Despite Significant Turbulence, AerCap Still Looks Undervalued As Air Traffic Continues To Grow

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About: AerCap Holdings N.V. (AER)
by: Stephen Simpson, CFA
Summary

With consistent operating performance, it looks like sentiment has been AerCap's biggest issue, with concerns about market lease rates, airline bankruptcies, and air traffic demand growth/stability.

AerCap's upcoming deliveries will lower its fleet age, extend its average lease terms, and reduce the net spread in the short run, but support stable long-term growth.

The grounding of the Boeing 737 MAX fleet will likely delay some deliveries to AerCap, but it's a manageable issue.

AerCap shares look undervalued if the company can manage long-term adjusted net earnings growth in the low single digits.

Down about 25% since my last write-up, AerCap (AER) has been a lousy stock over the last six months and investors can’t even console themselves with “at least I’m getting dividends”, as AerCap management puts surplus capital to work through share buybacks instead of dividends. I think there are multiple issues affecting the stock, including worries over some recent airline bankruptcies, concerns about the health of the Chinese market, rising rates, increased competition in leasing, and near-term pressures on reported earnings metrics.

None of these issues impact my core long-term thesis on AerCap, though, and I continue to believe that these shares can and will reward long-term patience from shareholders.

Have Rate Pressures Peaked?

One of the issues that I believe has pressured AerCap and other publicly-traded air lessors is the entry of multiple new leasing companies. With weak returns on offer in the bond market and in other traditional non-equity destinations, a lot of capital has flowed into new aircraft leasing companies (particularly in Asia). Lacking the connections and relationships to build their own fleets, many of these entrants have turned to sale-leaseback transactions to build their businesses, and have been willing to compete aggressively on rates.

While rates can vary a lot, determined in part by the type of aircraft, the length of the lease, and the credit worthiness of the lessee, the norm has generally been a monthly rate of 0.75% to 1.5% of asset value. In the fall and winter of 2018, though, some sale-leaseback transactions were going off at rates under 0.5%. This hasn’t impacted pricing for the major players to any noticeable degree, and it looks like the race to the bottom is over, but I can understand why investors would be concerned that new entrants could be launching a pricing war in trying to establish their own businesses.

That said, it’s worth repeating that AerCap’s net spread margin is going to decline over the next year or so, likely bottoming around 8% in mid-2020 (from 8.8% in the fourth quarter of 2017 and 8.2% in this past fourth quarter) and not really accelerating rapidly from that level as the company leases out its much newer fleet.

Bankruptcy And Market Risk Seems Overstated

A handful of bankruptcies in 2018 (Shaheen Air, Primera, and Small Planet subsidiaries) seems to have also stirred up some renewed concerns about the health of the airline market. I don’t really see this as a problem. I’m not sure there’s ever been a year with no airline bankruptcies, and AerCap has reported no meaningful difficulties in re-leasing those assets (utilization in the fourth quarter was 99%), even if remarketing plans can cause a small temporary blip in operating expenses.

I expect there will always be what I’d call an “ambient level” of airline bankruptcies, and particularly with small emerging market and/or budget airlines where there’s a disconnect between local currency revenue and dollar-based costs (including leases and fuel). If the entire global economy skids and takes air traffic demand with it, that’s another story, but for the near term there doesn’t seem to be much re-marketing risk.

As far as the underlying market goes, I see no major changes in what are fundamentally positive drivers for AerCap’s model and leasing in general. For close to fifty years, global air travel demand has trended around 2% to 4% above GDP, and rising middle classes in countries like China continue to travel more. At the same time, lessors like AerCap continue to enjoy better credit ratings (lower cost of debt) and better access to new planes than most airlines, allowing for “win win” business relationships between lessors and lessees.

737 MAX Issues Should Be Manageable

Boeing (BA) has come under increased scrutiny regarding the safety of its relatively new 737 MAX platform after two fatal crashes of MAX 8 planes in October of 2018 and March of 2019. All 737 MAX 8 and MAX 9 planes have since been grounded, and it is unclear how long this review and correction process could take – although six months seems like a reasonable guess based upon past incidents.

As of the end of the fourth quarter, AerCap had just 5 MAXs in service, though future deliveries represent close to 30% of the company’s order book, with 17 deliveries expected in 2019, 24 in 2020, 28 in 2021, and 30 more beyond that. It seems rather safe to assume that 2019 deliveries will be delayed, with that possibly impacting deliveries in 2020 and beyond to some extent. There are other options for both AerCap and its customers within its current fleet and order book, and I believe this incident will be manageable for the company without any serious disruptions to business.

The Outlook

My basic assumptions for AerCap really haven’t changed much. I’m still expecting low-to-mid single-digit lease revenue growth in 2019, accelerating into the mid-to-high single-digits in the next two years and a deceleration thereafter. Operating income should fall in 2019 on higher depreciation and interest costs before growing again in 2020/2021. Longer term, I expect core adjusted income growth in the neighborhood of 3%, and while I do believe AerCap may under-earn its cost of equity from time to time, over the long term I expect it will out-earn that cost.

Discounting back the earnings streams, I still believe fair value for the shares is around $65. I’d also note that AerCap’s average price/book value over the past five years or so has been 0.9x; assigning that multiple to today’s book value support a fair value of close to $57 versus a share price around $43.

The Bottom Line

Owning AerCap has been less productive than watching paint dry or grass grow, and clearly the share price performance is not immune to sentiment. Although I am concerned about the potential impact of more capital entering the leasing market, I believe AerCap’s proven capabilities in fleet management and capital/liquidity management are more valuable than the current market estimate. For patient investors who don’t need a dividend, I believe this is a name still worth considering even in the face of disappointing recent share price performance.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.