AL - Air Lease: Still A Mixed Outlook Maintain Hold

Summary

• Air Lease reported a decent fourth quarter but still faces headwinds going forward.
• Their adjusted net income and return on equity are, at a minimum, aggressive in their depiction of the business's performance. GAAP measures paint a far less bullish outlook.
• Massive CapEx required over the next few years will likely see them issuing debt into a higher interest rate environment, putting pressure on future returns.
• I maintain a Hold rating. I continue to prefer AER equity to AL for exposure to the space.

I previously wrote about Air Lease Corporation (AL) a few months back, highlighting my lukewarm views on the common stock and constructive view on the preferred shares. The company just reported its fourth quarter results , and while they had a decent quarter, I don't see anything that would change my view on AL's prospects. I maintain a Hold rating on the stock and prefer AerCap (AER) for those seeking exposure to the sector. My reasoning is as follows:

Adjusted metrics not useful for performance

The company's pre-tax, adjusted ROE was 11.0%, which seems compelling on its surface. However, this ratio, and the net income behind it, is a flawed metric in my opinion. It backs out multiple important line items that are absolutely recurring and material to the company's business, including:

1. Amortization of debt discounts and issuance cost: This is currently amounting to ~$50 million per year in deferred financing costs. The company is a serial issuer of debt and will continue to be given its huge purchase commitments and upcoming bond maturities. This is a cost that cannot be ignored.

2. Income taxes: This is interesting, but again, fails to pass muster. The company has managed to only pay approximately $68 million in cash taxes on $2.7 billion of after-tax net income earned over the past six years, or roughly 2.5%. These deferred taxes are quite meaningful from a cash flow perspective, but the key word there is deferred. And the ability for the company to defer taxes in perpetuity is fairly to very unlikely to reflect reality.

3. Stock-based compensation: While non-cash in nature, the $4-6 million per quarter of expenses do have real consequences for shareholders, and there's no reason to back them out of net income calculations in my opinion.

All said, I estimate Air Lease's 2022 return on equity, excluding the impact of the write-off of its Russian fleet and assuming a 20% tax rate, to be approximately 7.5%. I estimate that return on equity will continue to be around the 6-7% level going forward and book value per share growth will be around 6% per annum. I see AerCap, on the other hand, achieving a return on equity 100-200bps higher than Air Lease. I also see annual book value growth for AerCap of 10%+ for the next few years, in part driven by my view that the company is well positioned to institute significant share buybacks now that they have reached their target leverage metrics post-GECAS acquisition. This should, in my view, drive AerCap to trade at a premium to Air Lease's valuation.

Lofty asset sale targets

On its earnings call, the company set a target of $1-2 billion in asset sales for 2023. While management is very experienced, Air Lease has only approached the lower end of this range in two years since its founding over a decade ago. So far, the company only has four aircraft carried at $153 million designed as held-for-sale, which is a small head start, but still leaves much work to be done. In addition, as described in my prior article, much of these prior sales were to its Blackbird and Thunderbolt joint venture entities, and the securitization market has remained closed given macro volatility.

The company routinely achieved double-digit gains in margins on aircraft sales in lower interest rate environments where liquidity was abundant and the capital markets were wide open to aircraft issuance. However, to achieve the same or similar profits in the current market, the company may need to either divest more aircraft and/or sell higher-yielding aircraft, foregoing the earnings that these assets will generate in future years for gains in the present. A significant portion of new deliveries the company took in the past couple years have likely been rendered untradeable by the rise in interest rates.

Finally, management did allude to the level of asset sales being at least partially dependent on the volume of new deliveries received from Boeing (BA) and Airbus (EADSY) relative to their plan. While from a pure cash management angle this is understandable, from a capital allocation perspective it is frustrating that, particularly in what they describe as a strong trading environment, and with the stock still trading at a large discount to book, that management does not more aggressively pursue dispositions and use the proceeds to acquire shares. This was not mentioned, and seemingly is not on the horizon.

Refinancing into a higher interest rate environment

The company's refinancing and purchasing needs are starting to bite in the form of higher interest expense. The company has roughly $5.3 billion of debt that matures in 2023-24 with an average fixed coupon of 2.7%. The two most recent bond issues, each for $700 million, priced at 5.85% and 5.30% respectively, not including discount or issuance cost. Management has noted that there is a "lag" between changes in interest rates and changes in lease rates, but was hesitant to take a stand on how long the catch-up takes and how well situated the portfolio is to withstand these pressures. Interestingly, the company has drawn $1 billion in funds from its ~$7 billion revolving credit facility.

This is the first time since 2017 that the company has had net drawdowns from its revolver at all, and the first time that those net draws exceeded $100 million since 2013. While the drawn spread on the revolver is attractive, it is floating rate in nature, and to the extent it remains outstanding and rates remain elevated, the company is likely to incur more interest on these borrowings in 2023 than it did in 2022. While the revolver provides flexibility in terms of cash management, the more reliant they become on it, the more interest rate exposure they have to deal with.

Conclusion

There remains a significant amount of uncertainty based on the points highlighted above. I will continue to monitor Air Lease stock, but I am not overly bullish and see potential for a challenging next few quarters ahead. I maintain a Hold rating, with a price target below current levels.

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