WLFC - Willis Lease Finance Corporation: Significantly Undervalued Assets And Strong Industry Tailwinds

2023-10-30 02:30:51 ET

Summary

• Willis Lease Finance Corporation is a good business that is likely to continue growing.
• The company's book value is significantly understated due to the recording of assets at cost and the acquisition of cheap assets during COVID-19.
• WLFC is well-positioned to benefit from the upcoming spike in MRO visits and the scarcity of spare engines, creating a high demand for their services.

Thesis

I believe Willis Lease Finance Corporation ( WLFC ) is a good investment and that the stock has a ~232% potential upside. The company’s book value is severely understated because the engines and equipment are recorded at cost, the management has been smart in asset acquisition (buying cheap assets during COVID), and engine value has been rising due to scarcity. According to my calculation based on a credit rating report of WLFC’s Willis Engine Securitization Trust that was published only a couple of days ago, WLFC’s non-GAAP book value is worth ~ $133 a share vs. ~$65 GAAP book value on the balance sheet.

WLFC is also a good business that will likely thrive in the extremely favorable current environment : Financing and engine prices would be too high for new entrants while WLFC enjoys long-term fixed low rates and cheap engines secured during COVID-19 . Historically, there has been a high correlation between WLFC's pre-tax income and interest rate level because engine lease rates increase with interest rate but the majority of WLFC’s debts are long-term with locked-in interest rates. The upcoming MRO visit spike will create a huge demand for spare engines. Asset utilization will also recover as airlines coming out of COVID (currently 84% vs. > 90% pre-COVID ).

WLFC is a family business with aligned management that has been in the aviation industry for generations. There have been t hree management buyout attempts in the past (2023, 2021, and 2015) at 0.8-1.1x GAAP book value vs. 0.6x GAAP PB today which greatly reduces the downside. Today, WLFC is trading at 0.6x GAAP P/B ratio which deviates from the historical level (0.8-1.3x) despite the tailwinds mentioned above.

Last but not least, there is ~$20 million of possible insurance recovery from asset write-off in Russia as other companies settle with insurance carriers .

Business History

WLFC primarily engages in aircraft engine leasing and offers supplementary services such as engine management, maintenance services, and spare parts sales. In simpler words, WLFC leases spare engines to airlines when the engines on the wing are overhauled.

WLFC has been a pioneer and provider of aircraft engine leasing services for over 45 years. When the ex-CEO Charles Willis founded the company 45 years ago, leasing jet engines to commercial airlines was actually a "new and radical" idea. WLFC has since purchased, leased, and sold more engines in more countries over a longer period of time than any independent competitor.

Through two of its wholly owned subsidiaries, Willis Engine Management and Willis Aero, WLFC can provide an integrated end-of-life engine solution. Willis Engine Management engages in providing engine management/maintenance service. The number of engines under its management grew from 40 in 2015 to 289 in 2020. Willis Aero engages in the sale of spare parts and technical support. It was launched in 2013 to augment WLFC’s business model, which has proven effective: WLFC’s net income from the sale of spare parts grew from almost $0 in 2013 to $12 million in 2019, accounting for 18% of the total.

The Leasing--Managing--Selling model has the following advantages:

1. The synergies between the engine management business and the leasing business can reduce operating costs.
2. WLFC’s history shows management’s effort to keep augmenting the business model, a quality that virtually all competitors lack.
3. The Leasing--Managing--Selling model creates lots of cross-selling opportunities such as offering management/repair service to engine lessees, attractive equipment acquisition opportunities provided by management service customers, etc. This also provides convenience to customers.

These qualitative “moats” are backed by stellar numbers: From 2010 to 2019, WLFC's pre-tax income grew from $20 million - $89 million (20%CAGR), while revenue grew from $148 million to $409 million (11%CAGR).

Industry Background

Aircraft engines are good assets to own because their value remains at almost 100% over many years since each major overhaul restores value. A quick research would show that most engines only appreciate in price until their host aircraft is retired. All of WLFC’s engines are phase I or phase II engines, which eliminates the risk of a decrease in engine value.

Here are two charts that show the appreciation in engine price over time:

Note that the drop in the chart below was due to the retirement of aircraft and engine part-out, not oversupply.

Here is how spare engine leasing works: after a certain amount of flight hours (TBO, time between overhauls), an engine needs to be overhauled by MROs, which is called a “shop visit”. When airlines take their engines to shop visits, they need spare engines to keep the aircraft flying. That’s why they lease engines from WLFC.

During COVID, because most aircraft were grounded therefore needing no engine shop visits, MRO visits significantly decreased. After COVID-19, although airlines recovered, MRO events were still depressed because of the underutilization of engines during COVID-19, as shown in the chart below. Trade articles say these MRO events are pushed back to the “second half of 2023” and this is why WLFC has never recovered to pre-pandemic level in the past two years but will likely have a very high margin in the next 12 months. Per Oliver Wyman's report , aircraft engines are the largest segment of the MRO market, with the highest forecast CAGR. By the end of the forecast (2033), engine MRO will represent 50% of the market versus 45% in 2019.

Other trade reports also suspect that MRO issues will be long-term. This will benefit WLFC in the long run. FTAI recently entered the MRO business and its hefty valuation more or less reflects the importance of MRO.

Barrier to Entry

WLFC is very selective about business partners. They don’t like doing business with unstable airlines (ones with legacy issues and unions, etc.) and like state-owned airlines that virtually will never go under. The relationships with high-quality airlines are very hard to replicate. If the competitors lease to unstable airlines (start-ups) to achieve growth there are way more risks.

In a triple lease, the lessor centralizes the maintenance of engines instead of letting individual airlines arrange overhauls themselves. Value is created in this process because engine repair and deployment/management require in-depth technical knowledge and could become a bottleneck for airlines. Customers pay lessors a maintenance reserve that is less than the cost if they were to manage the engines in-house.

The Willis family said the best macro environment for their business is when the economy is not so good that airlines are flushed with cash but also not too bad for airlines to operate normally. This is exactly what the macro looks like today.

Understated Book Value

I’ve always believed WLFC’s book value is significantly understated due to the following reasons:

• The company is good at bargain hunting (i.e. issuing large amounts of debts at low fixed rates during COVID to buy cheap engines) but only records them at cost.
• Engine value surged post-COVID. According to several trade publications, there is currently a scarcity of aircraft engines. A program coordinator at EAP said : “You now can’t find spare engines out there...People who weren’t on a program thought they could just buy an engine, but now they’re [finding themselves] grounded, or sending their engines through the [MRO] shop at great expense.”
• Indian airline giant IndiGo was forced to ground 30 planes, or 10% of all aircraft, due to a lack of engines. Trade publications indicate that some engines are seeing their value increase by 20-30%.In 2Q23, competitor FTAI sold 17 engines and 17 aircraft for $101.5 million, a 31% NBV gain of $31.9mm.

The data points above led me to believe that WLFC’s book is understated. However, KBRA released the WEST VII presale report only days ago validating the thesis with concrete numbers. As shown in the models below, by dividing the outstanding balance of each of the Willis Engine Security Trusts by their respective LTV disclosed in the credit report which was calculated based on the most recent appraisal, the engines that are funded by the WESTs should be worth $1.353 billion. 50% of WLFC’s engines are funded by WESTs, and the rest are funded by equity (10% conservatively) and revolver (40%). If we assume a similar valuation for the other 50% of engines, WLFC’s lease book should be worth $1.353 * 2 = $2.706 billion. The lease book is recorded at $2.162 billion in the last quarter. So the engines alone should add ~$68 worth of book value per share after 20% tax(vs. current stock price of $40 and current PB of 0.6x). So my estimated book value per share for WLFC is $68 + $65 = $133 .

According to a PR on Oct 19th , WEST VII is priced at 8.000%, with an expected maturity of approximately six years, an expected weighted average life of 4.6 years, and a final maturity of 25 years. The Notes will be issued at a price of 98.84814% of par. This shows how much value is in the WESTs and the pricing of leases has to have really gone up given the pricing of WEST VII is what the market rate is.

For the sake of conservatism, I will ignore the fact that WLFC’s debts are trading at 70%-80% of par due to their low fixed interest rate. These debts could theoretically be bought back at a large discount which creates even more book value for potential acquirers.

Benefits From Rising Interest Rates

As of June 30, 2023 , the Company had $1,966 million of equipment held in the operating lease portfolio, $95.0 million of notes receivable, $14.0 million of maintenance rights, and $5.8 million of investments in sales-type leases, which represented 348 engines, 12 aircraft, one marine vessel, and other leased parts and equipment. WLFC has a total debt obligation of $1,827 million, which comes from two sources:

Willis Engine Securitization Trust III, IV, and V (WEST III, IV, V) are three asset-backed trusts. The structure of the WESTs gives special advantages to WLFC compared to other leasing companies, and the management has been improving it for a long time. The WESTs have the following features:

• Long-term : Notes issued by WEST III, IV, and V account for 59% of WLFC’s total debt obligation and carry an average interest rate of ~4.1%. The ADR is around 2026-2029. WLFC constantly had a 3x EBITDA ($195 million)/Total interest expense ($65 million) ratio DURING the pandemic . This ratio was even higher before the pandemic (4-5x).
• Cash generation : WLFC receives monthly fees of 11.5% as servicer and 2.0% as administrative agent of the aggregate net rents received by the WESTs

Revolving credit facility - The credit facility carries a floating interest rate of one-month LIBOR plus 1.75%, which revolves until the maturity date of June 2024. WLFC has been consistently upgrading the facility to increase borrowing capacity. Per the last 10Q, WLFC has borrowed $758 million from it, accounting for 41% of the company's total debt.

As shown in the chart below, WLFC benefits from rising interest rates because it borrows a large amount of long-term funds at a fixed rate, and the engine lease rate increases with interest rate therefore increasing WLFC’s margins. This is validated by the high correlation between WLFC’s Pre-tax Income and Federal Funds Rate in the past. Most of WLFC's debts won't come due until 2027 .

WLFC is already seeing significant improvement in the ratio of leasing segment revenue as a percentage of utilized lease books, which increased from 14% in 2022 to 19.7% in 2Q23, compared to 20% in 2019. Meanwhile, the pre-tax income margin increased from 14% in 2Q22 to 18% in 2Q23. I expect this trend to continue.

Aligned Management and Three Take-out Attempts

The Willis family is a little aviation "dynasty": Charles F Willis Jr. , the father of the founder of WLFC, was a commander in the Navy who earned the Distinguished Flying Cross three times, three Air Medals, and a Purple Heart. After the war, he engaged in Eisenhower's campaign before becoming the president's staff (assistant to the assistant to the president). Then, he entered the private sector and served as the chairman and CEO of Alaska Airlines from 1957 until 1972. He was buried at the Arlington National Cemetery.

Willis Jr's son, Charles F Willis IV, founded WLFC. According to an early interview, he sees special advantages in leasing engines over leasing aircraft:

Early on, Willis dabbled with the thought of leasing aircraft but quickly abandoned the idea in favor of engine leasing. Today he has no doubt he made the right decision... "At the end of the life of an aircraft, you can determine its value by the worth of its engines,” he says. “That should give you a good idea of where it’s best to be in the food chain — you really want to be in engines.” ...He also invented the idea of the securitization of pooled engines...In 2005, the company undertook what it calls the first-ever securitization of a pool of leased aircraft engines when it closed the Willis Engine Securitization Trust, selling $228 million in term notes. However, his most distinguished initiative is the creation of an engine “pooling” program that is being employed by Willis Lease around the world. Willis says “Roughly 90% of the airlines in China are currently participating in the program, under which the company and the airlines pool their engines together and lease from each other."(Interview in 2007)

Austin Chandler Willis , the current CEO of WLFC and the son of Charles F Willis IV, founded and operated 2 aviation part sale and management-related firms, was enlisted in the Army, and holds a bachelor’s degree from the London School of Economics and Political Science.

After the new CEO took the helm, he started writing letters to shareholders again after it was stopped for two years. The company also developed a brand new website with significantly more information than the old website from decades ago and visibly ramped up the frequency of press releases. I see all of this as positive indicating the new management’s emphasis on investor relations.

The company also has a history of repurchasing stocks, as the amount of total outstanding shares was reduced from 8.6 million in 2012 to 5.8mm in 2019, a 33% reduction over 7 years. I expect more stock repurchases to come if the shares continue to be undervalued as it aligns with the management interest as well. The management has attempted to take WLFC private three times at 0.8x-1.1x book value vs. today’s 0.7x P/B. None of them closed.

Why did management withdraw buyout offers several times?

• There are many players/PE in the market (e.x. Carlyle) and if they buy WLFC and cut the admin cost it would be very profitable. So when the Willis family attempted to buy out other players would approach the board and offer a higher bid. This is also why there was an “exclusivity” clause in the last buyout offer that says the board can only work with the Consortium.
• In my opinion, the management knows the offer is low-balled (since they have offered at higher PB before). It would be easy for stockholders to assert a stockholder appraisal on the company’s assets given that it is incorporated in Delaware.
• They never state what the “fair value” of the company is in buyout offers because they don’t want to face legal remedies if an appraisal were to take place.
• The last buy-out offer was $58 vs. $40 share price today.
• They couldn't secure much financing to raise the offer during COVID.

Why will it likely be sold in the future?

• If the company stayed public, the IRS would argue that the tax basis for Austin Willis the son would be whatever the share price is when he inherits the company. If the company was private, the tax basis would be based on appraised asset value which would be substantially higher than $40 a share.
• From my conversations with major shareholders who've had direct interactions with the Willis family, I think the son may not stay in this business forever.
• A large amount of the Willis family’s fortune is tied up with this one company. Black swan events such as COVID and the Russia-Ukraine war would put their family wealth at risk therefore it’s reasonable to speculate that the family will try to diversify their asset.
• There are likely many buyers that offer very good prices such as Carlyle, the Japanese companies, etc.

Why have insiders been selling recently?

• They’ve been doing it for decades. They get most of their paycheck in stocks. If you look at historical records, they do it regardless of the cheapness of stock.
• Their legal person is very by the books, so insiders can only sell during a really short window. This probably explains why all of them sell together.

Valuation

Methodology: I believe the PB ratio is the best benchmark for valuation, as WLFC has the characteristics of a financial institution and holds relatively liquid assets with high residual value.

Bull case: 1.3x; Base case: 1x; Bear case: 0.8x.

These multiples are justified because:

• Management has been trying to take the company private at 0.8x-1.1x GAAP P/B
• In 2019, the company was trading at ~1.3x GAAP PB at its peak.
• During the past decade, the company has been trading at ~0.8x PB
• Sanity check: pre covid, Air Lease ( AL ) was trading at >0.9x PB.

If we use GAAP book value ($65), at 1.3x PB bull case the stock should be worth 1.3 * $65 = $84.7, with 109% upside; at 1x PB base case, the stock is worth $65/share, 58% upside; at 0.8x PB bear case, the stock should be $52, 26.7% upside.

If we use my estimated book value ($133), at 1.3x PB bull case the stock is worth $172, 332% upside; at 1x PB base case, the stock is worth $133/share, 232% upside; at 0.8x PB bear case, the stock has 166% upside.

I believe the fact that the stock delivers excellent results in both scenarios really shows how large the margin of safety is.

What the Market Missed

• The stock crashed after the management (along with its partners Mitsui & Co., Fuyo General Lease Co., and JA Mitsui Leasing) withdrew their offer to take the company private at $45 a share.
• This is an obvious lowball offer as the management has made higher bids before, and the stock surged to $60+ after the offer was announced in the hope that the management would revise its bid. The stock was probably over-sold by arbitrage players.
• Lumpy earnings due to COVID disruption, which caused the stock price to nearly halve from the 2019 level despite the company currently having a record high book value.
• Future Industry dynamics such as a shortage of spare engines and an increase in MRO visits make WLFC’s book value severely understated since WLFC records its assets at cost. This is backed by a debt rating report published a couple of days ago that the market completely missed.
• Significantly under the radar as there is no analyst coverage, no earnings call, and little press release.
• The letter to shareholders was stopped for two years and was resumed in 2023 under the new CEO. This could be perceived badly but the reality is that WLFC is a family business, and the management is focused on the business, not attracting investors.
• The management borrowed a large number of long-term funds during COVID despite a tough macro outlook at a fixed low interest rate which was used to purchase very cheap engines. The company is set to benefit from a higher lease rate with a lower asset cost base secured during COVID-19.
• Possible insurance recovery from asset write-off in Russia.

Catalyst

• I believe next quarter's earnings will be great given the industry dynamic and WEST VII pricing mentioned in the write-up.
• Take-out offers from outsiders or management at higher prices.
• Good business in a great environment, which will drive growth in both topline and profitability.
• Accelerated share repurchase as less cheap engines are available for Capex investment.

Risks

• High executive compensation. I believe the management is overpaid, but they are hard workers too. The CEO personally flies around the world to close deals. One of the risks we have to bear.
• “Black Swan” events that negatively impact the aviation industry such as COVID.
• Geo-political risks due to WLFC’s large international operation scale. However, WLFC does not have any assets in "hotspots" such as Israel or Palestine.

Conclusion

As an integrated leader in a niche industry with well-aligned management and a proven track record, WLFC is a good business that was disrupted by COVID. Other than recovering along with the aviation industry, WLFC is set to benefit from the engine shortage created by the under-supply during COVID and supply chain disruptions post-COVID, and the increased amount of MRO shop visits which will create demand for spare engines. Moreover, WLFC makes a good hedge against rising interest rates given the historical correlation between its revenue/EBIT and interest rate, since the majority of WLFC’s interest expenses are locked in through long-term debts while lease rates increase with market interest rate. The thesis should come to fruition in the next twelve months as the industry is already experiencing engine shortages and inflated MRO visits.

The downside should also be limited as I believe the true book value of the company is more than two times larger than the book value on paper, and the management has tried to take the company private three times at 0.8x-1.1x book value vs. today’s 0.6x GAAP P/B . With a large engine book valuation buffer, it’s a head I win, tails I don’t lose much situation .

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