Why AerCap(AER) remains one of market's best deals
Disclaimer: Noting in this post should be construed as investment advice. Do your own research!
The Industry
AerCap is in the business of leasing planes, engines and helicopters to airlines and other aviation operators. Aircraft leasing has seen a huge rise in recent years with over 50% of planes aircraft being leased from lessors. There are 3 main ways for lessors to operate. The first is to enter sales-leaseback transactions with airlines. This is not a very good business as there isn’t any moat, the planes are often older planes that lose the most value in a downturn, and you have to compete with other financing option like equipment trust certificates that allow a company to leverage their planes to reduce borrowing costs. The second option is to buy older planes when airlines are done with them and lease them to another airlines. This is again a low return business as there is no moat. The third option is to order new planes from the OEMs (primarily Boeing and Airbus) and then place them with Airlines. It is the general practise of AerCap and their peer Air Lease Corp (AL) to lease planes for the first 7 years of their lives and then either sell them or renew the lease with the airline. This provides a few advantages over the other options. Firstly AerCap and Air lease are able to place orders with the OEMs when air travel is in distress. During times like 2020 the last thing airline shareholders were interest in was the airline making purchase orders, and they likely would not have been able to receive get financing anyway. The second benefit is that they are the largest buyers of planes, the largest airline by fleet size is American Airlines at around 880 planes, some of which are leased from AerCap, meanwhile AerCap owns over 1,700 aircraft. These two factors allow the lessors to buy planes at a lower price to everyone else. Another positive is that they sign leases 2-3 years prior to delivery so they are fairly well protected against a downturn and know the planes will be placed.
Another very positive factor for the leasing industry is how tight the market is. Due to combination of factors including engine manufacturing defects, Boeing being a mess, supply chains still recovering from Covid, and engine MRO(maintenance repair and overhaul) facilities closing and being very slow to reopen the supply of planes is very short and this is likely to stay the case for 5+ years. AerCap and Air lease should be able to sell their planes for more than book value when leases roll off, and they should be able to demand high leases on their planes as they are delivered. Both companies have large order books but Air Lease has a bigger book relative to their current size. I am mostly discussing AerCap in this piece but I encourage people to look at Air Lease too. I am long both.
Financials
There are a few things you need to know about AerCap’s financials. First is that the planes are depreciated on a straight-line 25 year timeline. This means that depreciation expense is the same on a plane in the 12th year of a lease as it is in the first year of the lease. Effectively a lessor with planes all near the end of their leases would have a superior return to a lessor with all new planes. Secondly, the lessees are required to pay security deposits that guarantee the condition of the plane at the end of the lease. Thirdly, when a lease is extended the revenue gets recognized immediately. To give an example if a plane is leased for 7 years at $4m a year and at the start of year 5 an extension was signed for an additional 4 years at $2m a year the extension would be spread over the initial lease as follows:
this is just something to keep in mind when reviewing results as it is pretty stupid and unintuitive that revenue is done in this way. It is not very relevant on a go forward basis though as the company’s strategy is to mostly sell planes when leases expire. Similarly during Covid AerCap entered into some Power by the Hour leases where for the first 2 years the rents were tied to aircraft usage and for the next 5 the payments were a flat rate. For revenue recognition purposes the flat payments were spread over the first 2 years as well while the power rents were recorded only in the periods where the usage occurred.
The final thing to consider in the financial policies is the net spread metric. This basically shows how much the company is earning on equity by taking rent revenue- interest expense - D&A and dividing by Lease assets. This metric was down from Q4-22 to Q4-23 because of less extensions due to plane sales and ending of power by the hour arrangements. Also due to the planes being placed 2-3 years before delivery the new planes are coming in at rates negotiated in early 2021 so the rents received should be increasing quite soon.
In terms of earnings in 2024 the company did net income of 3.1 Billion. Of this $490M related to gains of sale of Aircraft and $1287M related to insurance recoveries related to planes seized by Russia (I will touch on this later). I do not believe that the gains on sale should be adjusted out of revenue as they represent the Aircraft market fundamentals and management has indicated that they should be repeatable this year. After adjusting for the insurance recoveries the PE was 9.25x which still represents a bargain valuation based on the fact that it should be at least repeatable for years. In terms of guidance for the current year management said $7.5-$8.5 in EPS but then basically admitted that they would really earn more. Here is the full quote from the CEO
So look, last year, our initial guidance for 2023 was EPS of $7.00 to $7.50 and we ended-up producing EPS of $10.78. This year we're guiding to $7.50 to $8.50, so you can make an estimate as to where we'll end-up. It's the same management team running the company. We did the projections on the same basis that we did last year. And of course, we'd hope to beat those numbers the guidance excludes gains on-sale, it includes estimates for default costs and higher interest rates and there is good reason to think that we could outperform on all of those items
While the tight market has shown up in the prices realized on sales it has not really appeared in lease rates so this gives a lot of room for growth on that front.
The Russian Plane Situation
When the war between Russia and Ukraine broke out AerCap had 135 planes and 14 engines in Russia. These planes were unable to be retrieved by AerCap and will likely never be flyable in Western airspace as they have been maintained using unlicensed third party parts. AerCap recorded an impairment charge of $2.7 Billion which represented the book value of the planes minus the maintenance deposits which AerCap got to keep. Since then AerCap has managed to recover the $1287m mentioned above. The planes were covered by both AerCap’s insurance and the Russian Airlines’ insurance. The present recoveries have all came from the Russian insurers but they only cover 64/135 planes and the balance on those planes is still owed by AerCap’s insurers. Legal proceeding have been initiated against the insurers and claim of around $2.18 Billion is still outstanding and the facts seem highly favorable to AerCap. Obviously AerCap is not the only company that is owed a lot by the insurers and the lawyer for Carlyle aviation has suggested that some insurers could be insolvent. It is worth noting that hardly any of the existing payments have been made by real insurance companies, rather the Russian government transferred funds to their state insurer to basically buy the planes for the airlines. Overall it seems like the claim should be successful and I’m not a legal expert but I see AerCap getting at least $1.5 Billion in recoveries which can all be deployed into buybacks
Management
The company is clearly pretty well ran by their CEO Aengus Kelly. He has been in aircraft leasing since 1998 and has been the CEO of AerCap since 2011. Over his tenure he has made very astute decisions like purchasing GE Capital Aviation Services(GECAS) in 2021. AerCap bought GECAS for a discount to their book value and locked in financing at 2.6% for 7 years. Aengus Kelly has repeatedly made statements that show that his first priority is creating value for shareholders and he owns 2.8% of the shares himself. In 2023 he used the companies strong Cashflow to repurchase 18% in shares without taking on extra leverage which is almost unheard of for a company to do. The manor in which management did this also reduced risk as they were selling the older aircraft in the fleet to buy back shares. It is also worth noting that a relatively small increase in the planes values can have a large impact on earnings given that the company uses leverage to buy planes. Aengus broke it down like this on the earnings call
In 2023 AerCap sold 74 aircraft, 65 engines and 28 helicopters. These assets were held in our books for $2.27 billion. However, we sold them for $2.76 billion generating a gain of $490 million. This equates to a 22% gain on the carrying value of the assets. But importantly, an 80% gain on the equity component of those assets. So, after repaying The $1.66 billion of debt attaching to those assets to keep our leverage-neutral. We have $1.1 billion to deploy into share repurchases
In the Q3 earnings call he said the following when asked if he would order more planes
As I said many times, there's always a bunch of clowns hanging around the tents in Farnborough and La Bourget waiting to order aircraft when everyone else is there. That's not the time to be ordering airplanes. The last time we ordered a significant number of airplanes was in March of 2020 when we ordered NEOs. That is when you buy. That's also in the same environment when you bought GECAS. So great discipline is required, and that discipline is dealing with the manufacturers, but just overall in the capital structure, realizing why you're here. You're here for your shareholders and no one else.
Conclusion
Overall AerCap should be able to deliver strong financial performance for years to come and while the recent price action has been strong there is still plenty of room for both EPS growth and multiple expansion. The main question is if this is a better play than Air Lease who trade at a much bigger discount to book, have higher potential Russia recoveries as a percent of book, and have a larger order book coming off a smaller base. I hope everyone enjoyed reading!
Succinct write up! I am wondering if this trades on current book value or forward bv, and if you have any suggestions on how to model the projected BV for this type of company. Thanks!