Description

Introduction: Avolon (symbol: AVOL) leases airplanes to commercial airlines throughout the world. The company is based in Dublin, Ireland, and completed its IPO in December, 2014.

Summary: Avolon is an inexpensive stock with good prospects for growth. Its financial results are fairly predictable as virtually its entire fleet is leased. Also, the company usually orders and leases planes long before deliveries are made. The commercial air travel industry is booming and there is a growing trend towards leasing planes. AVOL has a $5.9 bil. EV and its stock price closed at $21.68 on 3/6/15. My 12-month price target is $27 (+25%).

Note: I published a VIC report on Air Lease (symbol: AL) on 3/18/14. Air Lease and AVOL have nearly identical business models. Their histories are also very similar. Both firms were founded in 2010 by executives who had built other lessors. Although Air Lease has met all expectations over the past year, its stock price is virtually unchanged. Air Lease is probably a stronger company than AVOL, but it also has a more expensive stock. I have long positions in both stocks.

History

            Avolon is a young company with an experienced management team. The company was founded in Dublin, Ireland, in May of 2010. The initial investment of $1.4 billion was provided by four investment firms, including U.S.-based Oak Hill Capital Partners. AVOL’s executives have an average of more than 23 years of experience in the aircraft leasing industry. Most of them worked together at Dublin-based RBS Aviation Capital (RBC AC). RBS AC was sold to Sumitomo Mitsui in 2012 for $7.6 bil. and is now known as SMBC Aviation Capital. AVOL’s CEO, Domhnal Slattery, became the first CEO of RBS AC in 2001 after RBS acquired his aircraft company. Although AVOL is less than five years old, it is already one of the ten largest aircraft lessors in the world.

The IPO

            Avolon completed its IPO on December 15, 2014. The offering price of $20.00 was below the expected range of $21.00 - $23.00. The lead underwriters were J.P. Morgan, Morgan Stanley, and Citigroup. AVOL did not receive any proceeds from the IPO. All of the 13.6 million shares sold in the offering were sold by the institutional shareholders that funded the company. The selling shareholders have agreed to the usual 180-day lock-up on remaining shares. There are approximately 81.7 mil. shares outstanding. The current EV is approximately $5.9 billion. The private equity investors still own approximately 83% of the outstanding shares. Some investors are concerned about the large overhang on the stock. Slattery has said that the company will allow the holders to sell their shares in secondary offerings. The timing of these secondaries is, of course, dependent on the trading and the stock price. Slattery owns approximately 1.1 million shares.

Chinese Bid

            Avolon was involved in takeover discussions in the months before the IPO. In August, 2014, reports surfaced that Chinese aerospace firm AVIC Capital was working with the Chinese Investment Corporation (CIC) to make a bid for AVOL. While the Chinese press reported an offer as high as $16.1 billion (!), the actual offer was probably in the range of $4 - $5 billion. AVOL was, apparently, willing to consider the Chinese offer because negotiations continued for a few months. On December 1, 2014, though, it was reported that AVOL’s board had rejected the AVIC / CIC offer as being too low. AVOL went ahead with its IPO a couple of weeks later. Despite the rejected takeover bid, I think that there is a decent chance that AVOL will be acquired someday.

The Business

            The airplane leasing business is a relatively straightforward spread business. A new airplane can cost $100 mil. or more. Many airlines have high borrowing costs and little negotiating power with the plane manufacturers. They lease planes to conserve capital and simplify their businesses. Leasing companies, such as AVOL, are able to lease planes at a profit because they have purchasing power with the plane manufacturers and are able to borrow money at attractive rates. It is very much a relationship-driven industry. AVOL’s management has very strong ties to the plane manufacturers, finance companies, and airlines.

There is a major trend towards leasing planes by the airlines. The aircraft leasing business is only about 40 years old and did not experience strong growth until the 1990s. Now, approximately 41% of the world fleet is leased. Airlines have traditionally financed aircraft purchases with equipment trust certificates or commercial bank loans. These sources of funds have declined since the financial crisis. Some investors view AVOL and its competitors as finance companies, but they can actually add a lot of value to the airlines. AVOL has every incentive to help its customers as it needs them to be successful. The lease portfolio produces stable cash flows as long as the customers remain financially secure.

            The second part of the business is the trading of airplanes. One of the reasons that airlines lease, rather than buy, planes is that they want to reduce their residual risk. A commercial aircraft can operate for 20 - 25 years, but AVOL sells its planes when they are still young. AVOL has the youngest fleet of any major aircraft lessor. The average age of an AVOL plane is only about 2.5 years. AVOL’s management has excellent knowledge of the secondary market for planes. The company is a more active trader of planes than Air Lease and other competitors. AVOL sold four planes in Q4 2014 and has sold at least one plane in each of the past ten quarters. Its average gain on plane sales since 2012 has been 8.7%.

The Customers / Geography

            Avolon delivers planes to commercial airlines throughout the world, but focuses on emerging markets. Its customers include everybody from Air Berlin to Philippine Airlines. The largest customers are Garuda Indonesia, American Airlines, and LATAM. AVOL has 50 airline customers in 28 countries. The company has approximately 60% of its fleet placed in fast-growing emerging markets. AVOL’s executives claim to have relationships with more than 150 airlines from their time at RBS AC. Approximately 1/3 of AVOL’s fleet is placed with customers in emerging Asian markets, such as China and Indonesia. AVOL also has significant exposure to Latin America and Europe. There has been some concern about AVOL’s business in Russia. The company actually has little exposure to Russia as the market accounts for just over 5% of its portfolio. Seven of its planes are placed with Aeroflot, but there are no outstanding receivables.

            Most of the growth in the airline industry is coming from Asia. The demand for air travel in Asia is increasing rapidly as more Asians move into the middle class. Asia / Pacific accounted for 43% of 2014 worldwide plane deliveries according to FlightGlobal’s 2014 Airline Market Review. The same publication states that 31 Asia / Pacific start-up airlines began service in 2014 and that total capacity in the region increased by 6.8%. There has been concern that some airlines have ordered too many planes. While it is likely that some airlines have ordered more planes than they need, AVOL protects itself through diversification and risk management.

            Avolon has never had to repossess a plane. The biggest risk in the aircraft leasing business is that a customer will default on its lease. The lessor will, in such a case, seize the plane and try to lease it to someone else. Lessors, obviously, want to avoid this situation as the process of repossessing and re-leasing a plane can be difficult and costly. AVOL monitors the financial health of its customers to proactively intervene in a possible default situation. The company has never suffered a default in its history. It did, however, terminate a lease with one customer in Q4 2014. The customer, a financially-troubled Indian airline called SpiceJet, paid a $1.3 mil. termination fee. AVOL immediately leased the plane to another customer. AVOL’s customer base is a mix of established airlines that need to replace older planes and younger airlines that need to grow.

The Planes / Leasing

            Avolon’s executives are extremely knowledgeable about the worldwide plane market. They have been buying and leasing planes for a long time. AVOL, though, is a young company that is not burdened with legacy aircraft. It has the youngest fleet of any major lessor as average age of its owned planes is only 2.5 years. Most of these planes are the fuel-efficient planes that airlines demand to reduce fuel costs and comply with environmental restrictions. The company owns numerous types of planes, but most (73%) are single-aisle, narrow-body planes. The single-aisle planes are the workhorses of the industry, especially in Asia. Including planes on order, AVOL has a portfolio of 235 planes. As of 12/31/14, AVOL owns 126 planes, manages 11 others, and has 98 planes on order for future delivery.

Here is the delivery schedule by year (from 2014 20-F):

2015    2016    2017    2018    2019    2020    2021    2022    Total

31        6          0          8          17        22        11        3          98

            Avolon buys planes directly from Boeing and Airbus and also engages in sale-leaseback transactions. The most heavily represented plane types in its current fleet are the Airbus A320ceo (46 planes) and the Boeing 737-800 (51 planes). AVOL has already ordered enough planes to nearly double the size of its current fleet value over the next several years. All of the planes that it has ordered were designed to be more fuel efficient than previous generations of aircraft. AVOL was one of the first firms to order the new Airbus A320neo that will be launched in 2018. More than half (52%) of its acquisitions are through sale-leaseback deals. The company conducts more sale-leaseback deals than many of its competitors (such as Air Lease). In a sale-leaseback, the lessor buys a plane from an airline and then leases it back to the airline. AVOL’s executives were very active in the sale-leaseback market while employed by RBS AC. The benefit of a sale-leaseback is that the lessor does not have to order planes far in advance of delivery and take the risk of cancelled orders.

            Avolon generates most of its revenue from aircraft leasing. These are triple net leases. All but one of its 126 owned planes was leased as of 12/31/14. AVOL has relatively high customer concentration due to its limited history. Its top five customers represented 32% of its 2014 total revenue, although none represented as much as 10%. The remaining average life of AVOL’s leases at 12/31/14 was among the longest in the industry at 7.1 years. The annualized rates of its leases increased from 10.6% in 2013 to 11.0% in 2014. It is important to note that 79.4% of AVOL’s leases at 12/31/14 had fixed rates for the duration of the leases. There is, therefore, some risk that AVOL’s cost of capital could rise faster than the rates on some of its leases. AVOL can, of course, increase rates on new leases, but its leases are long-term and have staggered maturities. Lease rates linked to floating interest rate benchmarks accounted for 20.6% of AVOL’s leases at 12/31/14.

Financing

            Avolon borrows money to finance the purchase of new planes. The company tries to match the durations of its debt with the length of its leases. The average remaining maturity of AVOL’s debt at 12/31/14 was 4.6 years. AVOL reports that 71% of its debt is fixed, 19% of its debt is associated with floating-rate leases, and 11% of its debt is hedged with derivatives. Its target debt to equity is 3:1. AVOL, unlike Air Lease, does not have an investment-grade debt rating. The firm is unlikely to achieve an investment-grade rating as long as private equity firms own most of the company. The lack of an investment-grade debt rating means that AVOL has not been able to access the public debt market to the degree of some competitors. It also means that much of AVOL’s debt is secured. The company has still been able to borrow at very attractive rates. It has committed financing from 31 firms, including Goldman Sachs, Merrill Lynch, and Lloyds Banking Group. AVOL’s cost of funding at the end of 2014 was 3.8%, down from 4.4% at the end of 2013. The implied interest rate expense on AVOL’s balance sheet appears higher than this due, in part, to losses on interest rate derivatives. Bloomberg calculates AVOL’s WACC at 4.2%. AVOL had $1.18 bil. in undrawn debt at 12/31/14. Interest rate expense is the single most important cost in the aircraft leasing business. AVOL’s lease yield is a couple of percentage points lower than that of Air Lease and AerCap. AVOL’s management is focused on reducing its cost of debt to that of some of its competitors.

Competition & Recent Deals

            Avolon faces competition from numerous other aircraft leasing companies and financial institutions. Airlines often prefer to deal with aircraft lessors over banks and other financial institutions because they have superior knowledge of the industry, planes, and the needs of their customers. There are dozens of companies that lease airplanes. Avolon, only five years old, is already among the ten-largest in the world. The largest company in the industry by fleet size is a division of GE called GE Capital Aviation Services (GECAS). It owns approximately 1,645 planes. The 2014 acquisition of Los Angeles-based ILFC by Netherlands-based AerCap created the second-largest fleet of approximately 1,300 planes. AerCap and GECAS have much older fleets than AVOL and have not experienced similar growth. AerCap, though, has been aggressively ordering planes since the ILFC merger. Other major companies in the industry include CIT, Aviation Capital Group (a division of Pacific Life), BBAM (a division of Babcock & Brown in Australia), and BOC Aviation in China. Most of these companies are expanding their fleets, but at slower rates than AVOL.

            There have been lots of major deals in the airline leasing business in the last few years. The $7.6 bil. acquisition of ILFC by AerCap was the most significant recent transaction, but there have been several others. In October, 2014, GECAS acquired Milestone Aviation Group for $1.78 billion. In March, 2015, Australia’s Macquarie Group announced that it was buying a $4 bil. portfolio of 90 planes from AWAS. Macquarie had previously lost the bidding for the previously-mentioned RBS AC. Japan’s Sumitomo Mitsui Banking Group bought RBS AC (now SMBC) in 2012 for 4.7 bil. British pounds. San Francisco-based Jackson Square Aviation was also sold to a Japanese firm in 2012. Mitsubishi UFJ Lease & Finance paid 100 billion yen ($1.3 billion) for Jackson Square. The weak yen has encouraged Japanese companies to acquire foreign assets. Chinese firms have also expressed interest in acquiring aircraft lessors. I would not be surprised if, someday, AVOL were acquired by a competitor or financial buyer.

Q4 2014 Results

            Avolon reported its first quarter as a public company on March 3, 2015. The GAAP numbers were rather messy due to large share-based compensation charges and IPO expenses, but AVOL reported adjusted numbers. The company reported revenue and adjusted net income that exceeded analyst estimates. AVOL reported Q4 revenue of $173 million (+39% y-o-y) and 2014 revenue of $606 million (+35% y-o-y). It reported Q4 adjusted net income of $49 mil. (+74% y-o-y) and 2014 adjusted net income of $179 million (+43% y-o-y). It also reported adjusted EPS of $0.59 for Q4 2014 and $2.19 for 2014. The company sold four aircraft in Q4 for a total gain of nearly $12 million. Aircraft net book value at the end of 2014 was $5.61 billion, up 32% from $1.35 billion at the end of 2013. AVOL reported an adjusted ROE of 12.5% for 2014. The company ended 2014 with $4.55 billion in total debt.

“Hidden” Value

            The value of AVOL’s fleet exceeds the balance sheet net book value of the planes. AVOL’s owned fleet of 126 aircraft was recently valued by nine independent appraisal firms. Using these appraisals and other factors, AVOL estimated that the 12/31/14 market value of its planes was $6.2 billion. The 12/31/14 net book value of the fleet was $5.6 bil., implying that the market value of AVOL’s fleet is about 10% higher than the stated book value. AVOL refers to this value as “embedded” value. The company can realize this value by generating profits when planes are sold. A simple calculation suggests that AVOL’s embedded value is $6.95 / share higher than the net book value:

Market Value – Net Book Value = $568 mil. / 81.7 mil. shares = $6.95 / share

2015 Outlook

            Avolon provided 2015 guidance in its Q4 2014 earnings announcement. The company expects $1.6 bil. in 2015 aircraft deliveries. All aircraft deliveries for 2015 have been placed with customers. AVOL has also placed all but one of its expected 2016 deliveries. AVOL expects a 2015 net trading gain of $55 - $60 mil. on total sales of approximately $700 mil., so it expects a gain of about 8%. The company expects year-end adjusted ROE to be in the range of 14.7% - 15.0%. Expected cash SG&A for 2015 is $55 mil. and the effective tax rate is expected to be 6%. AVOL did not provide specific EPS guidance. The company will not provide quarterly guidance going forward, but intends to provide annual guidance when it reports year-end results.

            Avolon deserves a premium valuation to some competitors as it has superior growth prospects. Many airlines are moving towards an asset-light model in which they outsource much of the business, planes included. They seek to deleverage their balance sheets. AVOL’s growth should come from continued increases in demand by airlines for leased, rather than owned, aircraft and the continued expansion of airlines in emerging markets. The strongest annual passenger growth rates will come from the Asia / Pacific market. AVOL has a young, fuel-efficient, high-utilization fleet. It is certainly true that the airline industry is cyclical, but AVOL’s management has long experience with these cycles. Management states that it has experienced “three and a half” cycles. While the airline industry suffered during 2008-9 recession, the aircraft leasing industry actually remained profitable.

            The airline industry is experiencing one of the best periods in its history. The International Air Transport Association (IATA) estimates that the worldwide profit for airlines in 2015 will be $25.0 bil., up from $19.9 bil. in 2014. The 2015 estimate is likely too low because it is based on oil prices which are much higher than the current prices. The precipitous drop in oil prices since mid-2014 is clearly positive for the airline industry. There has been some concern, though, that lower oil prices will encourage airlines to keep older planes in operation. AVOL’s management says that there has never been any correlation between oil prices and fleet upgrades. There was a big boom in plane sales in the late-‘80s to early-‘90s. Many of those planes are approaching the end of their useful lives in the next few years.

Comparison with Peers

            I believe that AVOL is undervalued. It is one of the fastest-growing firms in the industry but does not trade at high growth multiples. Aircraft lessors have historically not received strong valuation multiples. As recently as 2012, AVOL’s peer group of Air Lease (AL), Aircastle (AYR), AerCap (AER), and FLY Leasing (FLY), traded at less than 1.0x BV and a P/Es of around 6. Valuations have improved over the past couple of years. AYR and FLY are cheaper than AL and AER due to their slower growth. Here are some key financials for publicly-traded aircraft lessors:

Valuation

            Zacks reports fives analysts with current ratings on AVOL. All five of them have ratings of “Buy” or “Outperform”. The average 12-month target price of these analysts is $24.20. Estimated long-term EPS growth is 17%. Some of the 2014 numbers have been adjusted for IPO and stock compensation expenses. Here is a summary of the current estimates:

            Avolon is in a strong position in a strong market. The industry is hot right now and expected to continue to grow. It is expected that leased aircraft as a proportion of the world fleet will grow from approximately 41% now to 50% in 2020. As AVOL signs contracts years in advance, it has strong visibility on its future earnings. It has already signed deals that represent $6.6 bil. in future deliveries. My one year target price is $27 (approx. 25% upside). I think that the stock has great potential in the longer-term as well.

            Avolon will experience strong growth over the next few years. AVOL is expected to show 2015 year-over-year growth of roughly 19% in revenues and 36% in GAAP EPS. It is expected to report adjusted ROE of approximately 15% for 2015. Revenues should exceed $800 million in 2015, a near doubling of revenues in only three years. AVOL is based in Ireland and domiciled in the Cayman Islands and, therefore, pays minimal taxes. AVOL should report EPS of about $3.00 in 2015. The stock is, therefore, trading at only about 7x 2015 EPS.

            Avolon’s stock should trade at a premium to book value. Prior to the financial crisis, some lessors’ stocks traded as high as 2.4x BV. Their valuations crashed when the credit markets seized up. AVOL currently trades at approximately 1.1x expected year-end 2015 book value. It is true that many aircraft lessors have traded at a less than 1.0x BV in the past. I previously explained, though, that AVOL’s stated book value is likely understated by nearly $7 / share. AVOL has the youngest fleet of a major lessor and consistently sells planes for profit. Many of its competitors are stuck with older, less valuable planes. If investors adjust AVOL’s current book value by the value of its fleet, then AVOL’s trailing P / BV is roughly 0.8x and its forward P / BV is roughly 0.7x. I think that AVOL is undervalued whether the book value is adjusted by the value of the fleet or not. Given its growth characteristics and risk profile, I think that a P / BV of 1.35x is a fair multiple for AVOL. I use this metric to determine a one-year price target of $27.00.

Some Risks:

·         Interest rates rise, credit unavailable

·         Lease yields fall

·         Unable to borrow due to lack of credit rating

·         Airplane prices decline, hurting sale prices

·         Airlines cancel orders

·         OEMs unable to deliver planes on time

Key Points:

·         AVOL has the youngest fleet in the industry

·         Very experienced management

·         AVOL is growing faster than most competitors

·         Long-term leases

·         Lowering borrowing costs as company grows

·         Balance sheet book value understates the value of AVOL’s fleet

·         Airline industry is very strong and benefitting from low oil costs

·         Growth of airlines in Asia is expected to continue for a long time

·         Visibility on future plane deliveries / leases is excellent ($6.6 bil. future commitments)

·         Chinese investors nearly acquired the company pre-IPO

·         Stock is somewhat under-the-radar as IPO priced below expected range

·         Possible acquisition candidate

Legal Disclaimer: This research report expresses my research opinions, which I have based upon certain facts, all of which are based upon publicly available information. Any investment involves substantial risks, including complete loss of capital. Any forecasts or estimates are for illustrative purpose only and should not be taken as limitations of the maximum possible loss or gain. Any information contained in this report may include forward-looking statements, expectations, and projections. You should assume these types of statements, expectations, and projections may turn out to be incorrect. This is not investment advice nor should it be construed as such. You should do your own research and due diligence before making any investment decision with respect to securities covered herein. The author has a position in this stock and may trade this stock.

Catalyst

increasing estimates, lower debt cost, possible acquisition