Mohnish Pabrai (Trades, Portfolio), one of the best and most respected value investors today, does not like U.S. stocks.
After a nearly decade-long bull market, Pabrai is struggling to find value in the U.S. according to his letters to investors, which is reflected in his portfolio.
According to Pabrai Funds’ lasted 13F filing with the SEC, the guru only owned two U.S. stocks at the end of the third quarter, Southwest Airlines Co. (LUV, Financial) and Alphabet Inc. (GOOG, Financial). The other holdings listed were Ferrari NV (RACE, Financial), Fiat Chrysler Automobiles NV (FCAU, Financial) and AerCap Holdings NV (AER, Financial) (these last three have U.S. listings, but are domiciled in Europe).
I have already discussed Pabrai’s Southwest and Fiat Chrysler holdings. In this article, I will take a look at AerCap.
Betting on the spread
In 2015, David Einhorn (Trades, Portfolio) said AerCap was his top pick for the year. If you had followed the fund manager into this trade, you would be up around 30% (beginning in 2015 to today).
If you bought when the stock slumped at the start of 2016, you would be sitting on gains of around 60%.
AerCap is an airplane leasing business. The company describes itself as “the global leader in aircraft leasing and aviation finance. With $41 billion of assets, AerCap is funded by a robust long-term capital structure that produces strong earnings and cash flow generation.”
AerCap buys planes and then leases them out to carriers. Due to the company’s size, it can do this in a more cost-effective way than the airlines themselves.
WhenEinhorn pitched the company in 2015, it already had an impressive growth record behind it. Between 2006 and 2014, AerCap reported a book value per share compound annual growth rate of 19.6%. Meanwhile, return on equity came in at 13.1% on average between 2007 and 2013. Since then, the business has continued to expand. Since 2011, book value per share growth has averaged 24.3% per annum, while return on equity has not fallen below 12.4%.
At the time of Einhorn’s presentation, AerCap was making a return on equity of 13.3% on each lease, assuming a 75% debt, 25% equity funding ratio. Fixed-rate debt was costing 4% per annum, and a 12.5% Irish corporate tax rate turned a 6.8% return on assets into a 13.3% ROE.
There are pitfalls to this business model. As AerCap is reliant on leasing income to pay off its interest income, the company is exposed to credit risk. The company does what it can to mitigate these risks, but in downturns (2008) there will be defaults. As the company can reclaim and sell any planes that default, the chance of a total loss is slim.
Between 2007 and 2013, which included the financial crisis and some idiosyncratic airline defaults, AerCap’s annual defaults were approximately 2.5%. Total losses were only 0.2% because around 80% of the defaulted planes were repossessed and then re-leased or sold, and 20% of the defaulted aircraft went back to the airline under a restructured lease.
Buyback cannibal”‹
So we have low defaults, a high return on equity, was, at the time, a cheap stock trading at less than 10 times earnings and, finally, in 2015 management was looking out for investors. Einhorn’s presentation points to the following statement from CEO Gus Kelly on the second-quarter 2014 earnings call:
“We’ll find the right way to deploy our shareholders’ capital because in the end that’s why we’re all here, [is] to make sure that our shareholders get a fair risk and return from the money we deploy for them.”
In 2011 and 2012, the company repurchased 24% of its shares outstanding for an average of less than $12 a share, but then the share count started rising to fund acquisitions. Still, buybacks have now resumed with a vengeance. In July, a $250 million share repurchase program was approved and another $200 million was added to the authorization in October. Between Sept. 30, 2016 and September 2017, the company reduced the number of shares outstanding by 13%.
Slow and steady wins the race
Since Einhorn covered the company in 2015, not much has changed. AerCap has expanded to become the most significant player in the sector, but its business model and investment proposition remain precisely the same.
In many ways, you could compare the company to a low-risk subprime bank. Many of its customers have a low credit rating, so it makes sense to lease from AerCap instead of borrowing to fund their own fleet.Â
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In the 1980s, leasing among airlines was rare. Today, it is the norm as it gives carriers more flexibility. The lessor bears the risk of any slump in second-hand values and carriers that go bankrupt can tear up leases and hand planes back. Further, the contract means the airline does not have to worry about renewing its fleet every 30 years -- a considerable capital outlay. Leasing is not going away anytime soon, so AerCap’s size means it is uniquely positioned to benefit from the market expansion.
For the first nine months of 2017, the company reported a net interest margin of $2.3 billion. Lease rents of $3.2 billion minus an interest expense of $823 million. These numbers show just how lucrative the business is. For the period, the company generated a total of $2.4 billion from operations and spent $2.3 billion on new planes (funded partially with the sale of $1.2 billion in old planes). Around 50% of purchases are funded with debt, leaving nearly $1 billion for buybacks.
On the same flight path
There is no reason to believe AerCap’s flight path will change anytime soon. The company should continue to report a healthy interest spread and see high demand for its planes.
Meanwhile, its size will enable it to borrow at low rates, negotiate the best deals from manufacturers and offer customers the best deals, ensuring it remains ahead of the pack. All of this is good news for shareholders.
Right now, the stock is attractive trading at a forward price-earnigns ratio of 8 and a price-book ratio of 0.9, but this valuation is only half of the story. The last reported book value was just over $55 per share. At the current rate of share cannibalization ($888 million spent on buybacks for 19.2 million shares for the first nine months of 2017. To be conservative, I’m going to estimate 19 million shares acquired for the full year) and assuming the share price goes nowhere, book value per share will be $79.9 by Sept. 30, 2019 -- an unrivaled compounder.
Overall, it is easy to see why Pabrai likes this world-class leasing business.
Disclosure: The author owns no stocks mentioned.
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