residual values, I'm talking about lease rates today. And somebody who is talking about the MAX driving lease rates today, I don’t understand how that actually plays into what they do every day.
One of your competitors has recently done some funding and they are purported to be longer term. They actually haven't gone to the rating agencies investment grade and the financing cost as a result was commensurately lower than you were able to achieve. Can you talk about what you are looking to do in terms of your ratings longer term and how that factors into you know as well what your expectations are in terms of return for equity?
I will make one comment and then I will ask Roy to comment about the rating agencies and the process and stuff like that. Firstly, you know we are a BB+, BA2 corporate rating, so a little below investment grade and it is very different, the big difference is between who is rating you in their perspective online. I think that we are an investment-grade company today based on credit metrics. I do, I mean AirCactus came out with their investment grade rating for on a corporate basis from S&P and I think we look better generally. We are smaller, but I don't think we need to be investment grade. I think we are and we will become better and should become investment grade. I can't tell you when or how, but we are competitively doing really well and that's the first thing I wanted to say. So Roy?
Yeah I think just to add to Ron's point, I mean I think both the two main agencies have a different point of view, slightly different points of view from each other. I think both of them S&P in particular does give a lot of credit toward size. I think the agencies have, if you look at our credit metrics and they will tell you that you know they're pretty close up to investment grade. But you know ultimately you get penalized because of size.
Moody's I think that's a different question, I think they and they just came out with a new methodology and you know if you look at that methodology, it's tough to see any sort of monoline finance company ever getting to investment grade. But I think our general view is you know we are going to improve the credit metrics, make sure that credit market believe us and you know move towards investment grade you know when it makes sense.
You said that you have got a little over 20% of your planes at over 15 years old and the average is about 10. Given what we have been seeing to this day, ages come down. Usually they just come down, how do you sit there and decide how long you want to keep these planes, what kind of residual value you're expecting on these older than 15 year-old planes which I assume are mostly the freighters that you have?
What we do as a kind of a thorough fleetwide process every year and we do things more frequently depending on the airplane type, but we have the systematic process to go through our entire fleet and basically go through a development business plan for each airplane. And so you might look at a 776-300ER and say well what do we think, is this thing going to fly another you know to 2026 or 2016 like the conventional assumption would be. Where is it in the maintenance interval?
In this case it's probably too old to make into a freighter but we'd consider that possibility. Should we invest in (inaudible), should we sell it, is to have, are we better able to deploy the capital in some other way. So we have a fairly robust thoughtful process around each airplane and it takes us a lot to do that. That process itself by the way feeds into our impairment analysis process that we do for accounting reasons. So we have a business plan idea for each airplane first.
I think you need to have that otherwise you're just kind of doing through the spotless mechanical process, but you're right, a large part of our fleet that is older is our freighters and we still see a robust demand for those aircraft type. When you look at that age aircraft you are looking pretty much at a converted freighter as opposed to something that came out as a factory freighter and it's a different operator base. A large part of the operator base is what I would call the ACM-Air charter business and they will fly for the military on one hand, they might fly for customers that don't want long term lift, they will outsource and an example might be Asiana. Asiana has an expensive crew costs. They may want to keep the flexibility to allow for their ups and downs in the market and they will go to somebody with low crew cost and say for my peak lift I am going to go look to you guys.
So there are different operator basis, there is different demand profiles to these aircraft, but I think it all starts with a pretty aircraft specific down to the configuration type of analysis and we take it from there.
(Inaudible) shorter life planes and basically get the headwind to your analysis right?
When we buy the aircraft we are thinking about at the outset. Now I think its important to note that we are looking to buy new wide bodies, not just mid-aged aircraft. So to me if you step back and say, I know there is a new technology coming, I don't want to be the last off the line, if you buy that then you probably wouldn’t put as many eggs in the new A320 and 737 and G camp and instead invest elsewhere. I do think that the 777 for example and to a lesser degree A330 will be produced for many years to come. So that is part of our investment focus.
Could you specify what you meant by limitations to a share buyback program. Is there a number that you can go to with your next authorization?
Yeah, just to be clear in the context of our high yield indentures there are limitations on restricted payments and dividend, stock buybacks fall into that category. Typically, it starts with a bucket and it grows by 50% of net income minus dividends and its much more complicated than that and you should read it so you understand it.
But simplistically, at the end of the first quarter that basket given last year's stock buybacks and dividends is probably in the neighborhood of $68 million or $70 million as the highest.
Ron maybe you touched on this earlier, but I mean we’re seeing more and more reports of 12 to 15 years old aircraft being parted out as the owners of those planes decided that’s how they can maximum returns as opposed to re-leasing it or selling it outright. Is that a capability that you would ever consider trying to bring in-house given those are the exact types of assets that you specialize in?
Let me put that in context first of all, there have been a number of part outs of aircraft that are of that age but they are actually really small and they are usually pretty off the run aircraft to a lot of A318s that were parted out. Those are odd ball aircrafts, same with 737-600s, the more air fleet that [ILC] had I think is entirely being parted out, simply because there is no demand base. When you get into the bigger variants its not really so common. There is always an odd ball situation and I do think it puts more pressure on the smaller variants like the 319s, but I don’t think of that as a mass market thing at least right now.
Now having said that, we have looked from time to time just kind to fit more into one other businesses that are adjoining should we look at, I think the part out business is interesting business but it’s distinct. There is two reasons to get into it, one is because it’s a compliment to your existing portfolio or it’s a de novo opportunity.
We have maybe two or three aircraft a year that we are parting out; that’s not sufficient flow to justify business. If you ILC and you buy air turbine and you’ve got you know 40 or 50 stuff to part out, totally different story. That’s business we can sustain off of the ILC portfolio and they also look at it, is it one of this type or one of the other type because you are basically becoming, you are a supplier of spare parts to other people primarily airlines and MROs. So can that make sense for us one day, sure, but it would be something that we have to look at as new businesses. It’s not something that grafts on a portfolio by necessity.
Having said that, I think that is culturally a very different business and it’s a management challenge when you take on a part out shop as opposed to a leasing company. And I like to use kind of the metaphor of taking brining on (inaudible). So you have to be ready for that.
So fundamentally, just follow-up, I mean that concept to me is just a form of vertical integration and is there really enough margin to capture to justify investing capital and something like that. And in our context and in our scale the answer so far has been no; it may not always be no but that is simply how we look at it.
My last question is, you mentioned your interest in the new wide bodies, are you seeing any sort of short-term pop-up opportunities from the OEMs for 330s or 777s or it just have to be more of a sale lease back function?
The pop-ups are complicated things and I think just to be clear for everybody in the audience, pop-up is basically a situation where a manufacturer has got an aircraft, at some point in its production and the customer may no longer want to be able to take it, right, and so almost by definition that’s something that’s within a year or two of being delivered.
Now so when you look at the narrow bodies, I mean a little biased to get the narrow bodies because we probably gathered, but with wide bodies, it’s a much more complicated thing, because the lead time issues with wide bodies are seats and in-flight entertainment systems and galleries and even if somebody said to me, hey Ron, there is a Boeing 777 that’s coming out, the idiosyncrasies between Cathay Pacific’s deck and American Airlines’ deck might be such that I might have to wait for six months to a year before I can place it and spend a lot of money.
I think that the most interesting pop-ups that arrives right now Gary are probably in the freighter world, because the idiosyncrasies in the freighter are almost none. You don’t have to worry about the seats or the galleries or in-flight entertainment systems, so lets say Boeing is building an airplane and such and such airline want just doesn’t want it or can take it that’s an opportunity and then we’ll just have to see. And those are things that just kind of over the trends and type of deals you don’t plan on them. I hope that answers your question.
Ron, well what conditions would you have to see prevail in the capital markets for you to consider refinancing securitization number one and number two?
Neither one of those things is out of the question. We have to look at it in a context though that we’re placed to raise capital and we are priced to retire the existing capital and is that a better trade than letting that securitization one or two continue to run and just raise new capital and go do something else with it rather than refinancing.
So it’s kind of NPV analysis like it was for the first taken out of the term financing; good rate environment, extended maturities take-out, my only existing sort of bullet maturity in all of my secured financing and so we’ll keep looking at it and maybe some day that trade will make sense.
I hope you found today’s session useful. Thank you very much for joining us. My business card is included with each presentation, so if you have any follow-up questions feel free to reach out and we will be announcing our Q1 earnings call in the near future. So we look forward to speaking with you then. Have a good day.
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