AerCap: A Rough Gem For The Long Term
Summary
- AerCap is certainly going to feel the pain for the current downturn, but has shock absorbers to weather the storm.
- No liquidity concerns despite lease payments being deferred.
- Lessor positioned to play pivotal role in recovery of air travel market.
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In late February, the markets started an unprecedented entry into a bear market. The financial impacts of the corona outbreak are not quite clear yet, nor is the recovery profile, but we are now seeing markets having recovered 32% from their 52-week lows and 20% off their highs while the Dow Jones is crossing the 50-day moving average at the time of writing. Those seem to be positive indicators, even though I still think there is a lot of uncertainty.
Source: AerCap
The travel industry has been hit particularly hard; airline names have lost 60% of their value while names such as Boeing (BA) and Airbus (OTCPK:EADSY) have lost 60 to 70 percent of their value with the side note that Boeing jumped considerably from its 52-week lows. In this report, I want to have a look between one of the companies that forms the link between jet makers and airline customers and has seen its share prices collapse by as much as 84% measured from high to low and is still trading 63% off its 52-week highs. That company is AerCap (NYSE:AER). In this report, I want to have a look at what risks AerCap is facing, but also why the 60% drop the company suffered might be overdone.
Note: This report was published to subscribers of The Aerospace Forum in early-May.
A simple but rewarding business model
AerCap has a simple business model, the company buys aircraft from Boeing, Airbus and Embraer (ERJ) financed with a combination of cash and debt and leases those aircraft to airlines to collect a basic lease rent plus a maintenance rent. Another source of revenue is the sales of aircraft on which the company usually books a gain compared to the book value of the aircraft. The business model is quite straightforward, but it is a cash intensive one. So, prudent cash deployment is a requisite, and this certainly isn’t a business that everyone can access. The bar to enter this business is high and that really is to the advantage of existing lessors. Additionally, the business scales rather well. So, an aircraft leasing business can move easily with demand. Obviously, in downturns profits will be lower as the company could be owning more assets than there is demand for from airlines, but overall this is not a business that will go immediately belly up when demand falls. That’s very important to keep in mind.
Source: AerCap
Additionally, AerCap has a big scale advantage over other lessors. The company makes up for 12% of the entire leasing landscape. It gives the company a strong position at the negotiation table with Boeing, Airbus and Embraer, but also means that it has a big and diversified customer portfolio.
Source: AerCap
The coronavirus has dented air travel as countries are in lockdown and that does not bode well for airlines, lessors and jet makers. However, the figure above should make us feel a bit more confident about our investment in AerCap. AerCap’s business is built on the long-term trend of demand for air travel doubling every 15 years. It isn’t considered best practice to use history as an indicator, but we do see that the industry has weathered some significant storms that now show up as gradient changes in the long-term uptrend for air traffic.
So, what I am liking about AerCap is the following:
- Business driven by long-term uptrend in air traffic.
- Scale advantages
- Diversified portfolio
Obviously there also are risks we cannot deny, but we certainly can address the risks, put them into context or as I would call it “find a partial shock absorber” and then check whether it is reasonable to punish the stock with a >60% share price decline.
The risks are the following:
- Airlines bailing on lease payment and deferrals.
- Pressure on lease rates.
- Pressure on aircraft residual value.
Airlines bailing on lease payment, deferrals and lease rate pressure
Airlines bailing on their lease payment and deferrals of lease payments are a very real threat to AerCap’s business. It’s something we observed in the collapse of Jet Airways. AerCap didn’t have a huge exposure to Jet Airways, but we did see how lessors such as GECAS, Avolon and BOC Aviation accounted for over 30% of the Jet Airways leased fleet. Since AerCap is quite a bit larger than these players, you could also say that it had a lower overall exposure to Jet Airways, which brings us to the first shock absorber: Geographic and customer diversification.
Source: AerCap
AerCap has a highly diversified customer base. During the collapse of various airlines in the past, notably Monarch Airlines and Jet Airways, we observed how AerCap actually was pretty fast pulling its aircraft from the fleet when airlines bailed on lease payments and was able to place these aircraft with other customers rather quickly. That is to a major extent due to the customer portfolio and geographic diversification.
Currently, this shock absorber is one with a huge side note because a global customer base is not going to shield you if global demand falls, which is currently happening. The positive glimpse would be that East to West, AerCap has decreasing exposure and that is also the direction in which the virus spread.
Source: Flightradar 24
In China, domestic travel has started to recover, but the traffic figures are still down 50 to 60 percent from the baseline. We see that capacity has been flat from day 45 to 70 in China. There likely will be a bump in May as the summer season kicks in in China. You could really ask yourself if it is reasonable for a stock such as AerCap's to depreciate by 60% if capacity is already recovering in the East. Intuitively, you would say “No”. However, we are seeing that in China the recovery is partially carried by subsidies and even lower air fares. So, China is in the phase of attracting people back to the airport which is a tiny first step. Restoring profits is the bigger second step. Also, somewhat counterintuitive, the recovery in flights operated in China depends on what happens in Europe and North America. Domestic operations go hand-in-hand with international operations and those operations will remain pressured until we are seeing bigger signs of beating the COVID-19 pandemic. The positives would be that we are seeing some countries opening up a tiny bit at the moment, so distantly that could be followed by increases in passenger flights as well. For this global pandemic, the global customer base is not much of a help it seems, though having a global customer base creates a “wave effect”. With demand for air travel having fallen and brittle recovery, even if customers do go belly up, the previous advantage that AerCap had namely that of being able to place its aircraft with other customers quickly due to its huge network has evaporated. However, I would certainly not bet against that network for the recovery as AerCap can leverage it to assess recovery and restore lease payments, but also rental rates.
Some airlines will go belly up, but how well diversified the portfolio is becomes clear from the following table:
It is a given that some airlines won’t be making, but the highly diversified portfolio again shows. The top 5 customers make up for 26.6% of the total lease revenue. Out of these five customers we observed that 10% of the revenue (LATAM Airlines and Norwegian) could be under pressure as these airlines could go belly up as no lifeline has been guaranteed yet.
The subject of deferred rental payments is an important one. Recently, we saw industry peer Avolon signal that 80% of its customer base has requested relief from rental payment obligation accounting for 90% of the annualized rental cash flow. So, there is no doubt that AerCap is going to feel the pain. Low-cost carrier IndiGo is looking for a six-month deferral, while VBLT Leasing has granted UTAir a three-month deferral on its lease payment and AirAsia X is looking for a 30% reduction in rental fees.
For 2020, AerCap’s revenue has been estimated at $4.96B which would include some $65 million in other income, $200 million gain on sales and $400 million in maintenance rent, leaving $4.3B in lease revenues according to my estimates.
If we would apply a 30% decrease in rental rates, then we would be looking at a 31% decrease in rental fees year-over-year and a 25% decline versus what was initially anticipated. In the case a six-month waiver is applied, then rental revenues will decline by 54% year-over-year and 50% versus what was initially expected. On a three-month delayed schedule, it would fall 30% year-over-year and 25% versus what was initially expected. In there you could find the first indication that a >60% is overdone. These payment deferrals could be in the form of actual relief of lease payment obligation, but could also be in the form of reduced lease payments.
If we model this in for a 20%, 30% and 50% revenue pressure, we get the following P/E driven price targets:
If we look at the projected share prices, the targets will look somewhat familiar. The $63-68 range for a normal 2020 are the prices AerCap had been trading at, while it fell close to a 52-week low of $10.42 which is close to the 30% pressure scenario. Shares have now rebounded to the 20% pressure scenario. In the six months deferral or 50% pressure scenario AerCap would be loss making. This would start when around 40% of the lease revenues do not materialize this year. So, while 60% share price declines do look overdone, there certainly is a scenario in which this can be the case.
Pressure on aircraft values
We are likely going to see lower aircraft rent collections in 2020, the other pressure AerCap will be facing are lower gains on disposing mid-life aircraft.
Source: AerCap
Revenues and margins from aircraft disposals can contract due to the supply-demand imbalance. Depending on the aircraft type that is going to be in the 5 to 15 percent regime market value reduction for now. AerCap generates margins of 7 to 20% on their sales. That is something that could come under significant pressure. To get an impression, I modeled AerCap’s Q4 2019 sales volume in my internal model and found that this had an estimated book value of $723 million, which is in line with the $729 million of sales booked for these aircraft; AerCap generated a $48.6 million profit on those assets. Where it becomes painful for AerCap is that depending on the value reduction of the asset, sales would generate a 2% margin or even a 9% loss. I even modeled the value reductions for each of these aircraft types individually and what I found is a margin of less than 1% on these sales.
AerCap is known for its ability to book gains on its mid-life assets, but the supply-demand imbalance could zero the gains. However, there is a very clear shock absorber and that is that current year sales have been contracted previously and customers cannot step away from these sales contracts easily… unless they go bankrupt of course.
If we model that in, we get the following:
With this additional pressure, the break-even point would shift from a 40% pressure to a 30% pressure. So, the pressure seems to be real.
Source: AerCap
We can again look at what the shock damper here is for AerCap, and that is that it doesn’t really matter which way you slice it, but the company has distributions that make a lot of sense:
- A 54-42 share between Airbus and Boeing aircraft.
- A 70-30 percent distribution between single aisle and widebodies.
- A 30% of share of new-technology aircraft and even 40% when taking into account outstanding orders.
AerCap claims 58%, but that likely comes from a different definition of what is “new technology” and what is not. Either way, the jets that see most value declines are the Boeing 777-300ER as it became harder to fill that aircraft followed by the Airbus A350. Value retention has been better among the single aisle jets and smaller widebody aircraft. We processed the value reductions per aircraft type and found that on net-value level, the reduction would be in the range of 6%, which is small and demonstrates a lessor’s best practice to purchase those assets that have appreciable value retention.
So, the diversified portfolio with a focus on single-aisle jets and new-technology jets is the second shock damper where AerCap is now benefiting that it previously had already sold older aircraft with appreciable profits when demand was still strong. With demand having fallen, the older jets as well as the bigger jets are losing value. That is why lessors tend to aim to have a young fleet and dispose assets even when demand for air travel is high.
Book value
Having P/E-ratios to value a company’s share prices is convenient. However, a company like AerCap has its gems, the aircraft, sitting on the balance sheet, and even with base market values sliding, that still provides most value. We calculated the value reduction of flight equipment to the book value per share and found that it provides a $17.60 per share headwind and even $48.55 when we account for a $4B increase in debt during the year. So, also the book value per share shows the pressure if value retention of aircraft suffers and AerCap suffers reduced cash inflow which it will need to cover with its credit facility. In the above projection, we assume that cash and cash equivalents remain stable even with reduced cash flow projections still pointing at positive cash flow for the year.
Liquidity position
Source: AerCap
Next up is the liquidity. Looking at the liquidity, I have very little concern. AerCap initially expected $3.1B in operating cash flow while I was a bit more conservative aiming for $2.7B. For 2020, depending on the scenario we use (20%, 30% or 50% revenue pressures), this would result in operating cash flow to fall to $1.5 to $2.4B. Even if we allow for a mismatch between AerCap’s estimate and my estimate, the total sources in our worst-case scenario would fall to $9.3B and total uses would be $7.4B, which would give it a ratio of 1.25x, above the targeted 1.2x. So, I have very little concern about AerCap’s liquidity. The company can fulfill its debt payments and cash payments for purchases and I believe it even has the possibility to reduce those payments as it reschedules deliveries to balance supply to airline customers with the air travel demand profile. The major reason why I have little concern about AerCap’s liquidity is because while it had over $3B in costs last year, over 50% of those costs are depreciation items which is a non-cash item.
If we give AerCap the $400 million operating cash flow benefit, we can also redo the math for the P/E-method:
The $400 million operating cash flow benefit would result in a $3.10 per share benefit in book value per share. Overall, even with the immense pressure on the travel industry and subsequent pressure on the leasing business, I believe AerCap has what it takes to cope with the industry downturn.
AerCap as part of the solution
What we see is that AerCap has some shock absorbers, most notably:
- Strong liquidity
- Diversified customer portfolio
- Diversified aircraft portfolio
- Scale advantage
I believe that the company can play a role in the recovery of the airline industry. Many airlines had to be saved by governments, so their recovery profile is going to be one with a damper on it. They can’t invest a lot without repaying their loans, so in a recovery scenario for the airline industry, there will be an increased focus on leasing aircraft because airlines simply don’t have the cash. Leasing definitely is not the most favorable option because having a leased plane sitting idle on the tarmac costs more than an owned plane (actual cash payment versus largely depreciation costs), but it will be something airlines will be looking at. Now, in the crisis-mode there might even be some interest in deferring the milestone payments with original equipment manufacturers and engage in sale-and-leaseback transactions with airlines looking for liquidity. After all, values of aircraft have fallen, so AerCap could be buying even new aircraft at a relative discount. An example of such transaction are 6 Boeing 787-9s and 16 Boeing 737 MAX aircraft sold to BOC Aviation and immediately leased back by United Airlines (UAL) and also Etihad Airways sold a portfolio of aircraft recently. So, lessors can actually provide liquidity to airlines while buying aircraft at a discount.
On top of that, there are some airlines which will have strings attached to the aid package they are receiving. Those strings could relate to noise footprints, but also CO2 reductions. With some airlines going belly up and pressure on lease rates, AerCap could provide these airlines with the fuel efficient aircraft they will require when growth returns to the market with the big benefit for airlines that they don’t make progress payments with the original equipment manufacturer, but pay a depressed lease rate. It helps airlines recover the capacities that they are now permanently unwinding, while it also helps AerCap to put a new support under the lease rates and residual value.
As a lessor, AerCap has a pivotal role as airlines do need aircraft to stay in business so AerCap can work with airlines on providing these aircraft at reduced lease rates while safeguarding the longer-term lease placement with carriers. AerCap can either pull aircraft from the fleet with no new airline to place the aircraft sending lease rates and asset values down the drain or it can play a pivotal role in keeping airlines alive… After all, an aircraft placed with an airline customer is worth more than an idle aircraft. There is a lot unknown at this stage, but the indications are there that recovery in the marketplace will take 2-3 years to get back to 2019 levels. The benefit AerCap has is that airlines are now phasing out aircraft that won’t come back to restore capacity, while the lessor has the aircraft on order to support tomorrow’s recovery, and while not all airlines will make it to the finish line and tomorrow’s global fleet will be smaller than it is today, some airlines are kept afloat by governments, so it is unlikely that these customers will bail on payment anytime soon.
Conclusion
We are seeing that depending on the revenue pressure scenario driven by a combination of deferred rental payment, pressure on lease rates and residual value, there is risk to the book-value of the lessor. AerCap has some very useful shock absorbers, but even a small reduction in aircraft lease rates and values will materially affect the book value per share. We are currently seeing that growth profiles are pushed out four years at least. So, we are likely going to see pressure on lease renewals and the book value of the aircraft. At the same time, AerCap can use the lower aircraft values to bolster its portfolio at extremely low prices and provide airlines with liquidity that will help them live through this crisis.
When I started writing this report, I thought the drop in share prices was overdone. However, when reviewing the business environment, I am less convinced. AerCap has to walk a fine line as demand is insufficient to pull aircraft from non-paying customers and place it with other customers, so it is in the best interest of the AerCap to plan together with airlines and keep the average 7.5 years lease term remaining on their aircraft alive. By pulling too hard, AerCap could dislocate the market and send lease rates even lower while there likely will be pressure on lease renewals.
AerCap isn’t in a good spot, but I believe it is in a better spot than most players in the industry (from airlines to jet makers) as it can tweak order books and support airlines during times in which they don’t have deep pockets. That will result in AerCap intensifying its grip on customers, which in the longer term should help recover lease rates further down the road and supporting tomorrow’s growth because whether you look one year ahead or three or five, that recovery is expected and the trend of air travel demand doubling every 15 years is still what drives AerCap’s business. That is also something to keep in mind; the assets AerCap is investing in have a 25-30 year economic viable life and lease rates and residual values are not going to remain depressed for that long unless some extreme phenomenon occurs that is magnitudes bigger than the COVID-19 crisis. I believe that AerCap definitely is seeing pressures, but it has what it takes to be around in tomorrow’s market and be a stronger player in that market. That is also why I have tipped AerCap as an investment opportunity in a recent coronavirus roundtable for the travel industry and that has paid off so far with the stock gaining 25% versus less than 10% for the Dow Jones. I believe by investing in AerCap, you can enter the aircraft leasing business and have the company do all the work for you.
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This article was written by
Dhierin-Perkash Bechai is an aerospace, defense and airline analyst.
Dhierin runs the investing group The Aerospace Forum, whose goal is to discover investment opportunities in the aerospace, defense and airline industry. With a background in aerospace engineering, he provides analysis of a complex industry with significant growth prospects, and offers context to developments as they occur, describing how they might affect investment theses. His investing ideas are driven by data informed analysis. The investing group also provides direct access to data analytics monitors. Learn more.Analyst’s Disclosure: I am/we are long AER, BA, EADSF. 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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Comments (23)
In addition they trippled in last weeks, so a correction is also possible.
