2023-10-28 09:09:34 ET
Summary
- AerCap's shares are trading at a discount to book value, but with solid Q3 results and leasing momentum, they are attractive.
- The global air travel industry is rebounding, providing strong demand for AerCap's leases.
- The company has well-staggered lease maturities and is engaged in numerous aircraft leasing transactions, creating a positive outlook for its business.
Shares of AerCap ( AER ) have been a solid performer over the past year, rising about 13%. However, shares are still trading at a substantial discount to book value, likely over concerns about higher interest rates increasing its financing costs. However with solid Q3 results, leasing momentum and solid operating cash flow, I think shares are attractive and should trade toward book value of $78.
In the company’s third quarter , it earned $2.81 in adjusted EPS, blowing past estimates by $0.42. Revenue rose by 10% to $1.89 billion as AerCap has been able to renew leases at higher rates and maintain strong lease utilization levels. About 48% of passenger aircraft are leased rather than owned outright by airlines with a disproportionate share of that coming from non-US airlines who may otherwise struggle to finance their aircraft needs. Companies like AerCap buy planes from Boeing and Airbus to lease to various airlines. Because AerCap is one of the largest orderers of planes—its fleet totals nearly 1,500 aircraft—it also has the power to negotiate better discounts for planes than smaller airlines would be able to.
Right now, the operating environment is really quite strong. As you can see below, global air travel has rebound very sharply since COVID. However, global travel is still 12% below 2019 levels. For an industry growing mid-to-high single-digits pre-COVID, there is still meaningfully room for further recovery—in other words demand for AerCap leases should stay strong. I would note travel to and from Russia is likely permanently depressed (more on Russia’s impact on AerCap later), so global travel may not ever fully recover to the past trend. But there is still ample space for ongoing growth in 2024 and beyond.
Now, it is important to emphasize that AerCap does not have excessive single-year re-leasing risk. When AerCap purchases a plane, it finances that purchase with debt, typically maturing over 5 to 12 years alongside a lease of a similar period. In that way, it is matching its lease income with its debt repayments. The average outstanding term of its leases is 7.3 years.
AerCap only provides detailed lease breakouts annually, so the below table is as of the end of 2022, but you can see that it maintains a well staggered schedule of lease maturities, limiting the risk of lease rental falling off all at once. No year sees more than 13% of leases expire. I would also note that many leases provide an option for the airline to extend the lease—the below dates are the earliest possible lease expiration, but in practice as some planes will always be extended, its effective average term is likely to be even longer than 7.3 years.
AerCap is also not standing still. Just this quarter, it engaged in 86 aircraft leasing transactions. Some of these leases are for planes that would be expiring, and others are for new deliveries. Right now, it slated to have 94 plane deliveries next year, 107 in 2025, and 128 in 2026. Now on average, it is good to have the fleet well-leased out for the long-term. This provides certain cash flows for investors.
Ironically though, the market for aircraft leases is so strong, I actually wish AerCap had more leases expiring in the near-term. Now admittedly, having too much lease utilization is a very high-class problem, but the leasing market is very strong right now, and AER could probably get better lease rates on some of its plane than current contracts. As noted above, global travel demand has come roaring back. On top of this though, the supply side is quite frankly broken. As you can see, airplane deliveries have been massively underachieving stated targets.
Of course, the Boeing ( BA ) 737 MAX’s problems are a primary cause of this shortfall. That headwind to deliveries will fade, but it is not over. Just this week, Boeing lowered its delivery guidance for the 737 MAX. Beyond that, because of issues with Pratt and Whitney engines, RTX ( RTX ) expects to have 350 planes on average stored over the next two years as it fixes the problem, per AerCap management. As aviation investors following Boeing’s troubles can attest, when there is a plane or engine problem, at this point, it seems safe to assume the problems will last longer than expected. We will see how quickly RTX gets planes in the air, but I would be inclined to bet it takes longer than anticipated.
With planes being pulled out of service, and airlines not getting the deliveries they expected, there is a dash to get available leases to meet the growing travel demand. This is great for AerCap’s business.
The need for planes is also manifesting itself in other ways, namely gains on asset sales. AerCap depreciates planes every quarter, based on their useful life. To maintain the best lease rates, it keeps a young fleet, less than ten years old on average. As planes age out, it sells them with the average age of a plane sold is 15 years . Its depreciation schedule errs on the conservative side, resulting in a typical gain on sale of 8-10%. This year though, it has been averaging a gain on sale of about 20%, a ~$400 million benefit to earnings. Airlines are paying up for old planes because it is so difficult to get new ones delivered. Right now, it has $420 million of planes for sale, aiming to execute on that in Q4, with sales in 2024 likely to be in the $2.5-$3 billion range.
Given these tailwinds, AerCap raised guidance to $9.50 in adjusted earnings. This includes gains on sales, and underlying earnings will be about $8 excluding that. Even if we treat 100% of the gains as one-time items, at $8, shares have less than a 7.5x multiple. That is an extremely cheap stock, seemingly, which means the market has some concerns. The environment for leasing is strong though, and besides, it is well leased for the next few years. I believe the primary concern is tied to interest rates and the fear that rising rates will begin to erode margins. AerCap mostly debt finances its balance sheet with a debt-to-equity ratio of 2.5x.
As you can see below, AER has meaningful future financing commitments, both in terms of paying off maturing debt and buying new planes from manufacturers. These total $11 billion over the next 12 months and $16 billion in calendar 2024. Right now, the average cost of its debt is just 3.5%, and that will rise, though new leasing pricing is based off of the financing environment and should somewhat offset higher rates.
Now AerCap does generate $5 billion in operating cash flow from its leases, and it should have about $2.5 billion of dispositions. I would also note that purchasing obligations may come in below these levels if Boeing and Airbus cannot meet delivery needs. Still, in 2024, between its revolver and issuing long-term debt, AER will likely need to borrow about $7 billion—essentially it will have to roll over rather than pay down its unsecured debt. Assuming a 2% higher borrowing cost, that is a $0.50 headwind to EPS. Now, this is likely to prove a harsh estimate as it has new planes being delivered with higher lease rates in keeping with the financing costs associated with them. That still leaves $7.50 in earnings power in this pessimistic analysis.
We also have evidence of how cash generative AerCap’s business is, and it has proven resilient to higher rates this year. Year to date, its liabilities are down $300 million while assets up $1.9 billion. Even as it has de-leveraged its balance this year, it has aggressively been buying back stock. In Q3, it repurchased $1.2 billion of stock, as it has taken GE’s ( GE ) stake in the business down to 15% from 45% at the end of last year. After having to pause buybacks after COVID and the Russia-Ukraine war, they have come back with a fury in 2023. Alongside this quarter, the board authorized another $500 million program.
This gets me to the positive tail risk that shares are discounting. Last year, it took $3.1 billion of write-offs from Russian equipment. When the war began, planes it leased to Russian carriers were essentially stranded there as Russia functionally stole the aircraft, engines, etc. AER has insurance on its planes, and there is a question over whether this is covered by the policies. During Q3, AER received $646 million in recoveries from cash insurance settlements related to 17 planes leased and lost to Russia’s Aeroflot. Its losses clearly are much greater than that, and there are several billion in lawsuits over these claims set to go to trial in England next year.
I cannot say who will win these cases, or if they get settled to avoid the expense of a courtroom battle. It may take several years to entirely resolve, but since the assets have been written down and are already excluded from AER’s $78 book value, they only offer upside risk to AER. Every billion it receives from insurers essentially amounts to a $4/share windfall and will likely pave the way to even larger share buybacks. To me, this at least balances out the risk of higher interest rates.
Overall, AER reported a solid quarter. Leasing revenue continues to rise, and new leasing activity is strong. Given the supply-constrained aircraft market, we should continue to see strong leasing activity and wider margins. In my view, AER is positioned to pass on higher interest rate costs, given this environment, but beyond that, potential insurance settlements provide a possible positive offset. With $7.50-$8 in earnings power, a buyback aggressively reducing share count and an ability to sell planes above their book value, I believe shares should trade to book, which would still be just 10x earnings or $78. That provides about 33% upside, making AER a very compelling opportunity.
For further details see:
AerCap: Strong Q3 Results And Potential Insurance Claims Make For A Compelling Opportunity