In 1968, a recent UCLA graduate named Steven Udvar-Hazy created a small commuter airline named Astro Air. He became the youngest airline CEO overnight, certain that America's blue skies would reward him with wealth.
Armed with only a small Jetliner he leased for $4,500 per month, Hazy was in business. Six months in, however, he realized just how difficult the airline business really is. Bags were lost. Pilots wouldn't show up. Rain would put a damper on his flights. But no matter what, he owed $4,500 per month for the plane -- rain or shine, snow or sleet.
It was then that he had a breakthrough realization: When it comes to airplanes, it's much better to be an owner than an operator. He would go on to build one of the most prolific aircraft leasing companies, turning million dollar deals into a billion-dollar leasing firm, ILFC.
A top-shelf business
Despite the fact that the airline industry hasn't produced a cumulative profit in its entire American history, the financiers who provide the industry with planes have done quite well. You could say that the airlines do all the work, yet all the earnings accrete to the leasing companies, not the airlines.
So perhaps it's not surprising that David Einhorn, a perma-bear when it comes to airlines, recently identified one aircraft lessor, AerCap (NYSE:AER), as one of his newest "best ideas" at the Grant's Investment Conference on April 7, 2015.
Einhorn's thesis is relatively simple: AerCap is well-managed, and can generate impressive returns on capital by buying planes and leasing them to airlines. In addition, after buying ILFC -- the firm started by Hazy -- in 2014 from AIG (NYSE:AIG) it's poised for an even better 2015. Central to Einhorn's thesis is the fact that AerCap bought ILFC for a song -- a price less than the appraisal value of its aircraft.
What Einhorn sees in AerCap
Leasing is a simple business. AerCap buys a plane, and lets someone else (an airline) use it in exchange for a regular lease payment over a term that averages 14 years.
Einhorn's estimates suggest AerCap can buy planes today and earn 6.8% on each dollar deployed per year. That may sound low, but this is an unlevered return. Funded partially with low-cost debt, Einhorn's presentation suggested that AerCap should be able to generate a return on equity of 13.3% on newly purchased planes.
That return includes Einhorn's assumptions about potential loss rates. Some leases will simply go bad, just as you'd expect. But because aircraft are almost always in demand, finding another airline to lease a plane shouldn't be particularly difficult.
Over the cycle from 2007 to 2013, AerCap had a default rate of approximately 2.5%. Over the same period, however, AerCap's utilization rate, which measures the amount of time the average plane is leased, averaged 99%. If one airline can't make required payments on its leases, there is always another airline ready to pick up where the last airline left off.
And it's really, really cheap
AerCap currently trades for about 8.5 times 2015 earnings expectations. That's certifiably cheap -- less than half the earnings multiple of the S&P 500 as a whole. Perhaps the most convincing element of Einhorn's thesis is that while debt investors see AerCap as a small credit risk, stock investors haven't yet given AerCap the same tip of the hat.
I've always given a little more credit to debt investors than equity investors. Being creditors, they're more cognizant of the downside, and, in my opinion, much better at judging business risk because they have to be. The best case for a creditor is that they get their interest payments and their money back. The worst case is they lose everything.
With AerCap's unsecured debt (read: its riskiest debt) yielding just 3.9%, creditors are willing to lend it money for a fraction of the return stock investors are demanding to invest in its stock.
Based on forward earnings expectations, we can determine that stock investors require an earnings yield of 11.7% to own the stock, or roughly three times the return debt investors require. That ratio was closer to 2:1 immediately following AerCap's purchase of ILFC.
In other words, its creditors increasingly see AerCap as a low-risk business. Equity investors haven't yet "re-rated" the stock, however, letting it trade for a higher multiple than it did before the acquisition.
AerCap looks like a compelling play on the airline industry. Recent profits have buoyed airline stocks, leading to better profits for leasing companies, and much higher prices for airline stocks. But when the inevitable bust comes -- as it always has -- investors would be better off investing in the planes than the operator. If you like airlines, I believe that you should love AerCap.