guvendemir
At the end of 2022, I wrote an article about why investors should avoid the airlines (JETS) and own AerCap (NYSE:AER) instead for exposure to the airline industry. The relative returns in 2023 validated my view:
The longer-term view also validates this view:
As you can see above, whilst the airlines haven’t quite recovered from the COVID-19 drawdown as yet, AerCap delivered strong returns in the same period.
It is largely a feature of the business model. Airlines are exposed to a range of risks such as supply chains, inflation, oil price, and passenger demand, whereas AerCap’s business is akin to structured finance business collateralized by the metal (e.g. aircraft, engines, helicopters). In essence, it needs to make sure that it is repaid or otherwise it repossesses the asset instead and redeploys or sells it to recover monies owned. It is rare for AerCap’s balance sheet to be materially and/or permanently impaired.
In recent years, AerCap has gone through its share of stress tests including COVID-19 as well as the Russian and subsequent confiscation of its Russian leased aircrafts. Still, AerCap managed through these headwinds surprisingly well and managed to go on the offense with the GECIS acquisition at a meaningful discount to book value and intrinsic value.
The Valuation
Given its business model (collateralized lending), AerCap’s valuation is intrinsically tied to its book value. As can seen in the below chart, in “normal” times AerCap typically trades at a slight discount to its (growing) book value (~0.9x-0.95x book).
The spikes in the chart reflect noise from acquisitions AerCap made whereas the dips are market-driven or risk events (e.g. 2016 China-related markets sell-off, Q4-2018 Fed induced sell-off, March 2020 COVID-19 & February 2022 Russia-Ukraine war). All these drawdowns have proved to be temporary and great buying opportunities. The COVID-19 drawdown was especially lucrative and brave souls who bought at the trough would have made a 7x return since.
Current Book Value Is Materially Understated
This article summarises in great detail the assertion that the current book value is materially understated. I broadly agree with the author and note the following three key reasons:
- The current book value does not include likely recoveries relating to Russia (a total of $2.7 billion). AerCap has already recovered ~$1.2 billion including the current quarter recovery of $572 million. Additional recoveries will probably be achieved either through “all-risk” insurance or further settlements.
- AerCap is currently selling assets at a premium of mid-20s to stated book value. This is also validated by various reports of surging aircraft values and lease rates.
- AerCap’s acquisition of GECAS was completed as a discount to book value (~$3 billion). Per acquisition accounting, the total (discounted) consideration is allocated to assets proportionately.
So it is quite a credible assertion that AerCap’s book value is materially understated. The abovementioned article estimates the “true” book value to conservatively be ~$123 compared with the reported ~$78 currently.
Capital Allocation
AerCap does not pay dividends. The management team sees the most efficient use of capital allocation to share buybacks at below (grossly understated) book value or accretive, opportunistic acquisitions (such as the GECAS).
Before 2020, AerCap typically sold assets at a premium to book of 8% to 10% on average. It then utilized the proceeds to buy back shares at or below book value. This yielded an outcome of ~130%+ of book equity. In today’s market dynamics, the opportunity is much more lucrative, and with a premium of ~25% above book, this translates to ~200% of book equity gain. This is exceptionally accretive to shareholders as the CEO highlighted in the 3rd quarter call:
So, in essence during the last quarter we sold aircraft at almost 200% of their book equity value to expert aircraft buyers and repurchased our book equity at 80% of book value in the public equity market. These gains speak to the deep embedded value in our portfolio, and the strength of our book values.
As an investor, I highly value a management team that is a great capital allocator, and AerCap management has the track record:
the only thing that we think about is how to create value for our shareholders. As I said at one of a conference recently, my shareholders pay my wages. The shareholders of Boeing and Airbus definitely do not. And so we are more than happy to order aircraft when we believe that the price is right for the risk we’re taking. There are plenty of ways to grow in this business, it can be sale-leasebacks. It can be orders from the manufacturers. It can be M&A, it can be repurchases of shares, return of capital to our shareholders. But one thing we will never do is grow for the sake of growth. 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.
The above quote from the Q3 earnings call is certainly music to my ears.
Final Thoughts
The Street continues to under-appreciate AerCap’s potential. The Q4 consensus earnings of $2.44 is way below my estimate. I expect Q4 EPS to be in and around $3. By the end of 2023, AerCap would have bought ~20% of outstanding shares and is on track to buy ~15% in 2024.
Finally, the current favorable industry dynamics are likely to be sustained for at least four more years or even longer as per Aengus Kelly (AerCap CEO) recent CNBC interview.
I expect AerCap to compound book value and share price for many years to come. I rate it as a strong buy with a 12-month price target of $95.
