I mentioned AER in my markets in semi-panic post last week, and I wanted to revisit the stock this week.
The reason is pretty simple. I'm generally rather calm during market sell-offs; in fact, they generally excite me, as I feel like a kid in a candy store getting to buy all my favorite things at a discount. But this sell off was a little more stressful. Part of that may be simple human reasons: I'm married now, and as a professional investor my livelihood at some point depends on the stock market. So maybe this sell off is the first time I've thought "O no, what if everything goes to zero and I can't provide for my family!"
But I think major reason this sell off has been more stressful than normal is Aercap. I run a concentrated book, and Aercap is a large holding. The mark to market on Aercap over the past week doesn't bother me so much; in the past, I've had larger holdings down significantly more than Aercap over the last week without a concern. The bigger issue is that it's pretty clear the near term is going to be an absolute disaster for the travel industry, and in some negative tail scenarios that disaster would result in significant and permanent capital impairment for AER (a quick reminder that I wrote up AER pretty extensively last summer, so I'm not going to go over the basics of it here. If you're not familiar with it, I'd encourage you to read that post as I'll be re-referencing some valuation points).
So let's discuss those negative scenarios. Remember that AER is a financial lessor. They buy planes and lease them to airlines (hopefully for a nice profit). Planes are a depreciating asset; after ~20-30 years, the plane will no longer be an operating asset and will only be worth scrap value (what they can break it up and sell its different parts for).
Because AER's asset base is always depreciating / liquidating, a lost year of earnings could be a disaster for them. Consider AER versus something like Facebook. If Facebook was fined a full year's earnings by the FTC or some other government agency, that would suck for them, but if you fast forwarded a full year the Facebook business would still be there. In fact, it wouldn't just still be there, it would likely have grown in value, as more people will have joined, more connections will have been made, more businesses will be looking to push their wares on facebook, etc. That's the beautiful thing about a business with a moat and growth: assuming no external shock (i.e. another social network supplanting facebook), they should continue to grow in value over time.
Compare that to AER: if AER's earnings went to zero for a full year, it would suck doubly for them. Yes, they'd lose a full year in earnings, but even worse is the fact that their assets will have depreciated in value over that year. That's a rough double whammy!
Bottom line: AER is a financial asset company. The trick with AER is to buy it for less than the assets are worth (sounds simple when you say that, right? Of course, the trick for all investing is to buy things for less than they're worth!). However, if some external force hits and wipes out a year of earnings, that's harder on a financial asset company than an operating business with a moat, because the financial asset company's value depletes over time.
Note that I'm not saying AER's earnings are going to zero or anything; I'm just highlighting why lost earnings are so bad for AER (and other lessors)!
Alright, so I've covered why lost earnings for AER are something of a double whammy for them. Let's talk about why a pandemic is so bad for AER.
AER owns planes and leases them to airlines. In general, AER will buy a plane and lease it to the airline for ~10-15 years. Once that lease is up, the plane still has15-20 years worth of useful life, so AER is exposed to residual risk on that plane (I.e. if the market value of the plane has dropped by more than AER has depreciated the plane, AER will face a loss. If it has the plane's market value has dropped less than AER has been depreciating it at, as has historically been the case, AER will book a gain). So AER there are two big risks for AER (and I admit this are very connected):
On both of those factors, AER has had general favorable factors over recent memory. Airlines have been reasonably profitable since the financial crisis. More importantly, demand for air travel has been really strong, boosted in large part by the growing demand from emerging markets. And those trends seemed destined to continue for the reasonable future: as the world got richer, more and more people would want to travel (either for pleasure or for work), which would continue to boost the demand for planes (slide below from an Air Lease Jan. 2020 presentation).
Corona, however, has changed all that. Suddenly no one wants to travel. Businesses are cancelling non-essential work trips. Consumers don't want to go on vacations. Governments are cancelling international flights to slow the spread of disease.
That's an absolute disaster for the airline industry. The airline industry has huge fixed costs in the form of their airplanes (both from the depreciation of the airplane and from the financing cost of the plane, either from taking out debt to buy the plane or from the cost of leasing the plane). So there's no demand for travel and high fixed costs. I
It's tough to say how long the current corona disruption will last. But given that fixed cost dynamic, the costs of any drop in demand is going to rapidly hit the airlines. This isn't some recession causing air travel demand to drop; this is a health scare that's basically dropped demand for travel to zero.
That's a rough, rough combo for AER. A big piece of the investment thesis is that AER trades below book and they've consistently sold planes for well above book value. If AER tried to sell a plane today, I seriously doubt the demand would be there for them to get book value for a plane (in fact, I wonder if there would be demand at all right now...).
The good news for AER is that their planes have, in general, long lease lives. So, as long as AER's customers aren't going bankrupt, AER won't be a forced seller of planes. That is something of a big if; as mentioned a second ago, demand for travel is way down and fixed costs are high. I'd be surprised if we didn't see a lot of trouble in the airline industry if Corona doesn't miraculously solve itself in the near future.
Ok, so the near term for AER looks bad.
The question is how bad could things get? And that's where I think I come out a little more positive!
First, let's look at AER's liquidity. The slide below is from AER's Q4'19 earnings release. It shows their liquidity versus their capex and debt maturities. Even if you assumed operating cash flow of $3.1B went to zero because every airline defaulted on their lease, AER would have enough cash / liquidity for the next twelve months. Yes, that's probably too simplistic for a few reasons (if every airline defaulted and AER didn't do any new leases, cash flow would be negative given interest costs, corporate overhead, etc. at the same time, we're two months into the year already, so assuming cash flow goes to zero when they've already booked two months of it is kind of wild), but the bottom line is AER's balance sheet is strong enough to handle a short term shock of pretty dramatic magnitude.
So AER's got enough liquidity that they won't be forced to do anything uneconomic in the near term. That's really good news: in two or three years, I doubt markets think much about Corona. The world economy should be back to relative normal, and people should want to travel again (just as they did after SARS, or 9/11, or numerous other events that depressed demand for travel in the short term). If AER can make it to the medium term, then all of those favorable trends should kick back in their favor.
Liquidity out the way, let's talk about how much capital impairment AER is likely to face.
I think there are two ways to do this. First, you could look at how much capital impairment the market has already put into AER's stock. Second, you could make different assumptions around lost earnings and then see what that does to the stock.
Let's start with the first method: what has the market priced into AER's stock. AER was trading for ~$62.50 before Corona fears really went rampant in late February. As I write this, it trades for $52.50, so the market's dinged it ~$10/share. With ~130m shares out, that's about $1.3B of value lost.
If you go back to my original AER post, you can see an analysis I did of the residual value of AER's planes. It was based a lot on the slide below (from ALC). The basics of it were that you take the book value of a lessors planes, subtract out the minimum future lease payments owed, and the remainder is the residual plane value risk the company's shareholders face.
At the end of 2019, AER had ~$35.9B in book value of planes and ~$28.6b in minimum future lease payments (that number is actually from Q3'19, not Q4'19, but I doubt it's changed much), for a residual exposure of ~$7.3B. So, by wiping out $1.3B of market cap, the market is basically saying that residual risk for AER is worth 15-20% less than it was before the Corona scare (see math below).
You can quibble with the math a bit. Perhaps, for example, the market is factoring in a 10% residual decrease plus some losses in the minimum future lease category as airlines go bankrupt and AER can't release the planes (or has to release them at cheaper rates). But I think the math holds, and I think that's a really big drop in residual value for an issue that should be somewhat temporary.
The other way to think about AER is to make an assumption around lost earnings and see what the market has priced in from that angle. AER has five major expense categories: depreciation, asset impairment, interest expense, leasing expense, and SG&A. The two major expenses are depreciation and interest expense. Remember, even though depreciation is a non-cash expense, it is a real expense as assets need to be replaced over time, and in AER's case it is very real as planes last for a finite amount of time and get less valuable every year.In 2019, AER had ~$1.7B in D&A expense; let's just say that's their run rate for 2020. They also had $29.5B in debt at year end and an average interest cost of ~4.2%, so annual interest expense runs $1.24B/year. Put it together and AER's two major fixed costs run ~$3B/year. In addition, in 2019 they had ~$270m in SG&A and ~$288m in leasing expenses. I would guess those costs prove to be quiet variable if the travel world does shut down completely. For now, let's just say those expenses could get cut in half in a really draconian scenario. That would mean AER's fixed cost base runs ~$3.3B/year, or ~$275m/month,
We know the market has cut $1.3B off of AER's market cap since the Corona fears really began. That's just shy of five months of operating expenses with no associated revenue. So another way to look at the recent market drop is that the market is assuming Corona will cause AER to forgo five full months of revenues while eating all of those costs before things return to normal. You could change the numbers up a bit if you wanted to: you could say the market is implying AER will need to forgo half of their revenues for ten months or something.
Yes, all of that was a simplification. Obviously if air travel shut down completely for five full months, there would be plenty of issues on the back end for AER (plane resale values would be decimated, leasing costs for finding new airlines to take their unused planes would be high, new plane lease rates would be awful as people were desperate to get money in the door, etc.). But I wanted to highlight it just to show how big a bath the market is currently implying AER will be taking.
Again, the right answer is probably something more complex than all of this. The market is probably factoring in like 3 months of half earnings, a residual decrease of 8%, and some lost minimum future leasing. But, no matter how I cut it, I think the current drop is a bit overblown when you step back and really think about how long Corona is likely to impact the travel industry.
If you think Corona will be a multi-year long event that causes countries to shut their borders down and travel to completely cease, then the market is obviously severely underestimating the damage to AER's asset base. Plane values are going to be destroyed on a permanent basis, and a ton of airlines will be bankrupt.
But that's probably way too draconian. The chart below is from AER's 2015 investor day. You can see even the dual combo of 9/11 and SARS within a couple of years barely dented the annual demand for air travel. Perhaps Corona has a slightly more dramatic near term drop than those two combined, but I kind of doubt it and even if it did the effects would almost certainly be short lived (you could also argue that air travel had a much larger global emerging market growth tailwind 15 years ago, and without that air travel is more susceptible to dipping).
Rather than thinking Corona marks the end of air travel for the world for years, if you believe (like I do!) that any impact from Corona is likely to be both severe and temporary, then my guess is that the market is way overshooting with AER. Sure, a few airlines will go bankrupt and AER will have some credit losses, but the market is currently implying that AER gets zero revenue from any of their customers for almost five months. That seems... extreme. And, in a six months or a year from now, the travel market will start to return to normal and AER will be back to selling planes at a premium to book value. That combo will make the market current implication that AER's plane's residual values are worth 18% less than they were ~two weeks ago look downright silly.
One more thing while I'm here: as I mentioned in my first piece on AER, I have a lot of respect for AER's management (I think they check a lot of the boxes for being an Outsider CEO). And, as I showed above, AER has a significant amount of liquidity even if you assume their cash flows for this year go completely to zero. A savvy management team with a lot of liquidity in a market undergoing a temporary panic is a powerful combination. At a minimum, I would expect AER to take advantage of the current share price by buying back a lot of shares. However, I wouldn't be shocked if the dislocation gave them the opportunity to pursue some really accrettive deals like sale / leasebacks at really attractive rates from an airline desperate for liquidity or taking over some smaller, overlevered competitors.
Ok, one last note (for real this time!): I'm still thinking through the implications of all this. If you've done work on it and have different views or ideas, I would love to hear them!
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Good note. You miss a couple of things:
- you only look at the implied theoretical book value hit from the stock price ($62.5) to where we are ($52.5). But book value today is actually closer to $74. So the market was already taxing the co another $12/shr in theoretical losses (not specifically corona but as part of the general risk to the asset base) which clearly you need to account for. Do that and the buffer for residual impairment rises closer to 40%...
- while I don’t think AER is selling planes aggressively at current, I think you really overestimate the near-term disclocation in demand for aircraft assets. FLY had their call a couple of days ago and said they saw no change in appetite for planes. Rates are now at absolute lows meaning aircraft are extremely yieldly assets if you look out beyond the next 6mos. The market for aircraft is likely still open, even if softer.
- it’s worth discussing how default are customers doesn’t equal losses for AER. Many of their customers end up defaulting (on debt) and still paying lessors (otherwise they lose the planes), Alitalia did this; Malaysian airlines did this (historically). Since this is likely a global phenomenon, many of the state-backed airlines may indeed need financial restructuring but lessors get taken care of because governments don’t want to cripple the routes of their state airlines.
I agree the market was wrong to discount the residual when it traded at $62.50, but i addressed that in the first post and i was only trying to isolate the effects of corona.
Sure, book value may be $74 but it's been many years since the market valued them at book. I think the buffer for *an investor* is much less than 40%.
A year ago, the market gave $AER 0.60 x book, and that was with not a cloud in the sky. That was the result of supply and demand which included $AER's own stock repurchases. Today we're at 0.60 x book, but with likely impairment to book and $AER's stock repurchases likely on hold to conserve cash. What makes you believe we're going to rerate higher and not lower (at least in the short term)?
I guess you made a small mistake in the post and double counted depreciation as it is already included in earnings.
Overall nice post and decent logic.
can you point me to the specific place I did this? I reread the post and I think I properly seperated all of the different sections, so I think you're mistaken.
ahhh now that I think about it, I think you're referring to the first section, so i get what you're saying.
Everything you write makes sense to me. Thanks a ton for the detailed updates. I'll just add that if you really want to feel pressure as an investor, have a kid!
Thank You for your article. Although, I must say I tend to view things from different perspective.
(1) Aer presented some stress testing scenarios on their last capital markets day. The leases are long term and AER consistently improves time to lease end each quarter. Effectively managing this risk.
(2) More importantly, I don't think airlines will rush to return the planes to the lessor unless they absolutely have to. There is shortage of planes and airlines industry is bit more pragmatic with pricing and thus airlines have more cushion than ever after 2000. When You return a plane you take immediate hit as you pay penalties and at the same time you loose capacity with risk not being able to get the capacity back.
(3) Supply chain of Boeing or Airbus is extremely complex. We don't know how well they can manage the supply side shocks. Although, I am willing to bet that there is no way to switch suppliers. Remember that this is very regulated industry and every airplane part has to be certified and re-certified.
I am more concern about stagflation scenarios as leasing rates are (IIRC) pegged to rates and not inflation.
Disclaimer: Long time AER holder.
Thank you for your article...I'm heavily overweight Aercap, as well... Another safety factor for Aercap is that they often make money on terminated leases b/c they keep the maintenance rights.
Do you care to explain how the maintenance rights work? Thanks
One point I that I think you are overly pessimistic about is how to correctly depreciate the planes. While accounting conventions may be to continuously straight line depreciate over time, the real economic life cycle of a plane is measured by flight hours, or more accurately, pressurization cycles. Were the planes to be grounded for a few months, their value would not expire, but would just be "deferred" to a later date. In fact, I believe that this discrepancy between the accounting rules and economic reality provides an opportunity for astute analysts.
That is an interesting poitn and something I have given some thought and considered including here. I believe if the planes are actually fully grounded, they do lose some value, but it is at a slower rate than if they were flying (i.e. if you're grounded for a month, the plane losses only a week or so of its overall life). However, I couldn't find anything to fully flesh this out. do you have any sources on it.
I am certainly no engineer, so it's difficult to quantify the exact breakdown of what eats up the useful life of a plane. However, from what I was able to glean from quora
as well as from this paper from the FAA
the " Limits of validity", (or useful life in English,) are measured by pressurization cycles and flight hours.
The fact that I have not found anyone that mentions time, coupled with the fact that even when used at capacity, they last for 25 -30 years +, leads me to figure that the effect of the time factor of a couple of months of idling is negligible.
This is why they leave planes out in the desert: https://www.forbes.com/sites/jeremybogaisky/2019/08/12/boeing-737-max-desert-storage/#6f97020b1e61
There should be a lot less than a year of straight line depreciation on a properly parked aircraft sitting there for a year.
Hi Andrew, secondhand plane values typically depreciate according to the number of pressurization cycles and the kind of maintenance programs the manufacturers provide. This is why there are still some 25/30-year old planes flying out there without posing a safety hazard.
This is a good brief explanation: https://www.airspacemag.com/need-to-know/what-determines-an-airplanes-lifespan-29533465/
Thanks for continuing to publish this blog, although at times it is a little too technical for me. Your analysis is thorough!
Enjoyed it as always, Andrew. Obviously a lot of angles to think about here - I'm less concerned than you, I think, but I appreciated the thorough stress test.
One thing I'd add is that Aengus / the industry at large seem pretty convinced that 2019 RPK growth was actually constrained by supply shortage driven by the 737 MAX grounding. You remember that astonishingly in-depth filing you tweeted about, where AER agreed to move back delivery dates for some of its 737 MAX orders? My assumption is because Boeing has customers who are desperate for the planes ASAP and Aengus got paid something to take a later slot, and that capex will instead go to repurchasing AER shares at a great discount.
To your point about the V-shaped recovery, in the near term there will undoubtedly be meaningful demand erosion (the question is how much, and for how long). But at some point, either coronavirus will resolve or people will stop caring (you can't hide in a bunker forever) - and there is clearly pent-up demand. I'm not an expert, but from what I'm reading, it sounds like Boeing won't be back at full rate for quite some time, and given all the fixes to the grounded planes, they're not all going to hit the market at once.
So, in the absence of other exogenous shocks, it seems like the market is still supply-constrained (rather than demand-constrained) over the medium term. Ryanair CCs are a good example - they are frustrated that they won't be able to reach their growth targets because they need the MAX to do so, and their most recent estimate is that they're still looking at a one to two year delay, essentially all related to MAX issues. One of the other companies I follow noted that throughout 2019, they were seeing an impact to their parts/repair business because airlines were so supply-constrained that they were unwilling to take planes offline for non-mission-critical maintenance/upgrades. Obviously demand sloshes around, so one would think that over the medium term, there will still be a very strong bid for mid-life/older narrowbodies.
I think a more interesting question in the longer term is whether there is some path-dependency here. I've long held the opinion that a lot of business travel is unnecessary - certainly not all or perhaps even most of it, but a significant chunk, I think, could be replaced by remote interaction. Clearly in the short-term, as you mentioned, there is a big pullback on business travel, and I wonder if some of this "sticks" - if management teams realize they can run their business just as effectively without this non-essential travel, and/or redeploy those travel expenses into higher-ROI expenditures. This would obviously be negative for the industry as a whole - don't think it changes the AER value proposition materially, but I'll be curious to see if this plays out at all.
On the business travel - in our own industry, I'll give the example of investment conferences. The 1x1s are useful for sure. But I've never understood why people would fly to a conference to sit in rooms and watch presentations that are webcast online - and in some cases, the transcripts even end up online. When you take the cost of planes, hotels, Ubers, and the frictional losses of time, not to mention the opportunity cost of the time spent, I've never found it to be a good ROI, myself.
Flybe bankrupt....Lufthansa grounding 20 percent of their fleet.
More to come. Stress testing needs to be revised
Great write up! Couple questions:
1. AER traded as low as .3x in 2008. While fundamentals may not support it, sentiment may drive it down. Is there a reason to believe that sentiment on AER may not sour as bad as it did in 2008? Was there something unique about that liquidity shock that with certainty may not take place this time around?
2. Seems AL and AER trade at similar PB, but AL has less leverage, slightly better returns, newer fleet. Why is AER the preferred lessor? Seems can make an argument both are well postioned if not AL being better?
Why did AER lose near 90% in early 2007? If the Virus ends up hitting air travel worse than 9/11 did and if it lingers years what is a worst case downside: Single digit pps or maybe a 60% cut to book value?
A couple of years from now, some random individual will look at Aercap share price history, focus in this point in time, and say, "oh! if it dropped again to those prices, would I buy shares by the hundreds!!"
Today, the same individual is in panic, selling like Aercap is going bankrupt tomorrow.
ps: I hope the guy in charge of share buybacks at Aercap is not taking a holiday today. What a unique opportunity .
Buybacks are paused. Go listen to the Q&A at the today's conference.
I heard already, and it makes sense. Balance sheet must come first at this point - Aengus dixit.
Curious what your thoughts are now and also have you read the book "Crash Landing"
Hi great article. I don't know much about AER and am just starting to read up. But quick question: is there an even simpler way to look at it. Their assets are the leases. The pricing of the leases assumed an implied interest rate which, in part, is based on the credit worthiness of the lessee. Those credit spreads have blown out. Leases are long duration assets. A 100bps move has a large impact on the asset value. Given AER's own leverage, this will have an even larger affect on AER's equity value? Sorry if I am off base.