AerCap Holdings NV (ISIN NL0000687663) – How good is Einhorn’s new favourite ?
A friend forwarded me the latest presentation from “guru” David Einhorn where his main long pick was AerCap, an Airplane leasing company.
To shortly summarize the “Long case”:
– AerCap is cheap (P/E 9)
– they made a great deal taking over IFLC, the airplane leasing division of AIG which is several times AerCap’s original size
– they have great management which is incentivized along shareholders
– The business is a simple and secure “spread business”
– major risks are according to Einhorn mostly the credit risk of the airlines and residual value risk of the planes
There are also quite obvious reasons why Aercap is cheap and trades at lower multiples than its peers:
– share overhang: AIG accepted new AerCap shares as part of the purchase price and owns 45,6%. They want to sell and the lock up is expiring
– following the IFLC/AIG transaction, the company was downgraded to “Non-investment grade” or “junk” and has therefore relatively high funding costs compared for instance to GE as main competitor
What kind of business are we talking about?
Well, Airplane leasing is essentially a “special purpose lending business” without an official bank license, one could also say it is a “shadow bank”. What Aercap essentially does is to loan an airplane to an airline.
In order to make any money at all, they have to be cheaper than the simple alternative which would be the airline gets a loan from a bank and buys the airplane directly. As Airlines are notoriously unprofitable and often thinly capitalized, they often need to pay pretty high spreads even if they borrow money on a collateralized basis.
As any lessor funds the plane mostly with debt, the cost of debt is one important factor to make money compared to competitors. It is therefore no big surprise that GE with its AA+ Rating is the biggest Airplane leasing company in the world and that ILFC thrived while AIG was still AAA and had comparably low funding cost.
Airplane buying is tricky business
A second aspect is also clearly buying power. Planes have to be ordered many years in advance and the two big manufacturers want to be sure that they are getting paid. I assume a reliable bulk buyer gets better access to the most sought after planes and maybe even better prices. Prices for planes at least in my experience are notoriously intransparent. Nobody pays the official list prices anyway. I found this interesting article in the WSJ from 2012.
When Airbus and Boeing Co. announce orders at the Farnborough International Airshow this week, they will value the deals based on the planes’ catalog prices—which no one pays. Airline executives, when pressed for details, will probably say they got “a great deal.” But actual terms will remain guarded like nuclear launch codes.
The aviation industry’s code of silence on pricing is notable in this era of information overload. Thousands of people world-wide are involved in airplane purchases, yet few numbers spill out. That yields much mystery and speculation.
Discounts are large:
But there are ways to estimate the range of discounts. An analysis of public data by The Wall Street Journal and interviews with numerous industry officials yielded this: Discounts seem to vary between roughly 20% and 60%, with an average around 45%. Savvy buyers don’t pay more than half the sticker price, industry veterans say. But deal specifics differ greatly.
But no one wants to talk about it:
One reason for the secrecy surrounding all this, say industry officials, is psychology: Less-experienced plane buyers like to think they got a bargain and don’t want to be embarrassed if they overpaid. The safest approach then is silence. More-seasoned plane buyers also know that bragging about discount specifics would anger Airbus, Boeing or other producers and hurt the chances of striking a sweetheart deal again.
Clearly, as a large “quasi broker”, Airline leasing companies seem wo have a chance to make some money in such a intransparent market. But it is really hard to pin down real numbers. It reminds me a little bit about how you buy kitchens in Germany where the system is pretty much the same. Everyone gets a discount, but no one knows what the “true” price looks like.
But this also leads to a problem:
With the current funding costs, AerCap would not be competitive in the long run. Let’s take as a proxy the 10 year CDS spread as a proxy for funding costs and compare them across airlines and competitors (more than 50% of AerCaps outstanding debt is unsecured):
| 10 year senior CDS | Rating | |
|---|---|---|
| AerCap | 215 | BB+ |
| Clients | ||
| Air France | 96 | |
| Singapore Airlines | 105 | A+ |
| Southwest | 109 | |
| Lufthansa | 195 | BBB- |
| Thai Airways | 240 | |
| Delta | 256 | BB |
| Emirates | 257 | |
| Jet Blue | 362 | B |
| Competitors | ||
| GE Capital | 72 | AA+ |
| Air Lease | 175 | BBB- |
| ICBC | 194 | A |
| CIT | 229 | BB- |
So purely from the funding cost perspective, AerCap at the moment has a problem. Someone like Air France could easily fund a loan for an airplane cheaper than AerCap, so cutting out the middle man is basically a no brainer and even the smaller competitors could easily under price AerCap when they bid for leasing deals. On top of that, a lot of non-traditional players like pension funds and insurance companies want some piece of the action, as the return on investments on those leases are significantly higher than anything comparable. Even Asset managers have entered this market and have created specific funds for instance Investec.
AerCap does have a positive rating outlook, so there is a perspective for lower funding costs. Just to give an indication of how important this rating upgrade is: On average, 10 year BB financial isuers pay 2,4% p.a. more than BBB financial issuers at the moment. The jump from BB+ to BBB- will not be that big but it would increase the investor universe a lot for AerCaps bonds.
The biggest risk for AerCap
So although I am clearly no match for David Einhorn (*), I would argue that the biggest risk for AerCap is not the residual value of the planes or the credit quality of the Airlines but quite simply the refinancing risk. AerCap has to fund a significant amount going forward and if for some reasons, spreads move against them, they will be screwed. Just a quick reminder what happened to ILFC in 2011:
Credit-default swaps on the company climbed this month as global stocks tumbled and speculative-grade debt issuance all but evaporated. The cost reached as high as 663 basis points on Aug. 11, according to CMA, which is owned by CME Group Inc. and compiles prices quoted by dealers in the privately negotiated market. The contracts have held at prices that imply ILFC’s debt should be rated B2, according to Moody’s Corp.’s capital markets group.
However if they manage to to get an investment grade rating and lower their funding cost, then it could be an interesting investment as funding is cheap and they do have access to a lot of new and sought after aircraft. Again, borrowing from Warren Buffett, with any leveraged company, management is extremely important.
And one should clearly compare AerCaps valuation and risk/return to banks and not to the currently much higher valued corporates. AerCap is much more similar to a bank than anything else. This general valuation disconnect seems to be also one of major reason why GE announced the massive reorganization just 2 weeks ago. However, as far as I understood tehy will keep the leasing business as this is unregulated.
Summary:
Although I slightly disagree with the risk assessment of Einhorn’s case, I still think AerCap could be an interesting case and is worth to dig deeper. I don not have a problem investing into financial companies and I do like those “share overhang” situations. However, I will need to dig deeper and especially try to figure out how good AerCap’s management really is.
(*) I did disagree with David Einhorn already once with Dutch Insurer Delta LLyod which was Einhorn’s long pick of the year 2011. Overall in this case I would put the score of MMI vs. Einhorn at 1:0 as Delta LLoyd did not outperform.
value and opportunity 
Still looking at this one?
Absolutely not !!!
2 years later, still undervalued. How do you look at this company now ? Einhorn and Pabrai have large positions in this stock.
“Too hard” for me.
Let me be a bit pedantic about the Air France example. There are two CDS related to Air France: Societe Air France (CDS5Y @ 70bp) and Air France-KLM (CDS5Y @ 325bp). The former has left with only one 2020 convertible bond outstanding whereas all the new debts are issued from Air France-KLM. In terms of funding cost of the Air France (that it can borrow via unsecured borrowing), I would say it is likely to be >200bp.
good point, but AerCap would still struggle to finance cheaper than Air France / KLM….
Some years ego you wrote:
“The ideal short candidate should have most of the following “features”:
[…]
+ massive insider sales
+ negative free cashflows
+ pumped up growth through expensive acquisitions
[…]
+ high debt load and/or pension liabilities, operating leases etc.”
I’m generally no fan of capital-intensive companies.
Thank you for keeping track of what i wrote 😉
Interesting article as usual in your excellen blog. All the more interesting for me, as its for the first time about a company that I have also already written about in my own (German) blog. Aircraft Leasing is a bit of a speciality for me as I have a professional background in aircraft leasing although with a much, much smaller company than Aercap. Some general thoughts from me:
1) Last time I heard, Aercap/ILFC was the single largest customer of Airbus. It is safe to assume that they get excellend purchase prices and what might be as important they get much more flexibilty with their orders, i.e. they are able to switch between aircraft models and move forward or postpone orders much easier than most smaller customers. I don’t know any specifics of their deals. That is just what I heard and read.
2) The bank loan comparison implies that most leasing transactions cover all or most of the useful life of an aircraft. That is rarely the case. The typical lease for an aircraft is somewere between 3 and 10 years depending on model and age, i.e. much shorter than the useful life of an aircraft. The big difference to a bank is therefore that a leasing company gets the upside in aircraft values but also takes the residual value risk. Banks typically only take very limited residual value risk.
3) In my experience the big leasing companies dont’t often try to place aircraft with the the big airlines you quoted above. The big airlines probably get similar prices from Boeing and Airbus and if they want to do sale and lease backs usually smaller leasing companies compete for these as they don’t have huge orderbooks like Aercap.Not doing too much business with the very large airlines is not a problem there are hundreds of airlines out there and most are better off leasing because they would never get similar conditions from the manufacturers. This industry is not about airline credit risk but assets.
4) Regarding refinancing I am with you that this is a big large risk but my understanding is that Aercap management is already focussing on getting the leverage down again. Currently I have no doubt that refinancing requirements can be met.
5) In the past many of the larger leasing companies did ABS structures with diversified portfolios with 9 digit volumes per deal. Currently the trend seems to be to do senior unsecured bonds because it’s not much more expensive and give the company more flexibility. Aercap filed a registration yesterday with the SEC for 4 tranches of bonds with a total volume of 3.4 bn USD.
6) I bought Aercap before they took over ILFC (lucky on that one). Currently I think that Aercap is more or less fairly valued. I stay invested as this is an industry that unlike airlines has consistently earned returns on equity in the mid to high teens. Obviously a better time to buy is the next crisis in aviation. For example Aircastle another listed aircraft leasing company was founded by Fortress Investment Group after 9/11 and later listed. That was a huge success for them.
For those who read German I include links to my first introductury article and the latest article I did last year:
http://value-shares.de/2013/01/15/aercap/
http://value-shares.de/2014/08/17/aercap-q2-bewertungsupdate-nach-ilfc-uebernahme/
I also did a background article about aircraft leasing in general, that might be interesting
http://value-shares.de/2013/01/15/flugzeug-operating-leasing/
thanks for the comment. It clearly looks that their purchasing power is one “competitive advantage”. On the other side, Airbus and Boeing will make sure that they don’t gain too much influence and also promote other players.
Your point 2) is interesting as well. Aircraft leasing companies have benefited a lot form this “roll down” as interest rates went only down for 30 years, increasing the residual values. It will be interesting to see how this works if interest rates will go up at some point in time.
mmi
Leasing companies have benefited from decreasing interest rates and could be hurt by increasing rates but in my opinion in an indirect way. Often aircraft are financed with floating rates or short to medium fixing correspoding to the lease terms. Aircraft leasing is a competive business and as interest rates went down so did lease rates. Raising interest rates and therefore leasing rates might end the boom in airline business growth. Combined with the large order books for new aircraft that could hurt the leasing companies.
The biggest downside risk to me seems to be a recession where they get stuck with a lot of airplanes and nobody to lease to
Jana Partners a US Event Driven and smart Activist investor has taken a substantial position, validating potential and providing a catalyst.
thanks for the comment. I have seen the Jana position too. However I was wondering what they are doing there. Einhorn has stated that AerCap has great management with great capital allocation skills, so what additional value can bring Jana to this ?
$250M buyback isn’t enough, JANA will probably push for $1B.
That would be stupid. They won’t get an investment grade rating with that.
Great post! Good research. I’ve owned AIG for a while so have kept decent track of ILFC and the Aercap deal
Will Aercap fund airplanes using its own credit rating or does it use the ABS market to fund its planes? If it uses ABS markets then its funding cost will depend on the spreads in the ABS market. Auto financing is mostly done in the ABS market which worked well even in the financial crisis.
#vishal,
I don’t know. Currently they seem to fund mostly “on balance” sheet. The difference to an Auto ABS is that you won’t get a very diversified portfolio unless you are doing huge deals.
mmi
Congrats for the post, try to kill Einhorn’s idea is an excellent exercise.
Well done.