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My thesis is straightforward: AerCap (NYSE:AER) is well-positioned to survive COVID-19 and will reap the fruits of air traffic boom in the next 20 years. Compared to Air Lease (AL), it generates high rental yield and high rate of return from lease cashflow. Moreover, it's trading at such a deep discount that the margin of error is comfortable enough for a compelling investment case.
Great Leap Forward In The Last 20 Years
According to IATA, the number of airline passengers worldwide grew from 1.5 billion in 2000 to more than 4.2 billion in 2019 - a threefold increase in mere 20 years. Passenger number alone doesn't capture the full picture of growth in air traffic. Over the same period, commercial airlines not only carried more passengers, but also brought them to destinations further away. A common metric used in the airline industry is revenue passenger kilometres or miles (( RPKs or RPMs)), which multiply the number of passengers carried by distance flown. From 2000 to 2019, global RPKs grew from 1,250 billion to over 8,600 billion - a sevenfold jump.
The growth in air traffic mimics that in economic growth. Over the past two decades, the growth in airline RPKs bears a strong correlation with global GDP growth. The growth in air traffic also led to an explosive demand for commercial aircrafts. In 2000, global commercial aircrafts delivered to airlines were worth about $50 billion. By 2019, that figure rose to $120 billion.
In the same period, the aircraft-leasing industry experienced similar leap forward. In 2000, leasing accounted for less than 25% of the global commercial aircraft fleet. By 2019, that figure rose to 50%. The leap forward in aircraft leasing wasn't attributed to organic growth in air traffic alone, but, more importantly, also to airlines' shifting preference for leasing over outright purchase. In contrast to outright purchase, leasing reduces airlines' upfront capital commitment, and gives them greater operational flexibility.
Today, the 10 largest lessors have a combined fleet size of 5,600 aircrafts, which accounts for almost 20% of the world's commercial aircrafts in service. In addition, they collectively have close to 2,000 aircrafts on firm order with manufacturers.
| Rank | Company | Current Portfolio | Portfolio Value ($mn) | Firm Order Backlog |
| 1 | GECAS | 1,144 | 22,938 | 351 |
| 2 | AERCAP | 1,019 | 33,492 | 306 |
| 3 | AVOLON | 529 | 19,627 | 362 |
| 4 | BBAM | 509 | 21,067 | - |
| 5 | NORDIC AVIATION CAPITAL | 487 | 6,021 | 62 |
| 6 | SMBC AVIATION CAPITAL | 416 | 15,681 | 254 |
| 7 | ICBC LEASING | 402 | 15,090 | 123 |
| 8 | AIR LEASE CORPORATION | 384 | 17,662 | 316 |
| 9 | BOC AVIATION | 356 | 15,590 | 151 |
| 10 | DAE CAPITAL | 354 | 10,102 | - |
| Total | 5,600 | 177,270 | 1,925 | |
Source: Ascend by Cirium, Dec 2019 |
Further Growth Expected In The Next 20 Years
In the next 20 years, IATA projected three scenarios for airline passenger growth:
- In the worst-case scenario, where globalization is set in reverse, global passenger number will reach 5.7 billion in 2037 - a 40% increase from 2019.
- In the base-case scenario, where current policy supporting the airline industry stays put, passenger number will reach 7 billion in 2037 - a 70% increase from 2019.
- In the best-case scenario, where further policy stimulus and market liberalization are instituted, passenger number will reach 10.3 billion in 2037 - a 250% increase from 2019.
- Furthermore, in the best-case scenario, global RPKs are projected to increase by threefold, reaching 24,000 billion by 2040.
As air traffic follows the growth trajectory, new aircrafts are needed to meet the growing demand as well as replacing older and obsolete aircrafts. In theory, a commercial aircraft has a useful economic life of 25 years, but many aircrafts will be gradually phased out of passenger service after 15-20 years. This is usually due to poor fuel economy and maintenance cost associated with older aircrafts.
Airbus (OTCPK:EADSF) predicted that 39,000 new commercial aircrafts will be delivered to airlines from now until 2038. Out of these aircrafts, 36% will be for aircraft replacement and 64% to meet new demand. Boeing (BA) similarly predicted that 44,000 new aircrafts will be delivered between 2019 and 2038, and global commercial aircraft fleet will grow at 3.4% annually in the next 20 years.
The global aircraft fleet stands at 30,000 in size today. By 2040, that figure is expected to double. Moreover, over 90% of aircrafts in service by 2040 will have rolled off the production line after 2019. Given that airlines already lease 50% of their aircrafts, the doubling of the global fleet means almost 30,000 more aircrafts will be leased from lessors in the next 20 years.
AerCap Is More Profitable Than Air Lease
However, the road ahead for aircraft lessors isn't a smooth one. COVID-19 will be an existential threat to airlines and lessors alike in the short run. Many lessors will face lease rate reduction, collapse in aircraft trading market, and liquidity crisis. Many won't survive; only the strongest will - namely, the largest lessors with significant market share to negotiate favorable leases and cheap sources of capital to avert the short-term crisis stand a fair chance of weathering through this pandemic. These surviving goliaths will eventually reap the fruits of air traffic growth in the next 20 years.
Among global aircraft lessors, AerCap ranks second in fleet size with 1,019 aircrafts in portfolio, while Air Lease ranks eighth with 1/3 of the fleet size. AerCap's portfolio is worth $33 billion - twice of Air Lease's. If the game is won on size alone, AerCap stands a stronger chance of survival than Air Lease.
Apart from size, AerCap also outperforms Air Lease on profitability. A key metrics used internally by lessors to evaluate the profitability of a potential lease is internal rate of return (IRR), which measures the rate of return generated from discounted lease cashflow. In a typical lease, the lessor finances the aircraft acquisition with a mixture of debt and equity. It thus incurs an initial cash outflow in the form of equity investment in the aircraft. During the lease term, the lessor receives cash inflows from lease rental, maintenance reserve (MR), end-of-lease payment (EOL), and residual value of the aircraft (RV). On the finance side, the lessor incurs cash outflows in the form of debt repayment and interest expense. IRR is thus a measurement of the initial equity investment's rate of return from the discounted net cashflow received within the lease term.
In order to generate high IRRs, the lessor usually targets higher rental yields and lower interest rates. Rental yield is measured by lease rate factor, which is the ratio between monthly rental and purchase price of the aircraft. Rental yield net of interest expense is measured by net spread, which is the ratio between net interest margin and book value of the aircraft. Net interest margin is the difference between lease rental and interest expense.
From 2017 to 2019, AerCap consistently beat Air Lease on lease rate factor and net spread, despite incurring a higher cost of borrowing. This shows that AerCap was able to generate higher rental yield from existing leases after factoring in interest rate differential.
AerCap ($k) | 2017 | 2018 | 2019 |
Lease Rate Factor | 1.01% | 0.90% | 0.90% |
Avg Interest Rate | 3.90% | 4.10% | 4.20% |
Net Spread | 9.36% | 8.06% | 7.85% |
Air Lease ($k) | 2017 | 2018 | 2019 |
Lease Rate Factor | 0.80% | 0.76% | 0.75% |
Avg Interest Rate | 3.20% | 3.46% | 3.34% |
Net Spread | 7.90% | 7.35% | 7.14% |
However, rental yield alone doesn't decide IRR from lease cashflow. IRR is also affected by the aircraft's end-of-lease RV, which is notoriously difficult to predict. However, we can get a glimpse on how AerCap and Air Lease performed on IRRs relative to each other by comparing their free cashflow to equity (FCFE) on a year-over-year basis. FCFE measures a firm's total cashflow before any distribution, such as dividends or buybacks, to shareholders. The ratio between FCFE and shareholder's equity, or FCFE ratio, approximates the initial equity investment's rate of return from lease cashflow in a year. FCFE ratio isn't a perfect substitute for IRR because it includes the lessor's overheads and other costs exogenous to leasing and moreover it fails to factor in time value of money, but a comparison of two lessors' FCFE ratios does shed light on their relative performance on IRRs.
From 2017 to 2019, AerCap consistently outperformed Air Lease on FCFE ratio by a wide margin. While Air Lease saw its FCFE ratio stagnating below 2% from 2017 to 2019, AerCap generated FCFE ratios ranging from 2.6% to 9.3% in the same period. A consistently higher FCFE ratio, together with higher rental yield, demonstrates that AerCap was able to generate higher rate of return from discounted lease cashflow than Air Lease.
AerCap ($k) | 2017 | 2018 | 2019 |
Free Cash Flow to Equity | 799,578 | 230,973 | 532,215 |
FCFE/Equity | 9.32% | 2.62% | 5.71% |
Air Lease ($k) | 2017 | 2018 | 2019 |
Free Cash Flow to Equity | 55,339 | 63,827 | 89,319 |
FCFE/Equity | 1.34% | 1.33% | 1.59% |
AerCap Is Trading at Deep Discount
Despite its ability to generate higher IRRs, 2020 will be a challenging year for AerCap. Like everyone else, AerCap will see its bottom line severely affected by COVID-19.
However, a crisis may also be an opportunity. At the time of writing, AerCap is trading at ~70% discount from its BV per share of $72. Historically, AerCap traded at ~0.8x BV on average from 2017 to 2019. A ~0.3x BV valuation is overly pessimistic given what we know about AerCap's market share and profitability, as well as the aircraft-leasing industry's growth potential in the long run. Moreover, even if COVID-19 reduces AerCap's forward EPS by half, AerCap should still trade at ~$30 with the historical ~7x P/E multiple.
| AerCap ($k except shares) | 2017 | 2018 | 2019 | 2020 |
Book Value | 8,579,710 | 8,828,048 | 9,314,897 | - |
BV per share | $57 | $63 | $72 | - |
EPS | $6.43 | $6.83 | $8.43 | $4.22 |
Share Price | $52.61 | $41.80 | $61.18 | $30.59 |
Conclusion
Air traffic will continue to grow in the next 20 years, and airlines will need more aircrafts to meet the new demand. As a result, aircraft lessors will ride this wave and reap the fruits of growth in the long run. Nonetheless, COVID-19 will be an existential threat to many lessors. Only the largest lessors with market share and deep pocket will survive. AerCap is the second largest lessor in the world, with a fleet size thrice of Air Lease's. It stands an excellent chance of weathering through this pandemic.
Moreover, AerCap outperforms Air Lease on profitability, measured by rental yield and free cashflow to equity. This demonstrates AerCap's ability to generate higher IRRs from discounted lease cashflow. Finally, AerCap is trading at such a deep discount that it created a comfortable margin of error for a compelling investment case: AerCap is the best vehicle to invest in the growth potential of aircraft leasing.
