value stock

“A capitalist should have shot down the Wright Brothers during their historic “first in flight” moment.” Warren Buffett

Summary

Aircastle Limited (NYSE:AYR) is a global company engaged in the acquisition leasing and trading of high-utility commercial or freight jet aircraft to passenger and cargo airlines. As measured by the value of their airplane portfolio they are a global top 10 player.

Aircastle Limited (NYSE:AYR) was founded in 2004 by Fortress Hedge Funds and then IPO’d in 2006 at $23. AYR profits from the spread between their lease revenue minus their interest and operating costs and depreciation. Leases vary from 3-12 years and the lessee is responsible for maintenance, operating and insurance costs. All rental payments and deposits are paid in USD. The business model is very similar to a REIT for aircraft.

Key Metrics

Market Capitalisation $800m
Price $11.00
Book Value $20.00
Dividend Yield 5.5%
2013 P/E 5.5x

 

The Change of Industry Circumstance

On the demand side, Airlines are struggling to get finance because of their history of sketchy profitability(enormous understatement!), there is also a desire on their part to keep their balance sheets asset light and flexible and to minimise residual risk. Therefore leasing has some strategic advantages as it offers a far less committed way to attempt to fine-tune their capacity needs.

On the supply side many of  Aircastle Limited (NYSE:AYR)s historic competitors are leaving the industry or being rendered uneconomic just as AirCastle is reaching an economies of scale inflection point. In sum, we may be entering a decade where demand grows nicely but the economics of the leasing business tilt towards a few selected incumbent suppliers.

 

Emerging Markets Opportunity

The democratisation of air travel has been one of the most amazing developments in the last few decades in the western world – it no longer retains its aura of glamour or luxury. This trend has been globalising over the last 10 years with rapid growth of total seat miles due to an emerging middle class, opening up of trade routes and the internationalisation of previously regional franchises.

As the chart below shows there have only been 3 years in the last 30 when global air traffic growth has been negative although it is clearly strong correlated to global GDP growth.

AirCastle is positioned to capitalise on this trend by being a key facilitator for the growth of the airline businesses in the world’s fastest growing but often capital starved economies. Crucially, for small start up airlines leasing is often the only option to get up and running.

A Sampling of AYR Emerging Market Customers
Airline Country Number Of Planes
South African Airlines South Africa 4
Hainan Airlines Co. China 9
SriLankan Airlines Sri Lanka 5
Airbridge Cargo Russia 2
GOL Brazil 7
Iberia Airlines Spain (Essentially a frontier economy at this point) 6

 

Who Can Provide the Capital to Meet Air Traffic Growth?

Airlines are notoriously bad businesses and no-one wants to provide them with capital. Because of this the operating lessor penetration of the global airplane base has grown from 0% in 1970 to 35% today and it will likely increase more as airlines stay asset light through both a desire to remain flexible and because banks won’t lend to them!

Pre financial crisis, AirCastle was at a permanent disadvantage, two of its biggest competitors had AAA parents, American International Group, Inc. (NYSE:AIG) and General Electric Company (NYSE:GE) Capital, and used their balance sheets to borrow cheap and short – continuously rolling over the debt. This allowed them to either earn superior returns to AYR, or alternatively, to offer better lease terms to customers and still earn the same spread. Obviously, both parents encountered large problems and are no longer able to compete as effectively in this industry.

 

Increased Balance Sheet and Portfolio Flexibility

The risk for any leveraged company (and AYR certainly does have some leverage at $3.2bn of debt) is that lenders start to get nervous and call in their loans. AYR has done a great job here of insulating themselves from this risk by extending the term of their debt and by forging a strong relationship with the bond market by gradually switching some of their finance into unsecured bonds – raising around $1.2bn. This leaves the assets unencumbered and flexible and furthermore provides certainty on the financing that secured loans and bank finance don’t offer.

The table below demonstrates the power of the bond market access AirCastle have been coveting, freeing up the previously encumbered assets AND lowering the blended interest rate from 5.8% to 5.05%. A 75 basis point saving on interest costs on $3.175bn of debt is $23.8m a year or $0.33 per share (a big boost to a company that will earn around $1.50 this year).

As bond investors become more familiar with AirCastle and with the Aircraft Leasing business it is a distinct possibility that AYR will achieve investment grade status which would lower their effective interest rate further and allow them to finance their portfolio at tighter spreads.

As a result of the bond issuance the unencumbered proportion of total aircraft assets by value has effectively increased from 15% to 35%. This is key because it expands the menu of options available to management, they can be more opportunistic with purchases and sales as they no longer have the banks or creditors looking over their shoulders.

 

Weak Market = Opportunity for those with Firepower

The aviation bank market has contracted considerably. The European banks have almost disappeared from the market dropping from 36 in 2000 to just 10 today. The true willingness of these banks to extend credit could be in question too as the risk weighting on these kind of aviation deals does not make them attractive. The terms and pricing of their offers are no longer competitive which is why proven access to the bond markets for financing, which AirCastle demonstrably has, is a “moaty” quality.

 

Can AirCastle operate through a downturn?

As you can see below the utilisation rates of the portfolio has been pretty consistently in the high 90s from 2007 until 2012 through the GFC. Even better they did not have to drop the lease rates on the planes dramatically to maintain that utilisation – the yield stays pretty constant across the period. Customers went bankrupt and reneged on their leases; so AYR found new lessees within a number of weeks and delivered the planes to them.

Why does the yield and utilisation not fluctuate like you might expect? Well, these are long term contracts usually for 5-10 years, and it’s only in distressed situations that the keys are handed back.

 

From the 2011 Annual Report….

“For the full year 2011, Aircastle maintained a utilization level of approximately 99% and rental yield of about 14%. These strong results reflect our ability to effectively manage through several early lease terminations arising from the “Arab Spring.” We believe our consistent performance underscores Aircastle’s success developing one of the premier aircraft lease management platforms in the industry.”

 

Management Understand Capital Allocation

When I read the conference call transcripts I am delighted to see that Ron Wainshal (CEO) and Mike Inglese (CFO) consider the opportunity cost of the various

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