Volatility creates opportunity because the value of a business simply doesn’t change as much as its stock price does. I’ve always been fascinated how wide the swings in stock prices can be even for rather stable businesses. Today, we’ll take a look at one such stable business where the stock price has swung too low.
Also, I would like to thank my friend Shree Viswanathan at SVN Capital for his comments and suggestions on this post.
What if you could own a company with the following characteristics?
* Long-term contractual cash flows
* Set to double in size in the next five years
* Best management team in the industry
* Investment grade balance sheet
* Mid-teens ROE
* Yet trades for a single-digit price-earnings ratio and a discount to book value
Would you be interested?
Well, such a bargain exists…
Introducing Air Lease (AL)
Now, if you think you know the story, hang on. In this post, I want to show you why I find the stock so compelling. And most importantly, I want to address common misconceptions about the business.
We own Air Lease at $32 in the Woodlock House fund and it’s a top four position at about 8%. (See our disclaimers. I can sell it at anytime and I don’t have to tell you, do your own due diligence, yada yada.)
Air Lease owns and manages a fleet of 336 aircraft (as of January). It focuses on younger aircraft and plans to hold them for the first 1/3rd of their estimated 25-year useful lives. As a result, the average age of the fleet is just 3.8 years.
These are the most technologically advanced and fuel-efficient aircraft available.
Air Lease leases these planes to 94 airlines in 56 countries. Leasing has become a popular option for airlines and makes up about 40% of today’s global fleet. The advantages of leasing are numerous, but four main ones are:
1) Leasing requires less capital for the airlines
2) Leasing allows airlines key delivery positions for new aircraft, as Boeing and Airbus have huge backlogs
3) Leasing gives the airlines greater fleet flexibility (i.e., they can purchase the aircraft at the end of the lease or put it back to the lessor)
4) Leasing allows the airlines to lay off the residual risk (value of the plane when they choose to retire it)
Almost all of Air Lease’s business is outside of the US. Leases terms can run up to 12 years. These are triple net leases – meaning the airlines are responsible for taxes, maintenance and other expenses. Think of Air Lease as a landlord with planes instead of real estate.
This business is incredibly stable. The chart below shows you the lease yield, the average age of the fleet and the average remaining lease term since 2011 (when AL went public):
“Air Lease: Steady as She Goes…”
Try to find the European debt crisis, or Brexit, or interest rate increases or any of the macro concerns that have worried investors during this period of time… You can’t find them. Air Lease continues to chug along with nary a bump along the way.
Yet, the stock is very volatile. The 52-week his is $50 and the low is $28. Huge swings. Which creates an opportunity. Because today the stock at $37 trades for about 8x estimated 2018 earnings per share of $4.60. The consensus guess for 2019 is $5.73, a 25% increase. The stock trades for 6.5x that number. The stock also trades well below book value of $43 per share, which is hard to square with a company that earns double-digit ROEs and has an investment grade balance sheet.
Air Lease’s Economics are Even Better Than They Look
The numbers are even better than they look on the surface. That’s because Air Lease pays no cash taxes. Air Lease depreciates the aircraft much faster than their useful lives, so it has zero taxable income. Further, AL sells the leased plane well before the lease term is up. As long as they roll the proceeds into a new plane (a 1031 exchange), they don’t have to pay taxes on the gain.
A real economic “look through” would focus on pre-tax earnings. On a pre-tax basis, Air Lease’s ROE is over 15% (for the last twelve months through 9/30). Pre-tax earnings are nearly 30% higher. On a pre-tax basis, the trailing P/E drops to ~6x. Deferred tax liabilities likewise understate book value.
The stock is too cheap for economics like that. Compare AL to a bank. It delivers better ROEs with less leverage. (AL’s debt to equity is modest at about 2.5x and 90% of its debt is fixed). And it’s steadier. If AL were a bank, it’d trade for 2x book value.
Air Lease also has baked in growth. AL’s order book has 422 planes (as of January) from Boeing and Airbus. Air Lease is set to double the size of its fleet over the next five years. About 90% of those planes are already placed through 2020. Air Lease typically leases a plane 18 to 24 months before they take delivery.
Substantial Upside + The Best Management Team in the Industry
So, if the valuation doesn’t change at all, you should earn a ~15% annual return and double your money in five years. If we get a better valuation, the upside is considerably higher.
Nearer term, if the stock traded just for its estimated 2019 book value, it’d be close to a $50 stock by the end of the year. (Which is what it was last January).
Further, you get to ride along with the best management team in the business.
Stephen Udvar-Hazy, AL’s chairman, invented the industry. In 1973, he founded an aircraft leasing business (ILFC, eventually sold to AIG) and leased a single plane to AeroMexico. He founded Air Lease in 2010 after leaving ILFC/AIG. Air Lease went public in 2011.
Anyway, Udvar-Hazy is a giant in this business. Udvar-Hazy’s right-hand man is John Plueger, CEO. He has been with Udvar-Hazy for more than 30 years. They are the largest individual stockholders. Management and the board own 9.3% of the stock. They have skin in the game. And they have proven trustworthy, which is no small thing in the leasing business (where it is easy to book profits only to lose money on the residual values at the end of the lease).
A Great Backdrop for Air Lease
I would also add that the backdrop for Air Lease is also favorable. The key variable to track is air travel. And that too has been remarkably resilient over time.
Air Lease has a good chart on this, showing revenue per passenger kilometer (RPKs). It has gone up – through recessions, wars, etc.
"The Long-term Trend in Air Travel – A Positive for Air Lease!"
As the chart shows, commercial passenger traffic has been doubling every 15 years (~ 5.0% annualized). More recent data shows that it is growing at an even faster rate. Much of the growth is coming from emerging markets in Asia, Latin America and even Europe.
So, we’re going to need a lot more planes. If you include replacement demand, we’ll need 40,000+ aircraft over the next 20 years. That’s a big opportunity for the lessors.
I’d like to turn to objections, risks, concerns, etc. that people tend to raise.
Air Lease – Objections and Concerns
* What about the risk of an airline not paying? They aren’t the best credits, you know.
If an airline doesn’t pay, Air Lease seizes the plane. (All of AL executives are also pilots, by the way). They then re-lease it. Since their planes are relatively new and desirable, it is not difficult to re-lease them. For example, AL re-leased planes slated to go to Primera Air, which filed for bankruptcy recently; ditto for Monarch Airlines which folded a couple of years ago.
As a practical matter, this seldom happens. Airlines tend to sell their older planes first. This is another reason why I like AL’s focus on newer aircraft. Plueger addressed this point in a January presentation, talking about his experience at Udvar-Hazy’s predecessor company, ILFC:
“In 9/11, when that happened, at ILFC, we had just under 10% of our fleet subject to bankruptcy at 4, 5, 6 different airlines across the globe, about 60 aircraft. The reason why we had no credit losses at that time was because of the quality of the aircraft themselves. These were young aircraft. These were the aircraft that airlines wanted to keep. So whether or not we negotiated the aircraft to stay there in a bankruptcy scenario, it extends out the lease term, maybe we took a little bit less lease rate, but we kept in there, or placed the aircraft with other carriers. We had the shortest lease replacement time of anybody that time. It averaged 33 days. So the quality of the metal, I cannot emphasize to you enough, is of paramount importance especially if times get tough.”
As for the creditworthiness of their customers: We can’t see the credit quality of the lessees. But I think this is mitigated by the mobility of the assets, the diversity of the leasing base and a long history of not having problems on this front. Plus, as Plueger says, the quality of the metal is important, too.
* Leasing is a crappy business
I beg to differ. Leasing in general is a commodity business. But I believe aircraft leasing – and particularly the way Air Lease does it – is a good business. Unlike other leasing operations (container, railcar, office equipment, etc.), Airbus and Boeing have thousands of aircraft in backlog – years of production. It’s not easy for a new aircraft lessor to get new planes. Air Lease has coveted “front of the line” status on new aircraft from the OEMs. And because it a large buyer, Air Lease gets concessions on price.
Also, look again at the economics mentioned above. Mid-teens ROE. Modest leverage. Contractual cash flows. Built-in growth. Steady as she goes even through difficult macro environments. Seems a pretty good business to me.
* They don’t pay a high dividend, many peers pay nice dividends
The dividend yield is low, but I’m okay with this. I’d rather AL take their earnings and roll it back into new aircraft. As long they’re earning attractive ROEs and have a clear path to growth, I’ll forgo a bigger dividend.
* They don’t buy back stock
True. A peer, AerCap, does – and with gusto. At this price, I sort of wish AL did. But all their cash is earmarked for growth. And AL is committed to an investment grade balance sheet. I don’t think we’ll see buybacks. But it shouldn’t matter, given the growth ahead. The returns should be attractive as is.
* What about interest rates? If rates rise, won’t they get killed?
Most of their lease contracts have escalators that provide interest rate protection. Second, leasing rates tend to rise with interest rates. Third, most AL’s debt is at a fixed rate. And the composite rate is 3.2%. Over the long haul, the business seems capable of dealing with rising rates.
* What about the risk of selling aircraft when they want to?
Ah, this gets to something interesting I have not mentioned yet. Air Lease has two programs under which they sell planes (named Blackbird and Thunderbolt). These are sort of like funds where AL manages outside capital. AL sells aircraft to these entities, which AL controls. And AL earns management fees and performance fees. They don’t sell all their aircraft to Blackbird or Thunderbolt, but it’s handy to have.
I used to make a big deal of Blackbird when it started. I saw Air Lease growing an asset management business and thought: “Holy cow, what would that do to valuations? The market will love it – high margin, recurring fees.” While I certainly think they are good transactions for Air Lease, they’re not crucial to my thesis.
But they do mitigate that risk of where to put older planes. And remember, older planes in Air Lease’s case are still planes only 8-10 years old. Still very desirable and easy to sell.
* What about funding? That’s a lot of aircraft on order
It is. Air Lease has managed this kind of growth for years. The model works. Is there is a risk credit markets freeze up and they can’t raise debt as easily as they have? It seems very unlikely, but it’s a risk. Even in 2008, the aircraft lessors remained profitable. AL also has some flexibility over its order book.
* What about the 20% exposure to China
This comes up from time to time. About 45% of AL’s business is in Asia and about half of that is in China. I don’t worry too much about China. I think it’s an opportunity. Here’s Plueger:
“We only have 6 aircraft in our order book scheduled for future delivery to airlines in China. They need them badly… But more importantly, we're a well-known U.S. leasing company in China. In fact, we did some of the very first leases in China in 1990, which is a very bold step at that time. We were the only aircraft lessor back in the ILFC days that agreed to lease aircraft to some of the major Chinese airlines without a government guarantee. May not sound like a big deal to you, but to the Chinese, it was huge.
“So we've been building our business in China since 1990 very, very successfully. We're still getting just as many, if not more, request for aircraft in China. And we've seen zero change in that behavior.
“The bottom line is: I can't see any effect whatsoever to ALC's business because of the current state of trade wars.
“In fact, Boeing estimates that China alone will need almost 7,700 new aircraft for the next 20 years. And the final thing is that China is aiming to have about 450 airports by 2035, almost double the current number. China has more airports under construction than the rest of the world combined.”
* What about oil? The price has come down a lot, which means Air Lease’s new planes aren’t as prized as when oil was higher.
I would disagree. As Plueger put it in a January presentation: “Whether oil is $150 a barrel or $50 a barrel, one thing is true: Fuel and labor are the highest costs to airline P&L statements.”
Airlines will always be interested in minimizing fuel costs. Also, it’s not just fuel costs. Newer planes have substantially lower maintenance costs as well.
* This business has no moat
I think it has a narrow moat. It’s not easy developing the relationships Air Lease has. More importantly, you can’t just step in front of the line and get a new Boeing plane. Boeing and Airbus are sold out for years. So, that order book has value.
In any case, the track record and economics are compelling in my view. The business clearly has something it does right.
Conclusion: One of My Highest Conviction Ideas
In summary, Air Lease has a good business model. It uses its balance sheet and purchasing power to buy new aircraft from Airbus and Boeing at a discount. It runs a lean operation. (SG&A/Revenue is only 7.5% vs. more than double for its peers). It gets a tax break from Uncle Sam because of the depreciation and 1031 exchanges. The end result is one of the highest net profit margins in the industry.
I think Air Lease combines great upside with not a lot of downside at today’s valuation. It’s one of my highest conviction ideas. And it is a business I plan to own for years. The stock should, uh… fly higher!
*** Mailbag
A good rule of thumb and a great story from a reader:
“I am now mostly retired from money management, but used this rule of thumb for position sizing: Big enough so that if a stock doubled, it would be meaningful to the whole portfolio.
“At the same time small enough so that if the stock went to zero, the portfolio wouldn’t suffer permanent damage. That rule is subjective. My guess is, in your case of concentrated investing, 10-20 positions.
“BUT when there is a perfect storm in your favor, and you can withstand more damage, it is possible to invest a larger amount in a single stock for your personal account.
“Early in my career, I fell upon an investment that had everything - growth, value, great management, high insider ownership, a small market cap, well known brand, you name it. After weeks of research, and with the blessing of my wonderful wife, we put half of our money in that stock. We agreed that if it went to zero, we would pick up the pieces, buy a cheap house in Nebraska, and be happy.
“We later sold most of it for 30-70 times our money. My children still own some shares with over a 100 bagger gain.”
Send me mail at info [at] woodlockhousefamilycapital.com
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Published: January 24, 2019
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