Every now and then, when markets go haywire and in particular airline/travel stocks get crushed and my beloved Aercap (NYSE: AER) gets obliterated, I pull out my favorite chart. It shows the long-term trend in global air travel, and it looks like this:
Doesn’t that chart look great? No matter what crisis has occurred – be it terrorism, economic calamities, pandemics – we all seem to continue to want to hop on a plane and go somewhere. Global air travel demand has basically doubled every 15 years, like clockwork, and even though it has slowed down or stopped growing for the odd year here and there (after 9/11, and post the GFC), this chart is basically inviolate. People will return to the skies – it is simply a matter of when, not if.
This is not going to be a Pollyannish expose of why you should rush in to buy airline and/or aircraft leasing stocks. If you think Covid-19 turns out to be the pandemic to end all pandemics – if this really is ‘the big one’ – then it will necessarily change human behavior permanently; the above chart will fail; and huge swathes of the global economy (namely most every levered airline, hotel, and restaurant chain) will go out of business. Airline lessors will of course be no exception.
But if you believe that – like most calamities to have befallen us – we will both find a solution; persevere; and then, eventually, if not immediately, return to normalcy – it is time to at least consider what to own for the rebound. After all, the Spanish Flu in 1918 killed an estimated 20-50mm people…but here we are today, still traveling more than we ever have, year after year.
Aercap today trades at ~63% of book value (probably <60% of book value once we open on Monday). That is, shareholder’s equity is ~$9.6bn right now yet it is available in the market at ~$6bn. Since this business does around $1.1bn of net income a year, the market seems to be saying both that a large portion of the existing book will be impaired – through credit losses as airline customers default – AND that go-forward earnings will be nowhere near $1.1bn a year (around a 12% RoE on book today). I am not going to spend any time discussing theoretical forward returns and how this may compare with a theoretical cost of equity looking out 5 years. These questions are important, but they are not, to my mind, the reason why the stock is trading at a discount today. Instead the discount is being driven entirely by credit risk – that is, the market thinks many of their customers will default, impairing assets in the book today or near-term.
Stress-testing book value
OK, so let’s talk about aircraft defaults. A few things worth mentioning straight off the bat:
- there were 23 airline bankruptcies in 2019 yet AER generated record profits. This is the airline industry – there will be always be failures – but the good lessors have devised ways to manage the risks inherent in the customer base;
- If the lessor is any good they will maintain security and maintenance deposits covering a large portion if not all of the expected loss on default for troubled lessees. This is why – for its entire listed history – AER has not taken credit losses in excess of the maintenance deposits and security deposits that get swept into revenue when you do have a default/repossession event;
- There are many cases where airlines default on their debt and yet lessors still get paid (see Alitalia, for example). This is intuitive: if you don’t pay your lessors they take the plane. For many carriers (especially flag carriers), maintaining routes (and thus employee jobs) can be political and thus keeping the planes is paramount (especially in a very tight market where being able to release a plane soon thereafter as a bankrupt airline may be tricky). Recall that the narrow body market was – until corona – incredibly tight and the OEMs had sold out backlogs for many years.
The key points really are that even in bankruptcies, it is no guarantee that leases will be rejected en masse; nor is it that losses will be taken (that has certainly not been the example over the recent past). This is the key difference between lessors and the airlines: the lessors are essentially senior secured creditors – they are the last to not get paid. Even employees will be asked to take haircuts before lessors (cf Cathay Pacific at the moment).
That is all very well and good, you say – but in the past you had isolated failures so planes could be recycled quickly into a firm global market. But coronavirus is a different beast: we are seeing a global meltdown in demand for air travel – there is no safe space here. Surely the risk of a system-wide collapse in multiple airlines is much higher now than in previous isolated cases?
The short answer is yes. The longer answer is, in a force majeure event such as this – and no one would really deny that Coronavirus is that – it seems quite likely that many of the airlines will be supported by governments (certainly this seems quite likely for all the flag carriers). It hardly makes sense for governments to allow their national carriers to become insolvent – and thus potentially lose their fleets – because of a virus that was impossible to predict or prepare for. My bet is – with interest rates near zero globally – governments just print money to fund fiscal stimulus programs – part of which will clearly devolve to support state-owned airlines.
So, I think its reasonable to assume most all the state-owned airlines are not at specific credit risk from this force majeure event. Right there that removes a large portion of AER’s fleet – perhaps 25% of gross aircraft assets (Air France/KLM, 5% of the book, is joint owned by two governments; another 2/3 of the China-exposed book is state-owned, that’s about 15% of total book; and the rest should contribute another 5%+).
OK, now let’s make some very generic – and punitive – assumptions about what happens to the rest (75%) of the non state-owned customer book. Let’s simply assume:
- half (so 37% of gross aircraft assets) of the remaining customers default within a year;
- half of this half rejects all their leases (call it 19% of gross assets);
- loss given default on this half is 50% (above the top end of realized LGD rates that I can observe, looking back the last 10 yrs) – call it 10% then of gross aircraft assets.
Since AER gross aircraft assets are around $36bn, this would equate to a $3.6bn hit (all to equity clearly) – which is basically the discount to book implied in the stock today.
Of course, even in this crazily-punitive scenario, I think the actual hit would be far less, because:
- before these customers default they are – theoretically – still paying rents, so AER would get some portion of its $1.1bn in annual profits accreted during the year (maybe half?)
- the loss given default would likely only be realized if AER was forced to turn around and write new leases, immediately, at much lower rates than the returned aircraft (thereby forcing the impairment to be taken through equity).
This second point seems quite unreasonable to me. Here’s why. This is what the business has done in terms of PnL over the last 5 years:
You can see I have X’d a fair few lines. I am trying to establish the cash costs of running AER as it stands on an annual basis – it looks like cash open is around $1.5-1.6bn (interest + SG&A), maybe a bit higher in reality. Revenues – from the leasing business only – run around $4.7bn, covering cash opex by roughly 3x.
In our punitive downside scenario, we speculated that ~20% of the customer base would default. Lets just assume its EVEN WORSE than this at the revenue line (some customers may ask for deferrals even if they intend to pay) – so lets bump this up to 40% of the customer base, AND assume again that this situation lasts for a whole year. Then, revenue falls to $2.8bn – still well in excess of cash opex. So no problem, right?
Not exactly. AER still has chunky plane delivery commitments, of which ~$3.5bn fall in 2020:
If we assume there would be no deferral/extension of these deliveries (again, wildly pessimistic), AER would theoretically burn ~$2.3bn in cash in 2020 (haircut revenues less cash costs less cash out for new plane deliveries). And that’s before maturing debt of $3.5bn is taken into account (even though all AER’s debt trades above par and doesn’t seem to present any refinancing risk). This sounds extreme – until you realize that AER has ~$8bn+ in available liquidity – kept just for situations like this:
In summary: even in an armageddon-type scenario where a huge portion of their customer base becomes highly distressed, and this situation persists for a whole year, it seems reasonable to suggest AER would not be a forced seller/lessor of assets at temporarily-distressed levels, as they could survive this situation AND be shut out of the debt markets completely for over a year. Meanwhile, I have trouble seeing how absent the end of travel as we know it, they take more than a ~35% haircut to current book. To me, that makes AER at current – with the best management and capital allocators in the business – an incredible value at current levels.
How do you hedge? BOC Aviation
But what if we’re wrong? What if no one ever hops on a plane again? Well, thankfully, Mr Market is still somehow pricing a fairly similar (though, in my view, inferior) business at a crazy relative price – BOC Aviation (2588.HK). This business has more leverage; more Asian and direct China exposure (>50% of book); a much larger order book relative to its own fleet (meaning, more new lease placement risk); and is much smaller (only ~300 owned planes), with chunky and risky exposures to lessees like Cathay Pacific, Norwegian, and Thai Air:
While there are some other differences in fleet composition, age, and structure of the funding, and BOC is 70% owned by Bank of China, in the kind of general market meltdown that AER stock now discounts, it is impossible to see how BOC could protect its book value any better than the market leader. The fact that it still trades at 1.5x book value (!!) despite facing all of the same risks as a larger entity with more diversified funding and client base that currently trades at 0.6x book for a similar asset pool, still boggles my mind (and is why I’m short). If worst comes to worst, this spread must but narrow, significantly.
Disclosure: Long AER, short 2588.HK