Description

AerCap (AER) has the potential to fit the cyclical trough framework and could double over the next 24 months in a base case. 

AER is the largest aircraft leasing company in the world with a fleet of >900 aircraft with an average age of fleet of ~6.2 years and an average remaining lease term over 7 years ($40bn of contracted lease revenue).  AerCap’s stock is down ~50% since February and is now trading at ~0.4x book value (which may be modestly impaired over the next 12 months).   The outlook for air travel is clearly in question with the majority of global airlines still curtailing large portions of their fleet and IATA (the airline trade association) predicting enormous losses and the potential for significant bankruptcies in poorly capitalized airlines.  I agree with the consensus view that AER's customers (airlines) are suffering in this environment which in turn will lead to AER providing additional rent relief and in a worst-case repossessing aircraft of failed carriers.  That said, this is more than priced into the stock at current levels ($30).  Airlines are viewed by governments as critical infrastructure and for this reason I believe governments will continue to support their airlines (as evidienced by the many billions of dollars of grants and low cost loans that have already been distributed to airlines). Furthermore, over the medium-term (post vaccine) it is more likely than not that customers will return and airlines will ramp up flights.  Bankrupt carriers will be consolidated into stronger carriers. Older aircraft will be permanently retired which will drive improved capacity utilization of the global fleet.  The industry will heal and AER lease rates will improve driving earnings power and the stock materially higher from current levels.

A picture is worth 1,000 words (even if it is dated).

For the past 7 decades the number of Revenue Passenger Kilometers has doubled every ~15 years.  There have been 3 years since 1950 where air traffic has fallen (Gulf War, 9/11 and the GFC).  The above doesn’t account for freight traffic (the backbone of global supply chains) which is also growing at GDP+ for >50 years.  While we believe this cycle will be worse than ALL of the previous cycles, we believe over the medium term (2-4 years) the trend will persist as >80% of the global population has still not flown on an aircraft and as consumer discretionary income increases so too does the demand for air travel.  

The aircraft leasing business is a simple spread model.  The lessors acquire aircraft (through orders from Boeing and Airbus or in the secondary market) and lease them to airlines (charging them for all required maintenance as well).  The lessors finance themselves through a combination of secured, unsecured and government backed loans.  The lessors keep the net interest margin.  Aircraft have a 25+ year useful life and are transferable between customers.  If one goes bankrupt and novates a contract, the asset can be repossessed and deployed to a better capitalized airline. This makes the cash flows highly predictable over moderate periods of time supporting strong asset values and deep financing markets.  The keys to success in the leasing business are (i) the ‘right’ assets, (ii) a large and diverse customer base, (iii) strong underwriting of customers/risk management framework and, (iv) a highly diversified source of low-cost funds.  AER has each of these attributes and over the past decade has grown to be the largest scale player in the world which has driven its cost of acquiring assets and funding lower than all of its peers.

The right assets are critical to success.  There are two main types of aircraft – narrowbodies and widebodies.  Narrowbodies (B737/A320 family) are typically used for domestic traffic while widebodies (B767/777/787 and A330/350/380) are used for international traffic and cargo.  Narrowbodies are a fraction of the cost of widebodies and their lease factor (expressed as a monthly % of the aircraft value) are 50-80% of widebodies as conventional wisdom would suggest they are ‘lower risk’ aircraft.  The other variable is the age of the aircraft as newer aircraft can be more fuel efficient (driving down opex for the airline) which may allow for higher lease factors relative to older aircraft.   Like many things, the devil is in the details.  25-year assets require a deep understanding of how the future will evolve.  Fuel price changes are highly variable and can dramatically impact the relative value of newer more fuel-efficient vs older aircraft.  If a lessor overpays or buys the wrong aircraft (typically using debt at ~70% LTV), they will eventually be forced to take an impairment charge and destroy equity value.  AER is the largest lessor in the world which gives it the richest set of data for making the decisions of which aircraft to buy and which to sell.  AER has ~50% of its fleet in narrowbodies (by net asset value) and another ~38% of its fleet in the newest most fuel efficient widebodies (B787/A350).  We believe these assets are highly valuable and over the next 2-3 years the asset values will hold up.  At 0.4x book value, the current stock price/valuation clearly suggests that there is a debate about the value of these assets.  Over the past 15 years AerCap has sold 860 aircraft at an average of 1.3x book value.  While we doubt AER would be able to sell their entire fleet for a premium to book value today, we do believe that there is a deep market for both financing (still seeing secured aircraft lending at ~70%+ of book value) and asset sales (as evidenced by the sale of AirCastle to Marubeni  for ~1.15x book value which closed on March 27^th 2020).  Further evidence that AER has the ‘right’ assets is their fleet utilization which has averaged >98% for ~15 years.

AER has developed a large and diverse customer base with ~200 active relationships across every continent.  The company deals with almost every national carrier (supported by governments in China, Middle East, Europe, Latin America and South East Asia) as well as many of the largest and best capitalized independents (American, Southwest, etc).  We estimate that the quais-state backed/flag carriers represent ~70% of lease income.  The balance of lease income comes from smaller less well capitalized carriers.  This is why having strong underwriting/risk management is equally critical.  Many of the less well capitalized companies may go bankrupt and we have taken this into consideration in our analysis.  While bankruptcy rules vary by country, most courts allow the company to cancel leases.  We recognize that this is a highly likely scenario however we also believe that the draconian scenario priced into shares is likely not to occur which brings us back to having the ‘right assets’.  If an airline goes bankrupt but plans to operate going forward (with debt holders converted to equity) they still need aircraft.  If the leased assets are still a good value then the airlines will likely keep the aircraft (with potentially lower lease rates).  If the airline is liquidated AER will repossess the assets and place them with other carriers (once again at potentially lower lease rates).  In the event the assets are not re-leased in short order they can temporarily take them out of service (incurring modest fixed opex) and either re-lease the assets when the market recovers (25 year useful life), sell them to another company at a discount or in an extreme circumstance take the aircraft apart and sell it for pieces (engines are the highest value component at ~50% of total value and are easily transferred between assets).  Over the past 15 years credit costs have averaged under 1% of lease revenue. One component of the variant perception here is that I believe AER will be able to monetize their assets through leasing/asset sales/selling for parts which will give the market more confidence in its net asset value and earnings power driving the stock higher.    

A highly diversified source of low-cost funds is equally critical, and AER has the broadest set of financing tools of any company in the aircraft leasing world with hundreds of financing counterparties.  AER has ~$30.5bn of outstanding debt across its secured, unsecured and subordinated loans, bonds and credit facilities.  As of 6/30/20 AER held ~$2.4bn of cash and had $6bn in undrawn revolvers. While AER bonds during the trough days of the COVID sell off were yielding low double digits, spreads have now tightened considerably and the company has been able to issue debt on average at 4.2% throughout 2020, in line with its normalized cost of capital. With the debt the company has already raised, coupled with a renegotiation of its order book with Boeing/Airbus to reduce capex obligations (2020/2021 capex reduced by >$5B), AER has ample liqudiity to make it through the current crisis. Additionally, if the crisis goes on for longer than expected, the company has >$25bn in unencumbered assets they could use to raise capital at 70% LTV to pay off all of the remaining maturities and forward order commitments.  The company could also access the EETC market (aircraft whole loans) or get government guaranteed loans from the US and Europe both at ~5% (though both would reduce the company’s ability to refinance or sell assets freely).  A second component of the variant perception here is that the company has many tools to refinance its near-term maturities and pay for (or renegotiate) its forward order commitments. 

There are NO perfect precedents for the current air travel environment.  The airline industry at present is in much worse shape than during the GFC where traffic fell 15-20% for a few quarters.  On the flip side the US carriers have consolidated significantly (providing pricing power), have less legacy liabilities (as they went through bankruptcy), and will likely have very low fuel prices and strong government support (did not get bailed out in 2008).  The bank and credit markets are also in better shape which should allow airlines and lessors to remain liquid.  A third component of our variant perception is that we do not need a full recovery to pre-coronavirus utilization for a material improvement in AER fundamentals.  Airlines can run their aircraft at 70% (or less) capacity utilization (vs high 80% pre-virus) and still pay AER its lease rates. 

In the GFC AER was a much smaller and less well capitalized company with under $1bn of book value vs ~$9.7bn today.  Its stock fell ~95% from peak to trough (it was arguably overvalued at >3x book at the peak) and bottomed at ~0.2x book value and 1x EPS (vs this cycle where the stock traded down >75% to 0.2x book and 2.5x EPS).  While I am by no means suggesting the stock cannot continue to fall from current levels I believe the fundamentals of the business (asset quality and balance sheet) are far stronger than the stock implies. In any normalized state of the world fair value is $60-75 a share (vs $30 today). 

Key risks to the thesis include a more prolonged (2-3 years) period of weakness in air travel that drives even the national and well capitalized carriers into insolvency or that the secured financing market completely dries up for 2 years.  I believe both of these risks are low probability.  Long term impairment of air travel would suggest that globalization would effectively end.  In China, which in theory is already in the recovery phase post coronavirus, domestic air traffic declined by ~90% at the trough and subsequently rebounded to down 10% from pre-Covid levels (international traffic is still low).  China is the largest market for AER representing ~15% of rents predominantly from the big 3 national carriers. Europe and the U.S. have also shown fits and starts of recovery but remain depressed. I have no ability to predict with certainty when the rest of the world starts to recover but even in a very challenging scenario where air traffic takes 5 years to recover we think that AER assets will fair well as they are either cheap narrowbodies (for domestic travel) or young fuel efficient widebodies (best quality).  In terms of the financing markets, I believe the central banks led by the Federal Reserve’s backstop on IG credit will remain open.  In the event I am wrong, I also have shorts in the aerospace industry which should protect me from meaningful capital impairment. 

Catalyst

COVID vaccine, improving travel demand and flight schedules, earnings reports with low levels of impairments