How would one make money from the boom in air travel? Is the answer to invest in airlines? It sure looks like it in recent times as Warren Buffett, the Oracle of Omaha, has invested in multiple US airlines. However, one would do well to remember the timeless quote from Richard Branson – “If you want to be a millionaire, start with a billion dollars and launch a new airline”. Airline is notorious for its low returns per capex dollar spent. When an airline invests in new aircrafts, competitors would have to do the same in order to keep up. However, because competition is fierce, there is very little pricing power for airlines. All this results in a boon for consumers but very little benefit to the airlines.
A better avenue, I believe, is to look at an auxiliary business for airlines — aircraft leasing. The aircraft leasing business has high barriers of entry due to the significant financial muscle required and this has resulted in few global players. One of these global players is Aercap (NYSE:AER) which was listed in 2006. Since listing, it has grown book value impressively from $USD 8.83 to $USD 50 as of 2016. In 2013, it acquired AIG’s ILFC to become the largest independent aircraft lessor globally.
On a high level, aircraft lessors such as AER, borrow money from the financial markets to purchase planes from manufacturers and lease out these planes to airlines in return for monthly lease payments. Put it simply, AER is profitable when net interest margin is over and above all outgoings. AER currently trades at less than $USD 46 per share with FY 2016 EPS at $USD 5.52. Management has guided FY2017 EPS to be $USD 5.7 which gives AER a forward P/E ratio of around 8. From a valuation perspective, AER looks like a no-brainer.
One aspect of the business that may trip up investors is the amount of debt that AER carries — $USD 28B as of FY 2016. Should one be concerned by this? On face value, the debt to equity ratio of 2.7x may look distressing but the ratio that we should be looking at for a finance company should be the equity/asset ratio. AER’s equity/asset ratio is at 20% which shows that it is conservatively geared. Therefore, I do not concern myself with AER’s debt for my evaluation of the company. Before you get your panties in a knot, think of it this way — the interest expense on debt for AER is a cost of sales and with a 20% operating margin, AER will make a profit of 20 cents for every dollar it borrows to purchase an aircraft and lease it out. If this isn’t making money hand over fist, I don’t know what is.
A few other plus points from the earnings call – AER has obtained an investment grade credit rating from Moody’s which should bring down its borrowing costs. Also, AER board has authorised a $USD 350M share buyback which will run till 30 June 2017. Bearing in mind with a current market cap of $USD 9B, that is about 4% of the shares that could potentially be bought back.
My next post will be on Select Harvest (ASX: SHV) after it has reported earnings for HY2017.