An Aircraft Leasing Company Worth Watching

In this episode of Industry Focus: Energy, Motley Fool Canada advisor Jim Gillies joins the podcast to share his thoughts on aircraft lessor AerCap Holdings (AER -1.33%), following its recent earnings report, and on Berkshire Hathaway (BRK.A -0.76%) (BRK.B -1.14%) CEO Warren Buffett's annual letter to shareholders.

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This video was recorded on March 4, 2021.

Nick Sciple: Welcome to Industry Focus. I'm Nick Sciple. This week, I'm joined by Motley Fool Canada Advisor Jim Gillies to break down AerCap earnings and share his thoughts on Warren Buffett's annual letter to Berkshire Hathaway shareholders released over the weekend. Jim, welcome back on the podcast.

Jim Gillies: Thanks, Nick. Glad to be here.

Sciple: Yeah, great to have you back on the show. You're a value investor, Jim. [laughs] Value is coming back this year in 2021. How do you feel?

Gillies: Yeah, that's the rumor. I'm the least exciting investor at the party most days, but occasionally, I have my moments that it looks like the last week, two weeks. Yeah, I'm having a pretty decent year, but I planted those seeds a few years ago, I'll put it that way, in a lot of cases.

Sciple: Don't call it a comeback, that's all I'm trying to say. I mentioned off the top, we're going to talk about AerCap Holdings. That's a company that you clearly think of as a value stock. I mean, maybe we will talk about that here in a little bit. Long time listeners should be familiar with this company. I talked about it with Lou Whiteman back on October 22nd. The stock is up over 60% since then, compared to the S&P up 11%. So, it's been quite a good performer since we talked about it on the podcast. For folks that may have missed that episode, Jim, or aren't familiar with what AerCap does, what can you tell us about this company?

Gillies: Sure. AerCap is the world's largest owner of commercial aircraft. A lot of people, "What? Wasn't it one of the airlines?" No. AerCap, because what they do, they are a leasing company. They buy planes, and then they lease them to pretty much all of the major and a lot of the minor airlines around the world, a lot of the national flag carriers: our Air Canada, your Lufthansas, your American Airlines. If the U.S. can be said to have a national carrier, they lease to them, and they basically -- I like to look at leasing companies. Leasing companies are basically a spread business. AerCap's got, I think, about a $6 billion market cap as of today. You go look at them, they got what looks like about $30-odd billion in debt on the balance sheet, and people freak out. But this is a leasing company, so debt is a raw material for these types of companies. They're borrowing at one rate, 3%-4%. I think they're about 4% for the year just completed, weighted average cost of their funds. Then they lease out the plane to these carriers, some big, some small, like I said, and they get paid back 7%-8%, so they're earning a spread. Leasing companies are a spread business, and you want a company that's properly managing that spread. Full disclosure, I own shares myself. As you've said, I've recommended shares that are considerably lower priced, didn't catch the bottom, but I did pretty well, I think. My opinion is these guys are really good at what they do.

Sciple: Yeah. Full disclosure, I own some shares as well. Bought some after we did that episode back in October that we mentioned earlier. When you talk about airlines, aircraft leasing, certainly, this whole industry has been impacted by the pandemic when you can't travel anywhere. Folks that are exposed to the airline industry are going to have some impact. How has AerCap been impacted by these pandemic disruptions?

Gillies: Far less than I was expecting, and that sounds a little weird. As you mentioned, air travel just slammed shut pretty much a year ago. It started to come back. It came back first in Asia, then in Europe, and now in North America, but business travel is obviously way down. Personal travel is obviously way down. There were some expected hurdles, but far less than I was expecting. I had my catastrophic model setup, as you could see 50% of AerCap's equity wiped out. For a point of comparison, the book value where we find their equity, here, their equity is basically flat year-over-year. Their book value's down, I think, about 3%. Not even that, it ended 2020 at $69 and change, book value per share. It ended last year, really when the pandemic was known to be in parts of China, it ended last year at $72 and change in what is unquestionably the worst year for AerCap and the airline industry in our lifetimes, and I'm a bit older than you. That was down $2.70 or whatever that works out to. The reason you got the bargain prices you saw in AerCap with over $60 pre-pandemic, and I think it bottomed around $12 a share to about $50 today. The reason it fell so much is, of course, people tend to do this, investors tend to do this, the short term thinking takes over and people just want to get out. They project what is known in the here and now, they projected out into the far distant future. That's an opportunity to a guy like me. You already branded me as a value guy so I guess I'll run with it. That's an opportunity because that kind of want in selling, and I've known a little bit about AerCap before that. I owned a little bit before the pandemic drops mainly just to keep tabs. Then when it blew up, I owned a lot more.

These guys are, as I've said, they're really good at what they do. What they're able to do is to manage things to absorb the blows, because the blows did come. There are multiple airlines that have entered the sweet embrace of bankruptcy during the pandemic. The most prominent would probably be a recent one I can remember is Norwegian Air, I believe. They had a bunch of 787s. I think they went boom in about May or June of last year. It actually is a little weird because AerCap actually took back equity. AerCap will tell you, "We deal with bankruptcies all the time." Indeed, airlines go bankrupt all the time. I mentioned the flag carriers, Air Canada. Air Canada went bankrupt in 2003-2004. American Airlines, they last went bankrupt in, I believe, 2011. The flight carriers tend to keep flying, they just get reorganized within bankruptcy. The equity holders get wiped out, but the planes keep going and the service keeps going. It's often a national argument, like Air Canada, it would have to be a really, really bad set of circumstances for the Canadian government to let Air Canada go out of business, like, sell off the assets and close up shop. But you saw smaller carriers, like Virgin Australia went under, Air Mauritius went into bankruptcy protection, I believe Avianca out of Colombia as well.

But as CEO Aengus Kelly has said multiple times, before and also during the pandemic, if you've listened to the various presentations they've done, or conference calls, they said we deal with bankruptcies every year. We had a bit more this year, but what we don't have in other years where airlines go bankrupt; they tend to be allowed to go bankrupt, they don't have government money raining down upon them to preserve them through the pandemic. It looked bad, and certainly if all you looked at was the stock price and you see this thing down +80% from its high, or something like that, you could panic. But if you actually follow the company, understand how they make their money, read a few conference calls and see what they were doing. They said, OK, look, we will allow some carriers, you can defer. We will defer and spread out the payments that were due because the airlines don't want to give back the planes, because they would like to keep running, and quite often they got -- I'm thinking of some of the Chinese carriers who have been customers of AerCap and some of the [...] companies for three decades. What, we're going to panic now and close up shop? No, we want to be customers for the next three decades as well. It's one of the last things that goes, is the planes get taken back. But if this thing does go down and can't get back off the mat, AerCap will quite often take the plane back and redeploy it. They are masters at selling planes. Even in the case of Norwegian Air where they did take back equity, I don't think they wanted to, but they took back equity to help Norwegian Air restructure, and then they subsequently, after the restructuring, did go into bankruptcy, but fortunately AerCap did exit their equity holdings in that. So there's a lot of things they can do. They work with their customers, everyone involved, the airlines, AerCap, they've all got a long term perspective that you need when basically wheeling and dealing 25 and 30 year assets.

Sciple: Certainly [laughs] it's going to be a little bit abnormal relative to the regular operating procedure when you've got countries across the world shutting down travel. But to your point, AerCap and the airlines in particular, have been able to access capital in a way that I think surprised a lot of folks, which ties into the way AerCap has been able to continue collecting payments, and all those sorts of things. AerCap just reported earnings earlier this week. What are we seeing so far from the business as far as the state of the business today?

Gillies: State of the business is good, all things considered. As I said earlier, this is the worst the industry has ever looked in our lifetime. It is largely outside of the control of all involved. Everyone's got that long-term mindset, and we're going to work together, we're going to get through. The worst was the results reported in Q2 of 2020. That's when things looked the worst, the amount of cash flow that was being generated by AerCap was at its nadir. I mentioned Norwegian Air. That's when the bankruptcies spiked, or the airlines in trouble spiked. Where we are now is actually looking pretty good. Even though the stock has more than doubled, I will say roughly doubled, from where we put it in the Hidden Gems Canada, I really like where they are because for the full year of 2020, they did about $2.1 billion in operating cash flow. Now, that's down from the year before, obviously, but it's not that bad. Q4, for example, there was more than double the cash flow of that nadir quarter, Q2. That was pretty good. I believe it was up about 20% from Q3, and like I said, more than double from Q2. The deferral requests, airlines in trouble asking for a little relief on their lease payments, those are very significantly down. A deferral, basically, you just accrue a balance of payments that are not made, and over time, as those payments start coming back in, as business picks back up again, that balance will go down until hopefully it gets to zero. I think the deferral balance only rose $5 million quarter-over-quarter, which, for a company of this size, they're going to find that in the couch. So it's not a big deal.

They've also signed lease agreements for 22 narrow-body aircraft in Q4, another nine wide-body aircrafts. They sold 12 planes, because these guys are always buying and selling. For comparison, they own about 940 planes outright, and they manage another couple hundred, or 100 and change, for others. I just pulled up the number, they own 939, so that's pretty close to 940. They own outright 939, they manage 105 for others, and they've got 286 on order. Because the other thing that they did is they pushed out their orders in the delivery book, Nick, so that then takes the heat off what they need to push out in terms of cash. Most of these planes that they've already got on order but haven't been delivered yet, because it's not like a car production line where you're churning out a new vehicle every 90 seconds, these take a couple of years to build. These things have already pretty much got a customer on day one, the second they are officially cleared for takeoff, no pun intended. So they've got a pretty good fleet. They understand fleet management.

The other thing that I really like about AerCap is they have been really diligent about keeping newer aircrafts flying. The average age of their fleet is about 6.4 years, slightly up from where it was about a year ago, I think it was 6.2. But when you think about the average plane, it probably has a useful life, 25-30 years. They are very much at the forefront of this. They own new technology. Obviously, the average remaining lease term for these things is about seven years, just over seven years, and they're very good at selling and placing these into the secondary market, down the road. But from a valuation perspective, they look great, from a business fundamentals, it's all popping up. They look great. I think the industry is going to change in a way, and this is not unique to my insight. The CEO, Aengus Kelly again, was saying this on the conference call, but it's something that I was highlighting as well, I think when I recommended, I think it was May last year, so maybe 10 months ago, was post-pandemic, this industry is going to be tilted in favor of AerCap. You've still got AerCap trading at, not a dirt cheap valuation, but cheap, and I think the industry fundamentals are going to now favor it going forward. What I mean by that is, all of the airlines that get through this pandemic, a lot of them have got a lot more debt on their books, a lot of them owe the government a little bit of money. They're not going to want to tie up capital in owning planes. So what's the solution? Hey, leasing company, can I get a new 787? That's where I think we're going to go with AerCap.

Sciple: Absolutely. I pulled a quote from the conference call earlier this week from Aengus Kelly. To your point, he says, "The first priority for all airlines is to deleverage their balance sheets and increase their fleet flexibility going forward. Both of these objectives mean asset-light balance sheets for the airlines. Airlines will not repair their balance sheets overnight, and so the flexibility that comes from leasing will remain attractive to airlines for years into the future, such that we see a number of very strong years ahead for the industry." Jim, just to go back, we talked about over the summer, valuations were depressed significantly because of what was going on with the pandemic. As you look forward from here, is this still a stock you'd be excited about buying today given the growth opportunities and the valuation today?

Gillies: I'm going to answer socratically, if that's OK. Well, I used to teach at a local university as well and I always liked doing that because you could extend the lecture out when you got to fill a three hour block. Here is a company that in good times, pre-pandemic, traded between about 0.9 and 1.05 times book value, most of the time. Made a lot of cash, and they took practically all their free cash flow and they bought back their own stock, so they dropped their share count by about 40%, pre-pandemic. They halted their buyback plan during the pandemic. That's at zero right now, for now, temporarily. They're trading at 0.7 times book value, down from that pre-pandemic normalized range of, say, 0.9-1.1. They're trading at about six times earnings if you back out the one time expenses in 2020 associated with the pandemic. I believe, as I just stated, that I think the world will be more favorable to a company like AerCap, and their competitors as well, the leasing companies. The environment will be more favorable to them, and in line with the quote you just provided from CEO Kelly, for years to come. So, well below historical valuation, six times earnings, a better environment in a reopening world. Is this a stock I'm still interested in? What do you think?

Sciple: We'll leave it there. With 10 minutes left here on the podcast, I want to talk briefly about the Berkshire Hathaway letter over the weekend released on Saturday. Any big takeaways for you from that letter, Jim?

Gillies: You assume I've read it. Of course I've read it. My partner likes to make fun of me because basically I set my clock for that Saturday morning in late February early March and I read it before coffee in the morning the day it comes out. I think it was a good letter. I think Warren at this point is playing the hits a little bit. But I think he had a number of things to say that were good. I think there was a little bit non sequitur in there, which I haven't seen anyone comment on, so I think I'll comment on it. They talk about Berkshire buying back their own shares. They bought back about $25 billion of Berkshire shares, which, of course, is a departure from Buffett, for years and years resisted buying back Berkshire shares, even though it was at a ridiculously good value. He repeatedly, in every other letter, was always talking about how the intrinsic value of Berkshire Hathaway is far in excess to its book value and the book value is cheap, to which a lot of value types, myself included, then said, "Well, rather than buying airlines and IBM, why don't you buy back your own stock?" But he's talked many times about the buybacks not to be used at all times. You buy back stock when the business is trading at a discount to a conservatively calculated intrinsic value. Do that and buybacks are accretive to value for the shareholders who will remain. We all understand that, and that's great, and that's wonderful, and he's repeated that in this letter, and he said it before. Then he goes onto praise how Berkshire owns a larger piece of Apple because of their buybacks. I own Apple as well. I like Apple. I buy Apple routinely when it's 20%-25% of the pie. Apple is almost the definition of a company that buys back its own stock indiscriminately regardless of valuation. Hey, uncle Warren, I love you, but you can't have it both ways. That's the one thing that stuck out to me, and we could talk about all the other little nuances if you want. But that was the one I'm like, huh.

Sciple: That's a fair point, and there's some tension there as well where he said CEOs shouldn't buy back shares indiscriminately, praises Apple, also talks about how he sold Apple in the quarter. So if he's selling Apple, presumably it's not a great value and Apple shouldn't be buying back. But I did think it was interesting that he talked about Berkshire that owns 5.4% of Apple. Today, they've taken out $775 million in dividends, sold $11 billion, and they own more of the company than they did when they took the original stake of 5.2%, interesting.

The other thing I thought that popped out for me about Berkshire is he talked about the four jewels of the company, Apple being the one that they don't have a controlling stake in. The big thing that I thought was interesting is when you look at the property and casualty insurance business, he talked about Berkshire Hathaway Energy and you look at BNSF Railroad, when he talked about all those businesses, he talks about something that those businesses are able to do being a part of Berkshire that other folks in the industry aren't. For Berkshire Hathaway Energy, they're a utility that doesn't pay a dividend. So they're able to invest a lot more cash in this new recreation of the grid heading out into the future. BNSF Railroad, they pay dividends to Berkshire, but they're not required to. It's based on the capital needs of the business, and because of that, BNSF is able to invest massive amounts into the infrastructure of their railroad. The other jewel was the property and casualty insurance business, and because of the nature of the way Berkshire Hathaway is constructed, they have lots more capital to work with and are able to employ a much more equity heavy strategy than all the other folks in the industry. We're in this world that everybody talks about, of low interest rates, well, why in the world would you ever own bonds?

Charlie Munger, when he did his Daily Journal Meeting the other week, he said, "I don't own bonds anymore." These are three instances where because of the way Berkshire Hathaway is managed, they were able to take a much more equity heavy portfolio in their insurance business. They were able to invest much more capital into their railroad than other railroads are. They're able to invest much more capital in their utility than other utilities are. I think if you read the letter and see the points that he calls out, you see why this conglomerate form makes Berkshire special. Why those assets that are in Berkshire are arguably worth more as part of this conglomerate than they would be spun out on their own. I think, just seeing the points that he harped on in the letter, really highlights what makes Berkshire special and why I think it's a company that can still generate great returns for investors going forward from today.

Gillies: Nick, first off, I don't think I can add anything to that wonderful description. What you've just described, we could probably boil down to two words as, we'll call it three words, insurmountable competitive advantage, because who is going to come along and take on Berkshire in these three spaces as you call, well, we'll push Apple; in these three spaces, who can replicate that? It's the genius of Berkshire Hathaway, which has long said, "Look, we're not interested in taking over divisions or taking over businesses and controlling them from a central hub. Anybody we buy, you best be prepared to continue operating as you were before we bought a controlling stake in you, you better come with good management because we can't provide it." That's always been a line that's been in the annual reports from Berkshire.

But yeah, they have this almost insurmountable competitive advantage in those three spaces, which allow them to do things the competitors in the individual spaces cannot do. It's always the game. It's certainly not unique to me, but it's a game that I've seen from many other people. What would it take, how much would it cost to replicate a truly great business, a truly great brand? What would it cost to replicate some things? What would it cost to replicate Coca-Cola? Could you do it for $1 billion? Could you do it for $10 billion, $100 billion? The answer, of course is, well, you give me $100 billion to replicate. Berkshire, what do I need? Even the broad Northern Santa Fe railroad, how do you replicate what they do? Basically, there's them and then the other small number of railroads operating. CP [Canadian Pacific Railway] and Canadian National come to mind, but there's a few others. How do you replicate what they've got going? How do you replicate, as you say, the Berkshire Hathaway Energy and their foray into rebuilding the grid and also their focus on renewables, which they have. Berkshire, for me, I've been a shareholder for a while. I've never sold a share, no intention of selling any time soon. I'm happy to see that Berkshire is now buying their own stock back because that's the present price, I think it's a good price, and it's one of those stocks that I hold as a bedrock position. We all love our growth stocks and certainly when times are great, the growthy names that go up a couple of 100% in a year from time to time, which we've just seen in the past year almost spread a little too wide, those are fun. But when times get a little more troubled or the market decides to sell off, boy, it's nice to have some bedrock to anchor things down and buttress against your portfolio again. I even think Berkshire today is a great price, so Fools --

Sciple: I was going to ask you, I think I mentioned it off the top that Berkshire was my kind of energy and industrial spec for 2021 when we did our end of the year show on New Year's Eve. So far this year, Berkshire, I pulled the numbers up this morning, I think it's up 8.5% versus the S&P up 2% for the year. Do you think Berkshire can beat the S&P for the next five years, Jim?

Gillies: They haven't done it recently, but a lot of that, you could put down to some of the big tech influence on the S&P, and big tech, in a lot of cases, has seen multiple expansions. Now, I could make an argument that some of the big tech, Facebook, particularly, from a valuation perspective look good. I understand these issues with some people and Facebook, but that's not my place to tell people how to think on that. I think they can, because just from a valuation disparity, I think Berkshire probably got a bit of a head start because they were trading. I'm not too sure where they are now, I haven't looked in a while, but I know they were hovering into the 1.1-1.2 times book value range for a long time. That is traditionally a good position to be in with Berkshire.

Do they ever get back to the 1.5-1.8 range at their present size? Probably not. I'm not as optimistic about the S&P's chances over the next couple of years, given its performance. Like last year, it was up about what, 18%, or maybe I might be overshooting. Before with 31%, people forget how well it did in 2019. It's hard for the equity markets to grow much beyond GDP as a whole over the long term, like in stocks, the wealth of a nat -- you see things like the Buffett ratio, which of course, he likes to talk about, it's a broad valuation tool. I think you probably know it, but for those who haven't heard of it, it's a broad valuation tool where you compare the value of, basically, the stock market and the S&P and all the stocks in the known universe, kind of the American universe, against the value of GDP. Obviously, there's some pandemic stuff last year, but we'll do a normalized GDP. We're at all-time records on that level. When we're at all-time records, that doesn't bode well for the equity markets going forward. They tend to be flat. They can go down. So, if you want me to take a horse in this race, I will take Berkshire for five years and people can call me stupid in five years, and that's OK.

Sciple: Yeah. Well, if you look back over the past 20 years or so, a lot of Berkshire's outperformance has come in times where the market has maybe not been outperforming at its best. So those two things would align. The other thing I would say, I tweeted this out, they're kind of turning the buybacks on. That thing in Star Wars where the Emperor goes, we can now witness the full firepower of this fully armed and operational battle station. I think we're going to witness the full firepower of the Berkshire buyback machine here in the next couple of years and I think that can deliver some pretty surprising returns for investors, but we'll see. Jim Gillies, any last thoughts before we hit the old dusty trail on AerCap [laughs] and Berkshire and the future of value investing for all the Fools out there?

Gillies: Boy, we could do a long thing on value investing as well. I clinch up a little bit when people dismiss value investing. Because a lot of people, I think, think of value investing as just low P/Es, low P/Bs, low price-to-book ratios, which I've used. I realized I've used the low P/E and the low price-to-book ratio of AerCap here and low price-to-book ratio for Berkshire as examples. But I can tell you, I don't use most of those tools. Most of my tools are just thinking of oddball things that could happen. I'm a very cash flow focused guy, which is difficult in the SaaS world, sometimes not a lot of cash there. One of our compatriots, we had a meeting earlier this morning and he was saying that he's looking at SaaS companies, boy, it's nice to see an EBITDA multiple occasionally, because most of those companies are still losing so much money as they grow rapidly and try to take their market.

I would encourage people, as a value investing thought process, to go beyond and look for things where the cash flow story tells a different story from what the market is telling you. If you can find founder managements who are treating their own equity with respect, who also like a good cash flow story, I could mention a couple, I'm not going to go down one particular road. You find those and you just grab on, and very Foolishly, you never sell, unless you need the money for buying a house or whatever. Value investing is nothing more than just looking at a company and saying, what is the value of the future cash flows estimated reasonably, that this company will throw off over the course of its lifetime, sum it up, and then what is the current stock trading price. A little company like Amazon, for example, trading at $200 in 2011-2012. I bought that as a value investment. It's our friend Uncle Joe Magyer who pounded that into my head. It's like, "No, this is value." You open your eyes and go, yeah, this is value, actually. Maybe what my last comment would be is, open yourself to the world of maybe value investing for the 21st Century. We'll ignore those cigar butts, we'll ignore just working off of the stale ratios that we shouldn't be looking at and start really looking at businesses, looking at managements, and looking at how management generates cash.

Sciple: Follow the money, everybody.

Gillies: Follow the money.

Sciple: Thanks for joining me, as always.

Gillies: Thank you.

Sciple: As always, people on the program may own companies discussed on the show and The Motley Fool may have formal recommendations for or against the stocks discussed, so don't buy or sell anything based solely on what you hear. Thanks to Tim Sparks for mixing the show. For Jim Gillies, I'm Nick Sciple. Thanks for listening and Fool on.