Description

Air Lease is a leading aircraft leasing company trading at 6.6x consensus 2019 earnings and 0.87x TBV.  The company should generate 20%+ earnings growth over the next two years, plus it has an investment grade balance sheet, plus it is led by some of the savviest and most connected pioneers of the commercial aircraft leasing industry.

Los Angeles, CA-based Air Lease is the third-largest player in the global aircraft leasing industry, behind GE Aviation Services (NYSE:  GE) and AerCap Holdings (NYSE: AER). None of the other competitors (and there are a lot) come close in terms of scale to the top three players in a category where scale confers considerable competitive advantages.  The Company was founded in 2010 in the wake of Credit Crisis by Steven Udvar-Hazy, 73, the founder of International Lease Finance Corporation (ILFC) and the visionary father of the modern commercial airplane leasing industry; Udvar-Hazy was the CEO of ILFC, formerly a division of American International Group (NYSE:  AIG), from ILFC’s 1973 founding until 2010 when he departed from AIG.

The aircraft leasing business model involves Air Lease purchasing planes from Airbus/Boeing/Embraer directly in volume and at a discount to list prices and then leasing them to the global commercial airline industry.  AL receives monthly lease payments from their airline customers with the major cost items being depreciation, SG&A, and financing costs; leases are typically done on a triple net basis. 99%+ of AL’s leases are transacted in U.S. dollars, with the balance in Euros.  AL has 100% of its expected lease revenues for the next two years already contracted, and there are plenty of customers who would like to get their hands on AL’s fleet of new planes. Since AL’s inception, the Company has achieved an average rental yield of 11-12% with a surprisingly tight spread. The average age of the fleet has stayed near 3.6-3.8 years since inception, and the remaining lease term has averaged 6.8-7.2 years.  AL targets modest leverage of 2.5x debt/equity.

Key reasons to invest in AL include:

• Global air travel is growing at a 5% clip according to Boeing/Airbus (and other research providers), while the percentage of airplanes being leased is projected to increase from 40% to 50% over the next 15 years.
• The valuation is cheap, and ROEs are both high and growing.  For AL, incremental ROE expansion stems from increased operating leverage, the refinancing of their legacy higher yield debt, and the growth of its nascent Blackbird and Thunderbird investment management businesses.  Book value per share should grow at a double-digit rate for many years to come. AL’s current fleet equals only ~3% of global leased planes.
• After years of working with the credit agencies, AL now has an investment grade balance sheet with ample liquidity to source aircraft purchases as necessary.  .
• AL is at the front of the queue of the most efficient airplane models in part because they hold exclusive seats on aircraft design and planning committees, giving the Company unique visibility into future industry trends and providing them with top level access to new planes.
• Airplanes are depreciated over 8 years for tax purposes (and 25 years from an income statement perspective); because of this sizable depreciation shield, AL reports zero taxable income.  When AL sells its planes (typically at 7-8 years old), as long as the proceeds are used to purchase new planes, the process is treated as a 1031 exchange. Essentially, AL is able to roll its cost basis into the new assets and never pay any taxes from gains on sales of fully depreciated assets.  As a result, adjusted earnings for AL is calculated as price/(EBT/shares outstanding).
• Book value is likely understated because the current deferred tax liability is unlikely to be paid.  That deferred tax liability should continue to grow over time, continuing the compounding of the book value understatement.  ILFC never paid taxes in its 40-year history.
• Earnings visibility and business predictability are high.
• The ILFC management team essentially all came over to AL.  This team invented the industry and has extremely close contacts within the industry.  Management was a valuable asset for AIG for many years.

The Company stands out from its peers due to its unique, well-defined earnings growth strategy, focus on long-term lease contracts, young/high quality assets, and long-term relationships with over 200 airlines in 70+ countries, more than two decades of average industry experience amongst the management team, low debt funding, industry-leading multi-year earnings growth profile, and the largest order book relative to current market cap.

The Company

Founded in 2010, AL bought its first aircraft in May 2010.  CEO Udvar-Hazy raised $3.3 billion at the time of founding with $1.3 billion in equity and $2.0 billion in committed debt.  By the end of 2010, AL had signed leasing contracts with more than two dozen airlines. AL subsequently raised $758 million in its April 2011 IPO; the IPO price was $26.50, only ~10% above the current share price.  Since the IPO, AL has completed multiple debt refinancings (particularly so since they achieved the investment-grade credit rating several years ago) and continued to build its fleet.

None of the major aircraft lessors pay full list prices for planes, but Udvar-Hazy in particular is renowned to be a savvy negotiator.  Reportedly, AL receives 25-30% discounts off the list prices for planes which can cost $100 million or more. AL then leases its planes out under long-term (7-8 years) triple-net leases to airlines across the world.  AL does not have any customers that represent more than 10% of total revenues, and more than 95% of the customers are located outside of the United States.

Typically, airlines lease planes for the following reasons:

• Certain airlines have limited access to capital (particularly so for airlines domiciled in the emerging markets).
• Airlines have traditionally not been good asset managers, since owning planes is not their core competency.  Airlines are not well positioned to buy or sell planes to rival airlines, and they tend to sell planes at distressed times at distressed prices.
• Lessees can outsource the risk associated with residual values for airplanes to lessors.
• Airlines prefer fleet flexibility by keeping a portion of planes leased so they can better manage capacity.
• Lessors generally have a lower cost of capital and benefit from wholesale purchase prices, some of which is passed onto the airlines.  Many airlines cannot afford the pre-delivery payments which can cost up to 30% of aircraft value.
• If smaller airlines bought planes directly, they would be last in line for new planes, would be forced to pay full retail price, and would end up waiting many years for the planes (backlogs for many popular airplane models now stand as high as 7-9 years).
• U.S. tax laws allow for accelerated depreciation on taxes, which is a cost savings that the U.S.-based lessors can pass through in part to their international airline customers.

The Company owns numerous types of airplanes, but the vast majority of the fleet consist of the highly popular, single-aisle, narrow-body planes.  The most important aircrafts are the Airbus A319-320-321 and the Boeing 737-700/800. AL focuses on narrow-body planes because they are easier to lease and sell than wide-body jets due to their popularity.  Notably, AL is not burdened by a legacy inventory of old planes with limited resale/leasing value.

While this business is unquestionably capital intensive and AL must properly manage its balance sheet to generate attractive rates of return, aircraft leasing is not a business with low barriers to entry.  If that were the case, then the sale/leaseback business model would be far more prevalent and the ROEs would be lower. Surprisingly so, this industry is driven by relationships; AL’s well-respected management team has very strong ties to the plane producers, finance companies, and airlines.

Since inception, AL has experienced minimal repossessions of its aircrafts.  Of course, the risk that a customer will fail to make lease payments and default on their obligations exists.  However, AL monitors its customers’ financial health closely. Prior to default, customers typically pay their leases from 1-3 months in advance with maintenance reserves.  Should a customer default, AL has sufficient time to dispatch a team of pilots to repossess the plane within days of confirming a potential issue. Even in a difficult economy, management does not expect many repossessions to occur because its planes are young, fuel-efficient, and in demand.  A struggling airline is more likely to ground an older and more expensive plane to maintain than to default on a lease for a cutting-edge new airplane with lower maintenance, fuel, and noise pollution costs and with a wider flying range and increased seat capacity.

AL faces competition from numerous other lessors and financial institutions.  Airlines typically prefer to deal with lessors because they have superior knowledge of the industry, planes, and customer needs; if cost of capital were the driving force, the airlines would use the traditional banking sector to finance their aircraft needs.  There are dozens of companies that lease airplanes, with the largest companies being GE Aviation Services and AerCap. Other players include CIT, Aviation Capital, GATX, BBAM, AWA Aviation Capital, BOC Aviation, and Bohai Leasing. Aircastle and FLY Leasing are pure-play publicly-traded aircraft lessors, but their fleets are older than that of AL and AerCap and thus their go-to-market strategy is different.  KKR recently made an announcement that they plan on investing $1 billion in the aircraft leasing industry, but, like Aircastle and Fly Leasing, KKR’s business strategy will be focused on purchasing older planes from the secondary market and leasing them out. Most lessors are expanding their fleets but at a slower pace than AL.

Despite continued strong fundamentals, AL’s stock price has been highly volatile of late, dropping by more than 20% over the last year despite posting strong numbers, even after the recent rally.  The rationale for this decline does not make sense in my opinion. The possible reasons for such stock price volatility include oil prices, China/ emerging market exposure, interest rates, and/or demand destruction of air travel.  More details on these risks and a discussion of mitigating factors are set forth below.

Risk #1:  Oil

When oil prices were high, investors demonstrated concern that flying demand and, in turn, aircraft demand would deteriorate, putting a cap on AL’s stock price.  However, now that oil prices have declined, investors have become worried that AL’s massive investments in state-of-the-art fuel-efficient aircrafts may come back to haunt them in the future.

Unquestionably, airline cost structure has altered considerably in the last few years.  In July 2012, roughly 47% of the airline industry’s costs were associated with fuel consumption.  By January 2016, that number declined to 35% due to slumping oil prices. Flying old aircraft in a world of low oil prices has one advantage:  ultra-low ownership costs. However, flying older aircrafts leads to higher operating costs associated with inefficient fuel consumption and maintenance costs.  Beyond considerable fuel savings, newer aircrafts have ~50% lower maintenance costs than aging aircrafts. The poorer reliability of older aircraft may lead to unscheduled maintenance costs, untimely aircraft grounding, dependence on third-parties for maintenance support, the necessity to extend access to larger pools for spare parts, and unbudgeted compensation costs to passengers.  Beyond that, the reality is that very few airlines possess the requisite technical prowess in-house to purchase and/or retain aircraft of a middle age to senior variety profitably (probably just Lufthansa and Delta fall in that camp); most airlines need capable maintenance partners to continue to support an older fleet.

Moreover, newer generation aircraft have other advantages that should not be forgotten:

• More flying range and thus revenue capability, which can help to improve a carrier’s strategy.
• Significant savings from charges assessed at airports for less noise.  Depending on the aircraft, annual savings can be up to $1,800,000 per plane just for noise charges at airports.
• Optimize seat count due to higher density of seats, thus increasing potential revenue.

Risk #2:  China/Emerging Market Exposure

With an ~18% direct exposure to China and significant exposure to other emerging markets, investors may be concerned about outsized EM exposure possibly coming to bite AL sometime in the future.  Thus far, passenger traffic remains strong in the face of a GDP slowdown in China. Regional air travel is proliferating, which should result in higher aircraft values as air travel becomes more accessible to the broader population.

Airport congestion in China is high and growing, which is why China is building 25-40 incremental airports between 2016 and 2020, and many of these airports are located in developing regions far west of the eastern seaboard.  A growing aviation industry remains a key strategic goal of the Chinese government. Today, the average American takes 1.6 airplane trips per year, while that same figure in Europe is 1.2. As for China, airplane trips per capita stands at 0.3 and clearly has quite a bit of room to grow.  Furthermore, roughly 80% of AL’s Chinese exposure is with the three major Chinese airlines (Air China, China Eastern, and China Southern), all of which are growing at a low-double-digit pace and are largely owned/controlled by the Chinese government.

While an economic slowdown should have an impact on stock valuations in China and elsewhere in the world, it appears that the secular growth pattern in China for flying should remain in place for many years.  As long as passengers continue to queue up for a flight, demand for commercial aircraft should continue to hold up.

A trade war with China should have little impact whatsoever on planes that AL currently has leased with Chinese airlines.  It would have an impact future shipments to Chinese airlines. But, switching costs for these airlines is very significant, as the pilots would need to learn how to fly a new plane, the maintenance crew would have to learn how to fix a different plane, and the maintenance crews would need to inventory different replacement parts.  Beyond that, the queue to get a new Airbus aircraft is many years long. Thus, the impact of tariffs would hinder demand because of rising costs, but leased Boeing aircraft should continue to be shipped to China despite the incremental tariffs.

Risk #3:  Interest Rates

Investors are concerned that AL might experience a material deterioration of its business by changes in the shape of the yield curve or simply directional movements in the yield curve.  However, it appears that such exposure should be limited and is well-managed. On all of AL’s customer agreements for leases that have not yet commenced, AL insists on interest rate adjusters in those lease agreements.  Should interest rates rise, AL would experience a parallel and equal rise in the leases on future deliveries on all of its future aircraft leases. Generally speaking, lease rates do, over time, tend to follow interest rates.  Furthermore, the Company employs forward interest rate protections on all unleased aircraft orders as well. As for the existing leases in place, such lease rates are fixed – as is the associated leverage that AL employs for usage with those leases.  Essentially, that practice immunizes the cash flows associated with current leases for the length of the lease but would impact future lease rates once those contracts expire seven years from now (on average). However, it should be noted that, while the impact of interest rates should have little impact on AL’s business in and of itself, higher rates most certainly act as a drag on the economy, which certainly buffers the future prospects for AL’s customers.

AL CEO John Plueger noted that a higher cost of financing aircraft tends to increase demand for leased aircraft.  He noted on a previous earnings call that “In the good time, airlines need us for our delivery positions.  In the bad times, they need us for our balance sheets.” Essentially, at higher interest rates, airlines do not want to tap the debt markets for expensive funding to purchase aircraft; they would rather lease aircrafts than commit significant capital towards large capex projects.

Risk #4:  Air Passenger Demand Destruction

The International Air Transport Association projected in October 2018 that the air passenger numbers are anticipated to grow at a 3.5% CAGR between now and 2037.  So, more airplanes are necessary to address demand. The in-service commercial airline fleet is forecast to grow from 25,000 aircraft at the beginning of 2017 to over 35,000 by 2027, and aircraft deliveries will total about 20,000 over that 10-year period.  New aircraft will accelerate the retirements of about 10,000 aircraft over that period.

Demand destruction of air travel is the most important risk for AL, but it simply does not seem to be the in the cards.  Yes, a recession could occur in the near term, which would damper demand. However, the current global fleet continues to age, causing new fleets like that owned by AL to be that much more in demand.  Emerging markets continue to grow their economies, fly more, buy new aircraft – all of which is positive for AL.

Valuation

At first blush, AL appears inexpensive on a number of valuation metrics, primarily on a price/earnings and a price/book basis.  Compared to itself on a historic basis, AL’s stock price is trading near all-time low valuation multiples (except for a couple of weeks ago).  AL’s only true publicly-traded peer from a scale/quality of order book basis is AerCap, and AL trades at 87% of stated tangible book AL’s GAAP ROEs are in the low teens, and adjusted ROEs are in the high teens; it is difficult to fathom that this stock trades at a discount to tangible book value.

Rather, with new aircrafts generating IRRs at a ~22% pace, AL’s stock price should be trading at a material premium to tangible book value.  With the airline industry is growing at a ~5% pace, with the leasing business is growing at an even faster clip (probably more like 6-8% for the next 5-10 years) because they are taking share, and with top line double-digit growth for years, a price/book value multiple of 1.5x makes far more sense than the current multiple.  I see no reason why AL’s share price should not trade for $60/share.

To conclude, AL has a number of positive qualities for investors, including a business transformation story, a long runway of growth, valuable intangible assets, high and growing returns on equity, considerable tax free attributes, understated book value, a reasonably good level of earnings visibility, and a high quality management team.  And, to top it off, a fetching valuation to boot.

Catalyst

• End of the trade war.
• Continued earnings and book value growth as time passes.
• The Fed putting a halt on interest rate hikes.