I own shares in Aercap (NYSE: AER), the largest aircraft lessor in the world, for many reasons (some of which I have discussed here and here on this blog, for example). This is not an article about AER so much as an article about dispersion and inconsistency in how the market is pricing various sectors on a relative basis – AER serves as a perfect example of what is going on. One of the main reasons for my ownership is the long-term track record of creating consistent returns for shareholders, as measured by how it has compounded book value (shareholder’s equity) over time. Here is AER’s track record, since 2005:
After a few heady years in the mid-20s% (when AER was a much smaller entity and highly levered), returns have basically flatlined in the low-mid teens for about the past 7-8 years. Over the last 5 yrs book equity had compounded at around 13-14% (all whilst leverage has come down substantially) – not too shabby at all, especially considering this business has never lost money, not even during the financial crisis.
Today AER trades at $60/share whilst shareholder’s equity as at end’19 on my numbers is around $71.5/share – so call is 0.84x P/B. The normal way to value an asset-based lending business is to assess the sustainability of asset/equity level returns (in concert with how much leverage the business is taking) and then pay either a premium, or discount, to shareholder’s equity, accounting for whether those sustainable returns are above or below the cost of equity. In AER’s case, the cost of debt is around 4% (actually lower on a go-forward basis but let’s roll with it), and the generic equity risk premium in the market (using the S&P) is around 3% (SPX at around 5% earnings yield less risk free 10yr, let’s round it to 2%). Let’s be conservative though and say in AER’s case the ERP is 4% (so 1pt riskier than the market), meaning, in a theoretical world, AER’s cost of equity is around 8% (simply the ERP plus AER’s cost of debt).
Now, since AER is trading stubbornly and substantially below book value, the market is implying that the sustainable go-forward return on equity AER will generate is more like 6-7% – or less than half the historically-demonstrated level of returns – low/mid teens – over many years. What could happen to drive such a sudden and gargantuan change in business fortunes? Probably both a large secular decline in plane asset values over multiple years (AER owns lots of planes), combined with a number of large customer defaults (since residual plane values won’t be marked down on performing assets and only a small portion of the book comes off lease each year).
Is such an outcome possible? Of course. Do I think it’s likely? No. But that’s really the point I’m getting at. My underlying problem is with how the market is compartmentalizing, and pricing these risks into some segments of the market, but not others. That is to say, if you look at aircraft lessors, the valuations imply an imminent seachange in the earnings power of the business, without any historical evidence. But if you look at the OEMs, or the aircraft supply chain names, these stocks are pricing in a huge amount of growth, irrespective and independent of what is priced into the lessors. Take a look at the below:
Some of these businesses are better than others; clearly Boeing and Spirit are priced differently than the group due to the Max crisis. But even so – the average FCF multiple is 25x; there is no way this is a terminal multiple, the market is assuming substantial mid-term growth (as evidenced by the 15% average FCF growth CAGR consensus expects). But in a world in which lessor returns are cut in half, how will the OEMs be selling ever more planes, and the Tier 1 suppliers growing FCF so aggressively? It just doesn’t make sense – both of these world views cannot be correct, because the underlying drivers that will govern the future earnings power of all these names are largely aligned. The producers of the asset – from partmakers to OEMs – cannot be priced for high mid-term growth if the owners of the asset are priced for an earnings recession.
To me – a frustrated AER long – this is an egregious example, but this is not some unique pocket within the market. The stockmarket is pretty expensive as a whole, and there are large swathes of wildly expensive stocks – but there are groups of extremely cheap stocks, often in sectors adjacent or related to the most expensive. Lithium prices are in the toilet, while most all EV OEMs and EV battery names are going to the moon. Basically any listed coal company trades at a fraction of replacement cost – even as the electricity grid’s reliance on coal, globally, is going up, not down. Huge swathes of the energy E&P space can be bought below the value of their proven reserves – even as oil consumption and dependence rises globally. You can throw a dart at most any commodity or basic resource sector company and see it trading at bargain valuations – even though these industries provide the inputs for most of the hot sectors that are discounting continued global growth.
I do not know how it all ends; and certainly many of the cheap names – AER included – may earn their low valuations through lower forward earnings. But if that happens there must also be an almighty reckoning in the expensive stocks, too – so in sum it’s a great time to be a long/short manager. If only the entire market wasn’t dominated by passive flows, there might even be the opportunity to make some money 🙂
Disclosure: long AER, long coal (through stock basket)