AerCap Platform Strength On Display But Markets See Turbulence Ahead

Summary

• Quarter 1 was solid but some rent is being deferred.
• Management sends a strong signal paying back the majority of the revolver.
• Operating fundamentals remained consistent through the first quarter.
• AerCap's fleet is tilted towards new technology relative to the global fleet.
• The current stock price implies an ROE scenario that is highly unlikely.

2020 Q1 Update

Debt maturities for the next twelve months are $3.8B and management expects to spend $1.7B in cash capex for a total of $5.5B. At quarter end AerCap Holdings NV (NYSE:AER) had cash on hand of $4.7B and expected to generate $2.7B of operating cash flow, enough to cover the immediate cash outflows. During the quarter AerCap sold 12 aircraft for $265M, a gain on book value of 28%, impressive in this environment. Customer rents of approximately $300M were deferred, and AerCap expects another $300M of deferrals. This significant amount of deferred rent, which totals approximately 13% of annual lease revenue, is expected to be paid back during the remainder of the year. AerCap notes that it has over $1B of security deposits and letters of credit. Sixty near term aircraft deliveries have been pushed out, including twenty six deliveries scheduled for 2020. Approximately $1.6B worth of 2020 expected capex has been deferred. Additionally, the firm reports it is close to securing incremental funding of $1B. AerCap Holdings NV (AER) reported that 70% of its airline customers are considered 'flag carriers'.

Management Signaling

In March AerCap drew down $4B from its revolver. In a strong show of confidence from Management, $3B was repaid during April. We are interpreting this as a signal that management is confident in obtaining long-term financing from the credit markets to replace maturing debt. However, it is worth noting that the yield to maturity on AerCap debt due 2028 is high at approximately 6.86%.

Fundamentals

Balance Sheet

AerCap Holdings NV (AER) reported an increase in book value of 14% over the trailing one year ending March 31, 2020. The stock price is down over 40% from March 31 2019 through yesterday's close. Return On Equity ('ROE) was 13% over the trailing 12 months, higher than the median value of 12% over the past decade:

(Source: Bloomberg)

Income Statement

Revenue, operating income, and net income levels were all in-line with results since 2014:

(Source: Bloomberg)

Cash Flows

Importantly, the income statement does not reflect deferred rent, which is recognized as revenue. However, the impact of deferred rent has started to become visible on the Statement of Cash Flows. Quarterly Cash From Operations was $629M, below the recent average of $786M, mostly due to an increase in accounts receivable (deferred rent):

(Source: Bloomberg)

AerCap Fleet Vs Sector Fleet

A likely scenario in the short-term is that the sector shrinks due to the CoVid-19 pandemic. This will probably throw supply and demand out of balance for a while, i.e, there will be too many planes. It's likely that older planes with older technology are the ones that are retired. AerCap wants you to know that it has a high quality fleet relative to the global fleet. AerCap includes a presentation slide to highlight fleet quality, but we think it needs to be examined carefully.

The Apples To Oranges Slide

AerCap lists its new technology fleet at 59% Vs 12% for the global fleet. A fleet likely to be in demand for the next decade or more. However, the slide presents the global fleet in units and seats, and then presents the AerCap fleet by book value:

(Source: AerCap First Quarter 2020 Financial Results)

Apples To Apples

We decided to recast this slide comparing global units to AerCap units. Indeed, AerCap's fleet is highly skewed towards new technology, but we estimate the weight to be 45%, not 59%. This is a considerable difference:

(Source: Author estimates, AerCap Q1 2020 Financial Results)

Valuation Inputs

We last valued AerCap Holdings NV (AER) at the beginning of March 2020 in an article titled AerCap Holdings Shares Are Undervalued In The Midst Of The Coronavirus Crisis. We estimated intrinsic value at $76 and a justified premium to book value. Given the high ROE it's interesting that the stock persistently sells at a discount to book. The discount to book should only be justified if the cost of equity is higher than ROE, implying that the firm destroys value and that growth detracts from value rather than increasing it.

Given the recent collapse in stock price to $15 per-share and the recent bounce to $27 it would be wise to revisit the valuation. There are a few estimates we need:

1. Book value
2. ROE
3. Growth
4. Cost of equity

We have a reasonably accurate estimate of book value from the accountants, and ROE has been remarkably stable over the years with a median value of 12%. Estimating growth is a bit more tricky. We need a retention ratio (cash held back) to estimate a fundamentally driven growth rate. However, AerCap doesn't pay a dividend but certainly doesn't retain all the cash either. Over the past five years the firm has used 80% of net income to repurchase shares. We are using an 80% payout ratio (20% retention ratio). We are going to focus mostly on AerCap's cost of equity ('Ke), i.e., the discount rate.

Beta

In our valuation we estimated a fundamental (bottom up) beta of 1.51. This beta estimate implies that AerCap equity has about 51% more market risk than the S&P 500. Besides beta, we use two other inputs to estimate the cost of equity:

• The risk free rate (10 YR Treasury)
• Equity Risk Premium

AerCap's historic beta is different depending on the time period measured. It's usually well over 1 and usually below 2. When it is above 2 or below 1 it doesn't remain there for any extended period of time. Right around 1.5 is a good guess. Further, there are no sectors with a consistent beta of 2. We want to emphasize that we do not think AerCap's beta is 2, and it is also not 1. The following regressions highlights AerCap's beta over two separate two-year periods ending May 7 2020, and 2019. The betas are 2 and 1.2. The current trailing beta is 2:

(Source: Bloomberg)

Cost of Equity

We are using the trailing beta of 2 to get an idea of how risky the market thinks AerCap equity is. The risk-free rate is 0.69% and our estimate of the equity risk premium (including country risk adjustments) is 6.5% for AER. This results in a sky high cost of equity of 13.69%. This Ke above the firm's ROE implies a P/B ratio of less than 1. However, the current P/B ratio is 0.38. What should it be?

Valuation

Here we are creating a sensitivity matrix based on the valuation inputs to estimate justified P/B ratios. We are allowing an ROE range of 10.5% to 12.5%. The beta range, which drives the cost of equity, is 1.25-2. The justified P/B ranges from a low of 0.73 and a high of 1.58:

(Source: Author estimates)

Note as an example, in the beta column 2.00 corresponds with a cost of equity of 13.7%. There are five ROE estimates across the top row. A cost of equity of 13.7% and an ROE of 12% implies a price to book ratio of 0.85.

Using the P/B ratios and the just reported book value of $73.69 we can estimate the corresponding stock prices:

(Source: Author estimates)

Visible in the matrix is that when the Ke and ROE are close, intrinsic value equals book value. For example, when Ke is 10.44% and ROE is 10.5% the price is very close to book (it would be equivalent if 10.44 was 10.5). The same for Ke of 12.06% and ROE of 12%.

The range of values is from a low of $53.43 to $116.78. The current stock price is $27. Obviously there is a disconnect here. Either the market thinks ROE will be much lower or the cost of equity is much higher. We don't think the cost of equity is higher than 13.69% because we don't think beta is two or higher. What does that say about ROE?

Market Implied ROE

We are using the cost of equity of 13.69%, which corresponds to a beta of two, to solve for the market implied ROE. The market implied ROE is 5.8%. A 20% retention rate and a 5.8% ROE gives us a fundamental growth rate of 1.2%. The justified P/B is then (5.8% - 1.2%) / (13.69% -1.2%) = 0.37. Multiplying 0.37 by book value of $73.69 implies an intrinsic value of $27.30. The takeaway is that for AerCap's intrinsic value to be around $27 you'd have to expect long-term ROE to be 5.8% and the firms cost of equity to be 13.69%. Our previous article and the chart above highlight AerCap's historic ROE and it has historically been in the low teens. The firms lowest five-year average ROE was 10.5% ending in 2013 (2009-2013), and the lowest one year ROE during the period was 7.4%.

Conclusion

A turbulent period lies ahead. Airlines will go bankrupt and some have already started. Other airlines will be supported by their governments and they will make it. AerCap will have to repo planes and find new homes for them. The sector will shrink and supply will be in excess of demand. We think the tilt towards new technology and scale will help the firm at the expense of competitors. Competitors that have entered the space without a global platform to chase yield will leave. AerCap is not in financial distress, with ample liquidity to refinance debt and cover reinvestment in the business. The current stock price implies an ROE scenario that does not seem reasonable. There are two sources of a multiple re-rating. First, over time we think beta comes down from two to a more normalized level. Second, the firm will earn ROE in a range of what it earned in the past. Earning ROE in the range of the cost of equity should bring the P/B ratio closer to 1. If the firm earns an ROE of 10.5% the stock should trade at .73 book value or $53 per-share, potential upside of 100%. If the firm earns ROE of 10.5% and the discount rate drops to 10.5%, the stock should trade at book and the potential upside is 170%. The recent low around $15 may be a decent estimate of potential downside in the 40-50% range.

Analyst’s Disclosure: I am/we are long AER. 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.

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