AirCastle Ltd: Trading Below Book And Competitors Are Extinct

“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 options when it comes to capital allocation.

“Our mission isn’t to be the biggest aviation lessor, just to be the most profitable.”

“We will only seek to make incremental investments if they are accretive.”

Every dollar could be used to: pay down debt; free up encumbered assets; pay dividends; repurchase shares, or, used to make acquisitions in what they term is currently termed a “buyer’s market” for aeroplanes.

In 2012 and 13 the focus seems to be on expanding the fleet but as you can see below they have been shrinking the share count at a rate of around 10% a year for the last 2 years. When you consider the current Price to Book ratio of 0.5 or 0.6 you can get an idea of how accretive these buybacks are. They are attempting to balance this with the fact that scale derives a moat like advantage over competitors in this particular industry.

Dividend Policy

I think I would be less interested in AirCastle if I wasn’t being paid handsomely to wait with a yield of around 5.5%. The dividend is part of a flexible capital deployment program so there is no commitment to grow it. As far as I’m aware, it is a reflection of the opportunity set and profitability. However, I think it’s interesting to note that they have paid out $400m in dividends since the IPO in late 2006. This equates to half the current market cap returned to shareholders in 6 years and that’s off a smaller revenue base through a financial crisis!

Valuation – Bear Case

The most conservative way of valuing AYR would be liquidation value – AYR reports book value at near $20.00, Citi and Bank of America put “conservative” estimates of book value at $16 and $16.50 respectively. If we imagine that in a “scorched earth” scenario AYR had to find buyers for its fleet, or start selling the older planes for parts (“parting out”), then maybe they would be forced to sell for 0.6x “conservative” book which gets you $9.60 in return. That’s 15% downside from here before considering dividends. I can’t see this situation materialising when they don’t have a single debt maturity until 2017 and their customer base is so diversified. However it’s good to know – it provides our margin of safety.

Valuation – Base Case

There have been comparable transactions recently which we may find illustrative. Sumitomo Mitsui Financial Group, Inc. (TYO:8316) (NYSE:SMFG) purchased the non-core RBS Aviation from the distressed UK bank.

Royal Bank of Scotland Group plc (NYSE:RBS) (LON:RBS) sold its aircraft portfolio (206 owned aircraft with commitments to purchase a further 87 by 2015) to an Sumitomo Mitsui Financial Group, Inc. (TYO:8316) (NYSE:SMFG) led consortium for $7.3 billion. This not only removes a lingering overhang to sentiment in the industry, as everyone knew they were forced sellers, but at greater than 1x Book Value (versus AirCastle trading at 0.55 times) it’s likely to renew investor focus on aircraft leasing portfolios, particularly with visible growth and diversified customers. Additionally, the two bidders whose offers were rejected by Royal Bank of Scotland Group plc (NYSE:RBS) (LON:RBS) may re-emerge elsewhere as the rich and predictable cash flows of the lease streams obviously appealed to them.

>Another example is Mitsubishi’s $1.3bn purchase of 70 plane Jackson Square Aviation a company with a similar total asset value as AYR of around $4bn but yet a 2011 net income just $25m relative to AYR’s $124m.

So a takeover bid at 1x book, or near $20.00, which in theory values the infrastructure, management expertise, project pipeline and operating franchise at zero offers investors an 81% return from here.

But how accurate is book value? Clearly Citigroup Inc. (NYSE:C) and Bank of America Corp (NYSE:BAC) have different ideas from AirCastle management with a $4 per share difference in their numbers. I think we can take some comfort from the fact that management have managed to consistently sell planes for book value or more. From the 2011 Annual Report…

“Consistent with our focus on opportunistically divesting aircraft in order to unlock value for shareholders, we monetized a number of our investments in 2011. Specifically, we sold 13 aircraft for a total of $500 million in 2011, generating $39 million in gains. Since the Company’s formation, we have consistently demonstrated our aircraft sales capabilities. In total, we have now sold 30 aircraft, generating gross proceeds of more than $800 million and an aggregate unlevered return in excess of 14%”

On the March 14^th 2012 conference call with the stock at $12.70, Mike Inglese said “I think the stock is undervalued period. By a lot!”

Pretty punchy from an exec on a public conference call!

Valuation – Bull Case

Another way would be to presume AirCastle remains a going concern and put a multiple on the 2013 earnings. Here I will quote the chap who drew my attention to the stock, Harris Kupperman at Adventures in Capitalism, because I have no quibble with his back of the envelope numbers.

“In the first half of 2012, they earned $0.68 a share, but that also includes a $10 million impairment on an aircraft, add that back, and earnings come to around 80 cents a share for the first half before minor adjustments for tax. I should point out that this annualizes to $1.60 a share for the full year, but this is deceptive for two reasons. Firstly, there will be more planes in the second half of the year (those added in the first half that haven’t had the benefit of being in the portfolio at the beginning of the year and also new planes to be purchased in the third quarter), secondly, the company just refinanced their debt in a way that will save them approximately 50 cents a share each year. Add it all up, and I figure that run-rate earnings are better than $2.00 a share.”

So 5.5x 2013 earnings or an 18% earnings yield with a 5.5% dividend and a 45% discount to reported book value. At these kind of numbers not much has to go right for investors to make good money.

AYR has done a good job of growing book value over the last 6 years whilst continuing to grow its diversified revenue streams via long term lease contracts. We have discussed a few of the reasons why AYR is positioned to capitalise on the industry structure’s recent changes. Now since markets are forward looking you would expect that these qualities are starting to be priced into the stock via its rating; the chart below shows that this is quite clearly not the case. Revenue and book value have grown handsomely but the Price/Book ratio has been crushed from 3.0x post IPO to the current paltry rating of around 0.6x.

Now I don’t think 3x book is a reasonable valuation for the stock but that would be $60.00.

BAML estimate, using data from Ascend, that the aircraft leasing industry as a whole has been a profitable one over the last 30 years with annual returns of circa 10%, similar to that of a high yield/junk bond portfolio. Does that mean at 0.55x book I am buying an asset class due to give me 18% returns (10/0.55)?

The Depreciation/Inflation Hedge

We all know that current monetary policy is highly experimental and that there is the not insignificant potential we have a substantial inflationary accident in the next few years. In such an environment it will always be tangible assets that hold their value, and it will be real assets backed by nominal debt that benefit from a true wealth transfer.

Now obviously the planes that AirCastle owns depreciate at a rate which is up for debate but clearly quite significant. But if you think about it inflation is a force that will act contra to depreciation – a plane depreciating at 5% per annum in a 5% inflationary environment may not lose any $ value at all but the debt against it will be reduced by inflation + amortisation.

Why does the Opportunity Exist?

AirCastle is basically a sophisticated finance/investment vehicle selling to the most consistently unprofitable industry in the world. At a time where earnings stability is highly valued and non-cyclicality is prized I don’t think many investors can get over the “yuck” factor. This is an unloved business but it shouldn’t necessarily be so!

I don’t think there are many analysts out there considering whether AYR is gaining an advantage from its capital market access or how bank balance sheet deleveraging is having the unintended consequence of improving AYR’s economics.

What does the Portfolio and Lease Profile look like?

I want to highlight the diversification (across 67 Lessees and 36 countries) which helps to protect against any local disruptions like the Arab Spring or the Icelandic ash clouds. Another key attribute is the remaining lease term which blends to around 5 years across passenger and freighter for the portfolio as a whole.

The largest customer exposure, which I believe to be South Africa Airways, is less than 8% of book value and the top 10 customer accounts for around 45% of book value. Individual customers going bust is not going to materially affect this business, planes will be returned to AYR and then they can quickly be leased out again, sold off or parted out.

Management can also choose whether to tilt marginal purchases or sales towards the passenger or freight markets depending on which is more favourable. This is a unique position for AYR as no other listed leasing company is involved in the freight business which is around 1/3^rd of AYR book value – another element of diversification. The freight business is attractive because the planes are that much more fungible with no need to refit them between leases the capex required is a bit lower. It is interesting to note that the global freighter fleet has an estimated average age of 25 years so much of this is nearing the end of its economic life.

One concern in the portfolio is that 24 planes or 8% of the portfolio by value rolls off lease in 2013 into what could be quite a weak market but the management team have options at their disposal to cope with this due to the unencumbered assets and unrestricted cash. In 2014 the number rolling off lease is 32 planes at 15% of book value.

The stock IPO’d at $23 and has basically done nothing but decline since. Unless you had the cojones to swing the bat in Q4 2008 or Q1 2009 then you are almost certainly underwater on the stock. No-one has anything but ill-will towards it!

Global Aircraft Market

The market is actually a lot more liquid than I imagined, although I’d guess it gets a lot less liquid at the points where everyone needs it to be! The benefit of this particular real asset is that you can easily fly a plane from Johannesburg to San Francisco if that’s where the buyers are, not so with property or some other major plant.

The aircraft market is not a homogenous one and there are big differences in the supply and demand dynamics for different vintages of planes, varying manufacturers and between narrow and wide bodied models. I find it interesting that a few years ago when people talked about AirCastle they emphasised how they operated with new planes. Today management talk about the highest ROE opportunities being available in mid-age, in production aircraft in the secondary market – this demonstrates a flexibility and open-mindedness to go where they think they can get the best value to build their portfolio. Specifically, they have said that buying new planes can be quite capital intensive in that buyers have to place large deposits which ties up capital and worse commits to a large capital expenditure several years out into the murky economic mid-distance.

Some competitors in the industry only source planes direct from OEMs like The Boeing Company (NYSE:BA) or Airbus. AirCastle takes a different approach, one that I think gives them an edge; they will buy from OEMs, the secondary market, airlines, “sale and leaseback”, other leasing companies or anywhere else there is a deal to be done. Mike Inglese says that their portfolio has been sourced from 70 different counterparties! Now that is bargaining power.

Fortress Funds Stake

AirCastle was spun out of Fortress in 2006 and they have been slowly exiting the business ever since. They completed their exit in August 2012 with a final sale of 2.5m shares which were purchased by AirCastle and cancelled as part of their buyback. This obviously removes the overhang of a consistent and very large seller from the stock which can only be good news.

Insider Ownership/Management Incentivisation

Between them the top men at the firm own around 2% of the equity.

CEO Ron Wainshal owns 603,784 shares worth $6.6m.
CFO Michael Inglese owns 268,151 shares worth $3m.
Chairman Peter Uberroth owns 259,367 shares worth $3m.
General Counsel David Walton owns 243,072 worth $2.6m.

Last year CEO Ron Wainshal received $600,000 in basic comp and total comp of $2.5m which seems pretty reasonable relative to the size of the company. He seems to have a pretty solid CV being educated at Wharton, doing an MBA at Chicago then heading up GE’s aviation finance business before taking AYR public. Here are two useful videos of him in action.

https://www.bloomberg.com/

http://video.cnbc.com/gallery/?video=3000073095

http://www.executiveinterviews.com/delivery/v1/mini/default.asp?order=U14622

Michael Inglese is a mechanical engineer by training, a CFA Charterholder and did his MBA at Rutgers.
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