Aengus Kelly, CEO, Aercap
The last 12 months truly underlined the dynamism that comes with running a global leader in the fast moving air finance eco system. Internally, AerCap focussed on the inclusion of the mammoth ILFC fleet it acquired in May 2014. Externally, a key input for aircraft operations - fuel - collapsed in price as the year unfolded. Geopolitical challenges, most notably around Russia, created their own issues. This, then, has been a year that battle tested AerCap’s business model, strategy, and confidence in its potential growth trajectory. How did it do?
“Well” is the short answer. Mr Kelly points to four targets his team were set early in 2014; (1) Enhanced liquidity which has been delivered via $12bn of issuance and $7bn of liquidity currently on hand; (2) Cost savings that stemmed from an efficient transfer of 900 aircraft in to an Irish operational and ownership structure. That project had a completion date of end 2016 but is done now, leaving a combined fleet of 1300 aircraft and an order book for 380 units; (3) Integration of people resources and its delivery is measured by the absence of any unplanned attrition, and; (4) The combining of IT systems that are critical to a global and fast changing financial services group. That too is complete ahead of plan. Sprinkle on top of that a $1bn profit run rate that is a year ahead of guidance and the attainment of a 3 to 1 leverage multiple expected to be achieved 12 months early. Not a bad start.
So, how does a behemoth like AerCap truly offer competition to the other 100+ lessors in the global marketplace? Does scale offer a competitive edge ? “Imagine a large scale bond or equity issue” says Kelly. The “book” is nearly always built around the interest shown by the biggest investors, the anchor investors. Ditto for any airline of significance with a fleet requirement. AerCap offers the size of platform that can take off older aircraft from a customer while replenishing and growing an existing fleet materially. That one-stop-shop competence provides advantages for both seller and buyer. China Southern, Azul and LatAm are example of larger tickets completed by AerCap which occasionally include the trading of aircraft. AerCap, with its global reach and ability to opt for parting out older planes, can mix and match assets for its customer’s benefits. Kelly says GECAS has similar scale abilities to AerCap and goes on to describe an industry structure composed of two mega lessors that account for approximately 40% of the market, 7 further lessors that account for 30% of the market and another 100 or so that make up the remainder of the industry. This structure has not materially changed in decades although the number of lessors at the smaller end of the scale has started to mushroom.
Does AerCap want to be a larger slice of the overall leasing pie? “Not for its own sake” says Kelly. He thinks there is always a risk of price degradation if a lessor is so big it simply has to participate in every deal. Instead, he wants to evolve in ways that prioritise equity value creation. That means any strategy conversation has to have seats reserved for debt pay down, equity returns and profit enhancement alongside any discussion about scale. With over $600m of annual free cash flow from the existing platform AerCap can choose to enhance its contracted 5% CAGR growth but that risks running ahead of an industry growing at the same clip.
Tied in to this strategy discussion is the scale of orders in the AerCap book. It currently has contracts to buy equipment equivalent to about 60% of its net book value. That compares with 380% at ALC and close to 100% at Avolon as examples. Kelly says value is central in how to deploy capital and makes two key points; (1) sale and leasebacks are a well trodden route for AerCap to buy metal, and; (2) OEM orders will be made when the price v return formula works. In that context the decision to convert an option to an order for the Airbus A320 NEO family made sense given the economics available as a launch customer.
One factor outside of AerCap’s control which has a bearing on asset demand and values is fuel price. After a 50% fall in oil prices during 2014 how does an input that accounts for up to 40% of an airline’s costs impact the AerCap business ? “The ILFC deal was done during $100 oil” says Kelly so things have changed. Starting at the tail end of the AerCap portfolio low fuel prices have re-ignited interest in gas guzzlers like the A340 and older B747s that AerCap assumed would have to be parted out sooner than later. In fact, users are extending operation of these jets and interest in them has reawakened. Kelly thinks that is fine before any needed refurbishment which can cost up $30m in a widebody. While welcoming the renewed interest he retains a conservative attitude towards these assets. Other out of production aircraft seeing improved demand include the B757. AerCap recently took back a package of six 17 year old 757s from Russia and encountered competing buyers for the assets at attractive prices.
At a broader level low oil prices are an effective tax cut for consumers worldwide and that in turn should drive demand for air travel. Moreover, the airlines that pay AerCap its monthly bills are enjoying robust profits as fuel costs fall and this improves the overall credit profile of AerCap’s customers. Within the portfolio, Kelly thinks low prices underpin the already solid demand for mid life and current generation aircraft. For new technology equipment AerCap is not experiencing major customer pushback on demand as they are choosing these aircraft for long periods of fuel efficient operations. All airlines remember the severe challenges posed by spiked oil costs in 2008 so they remain wedded to the need for new aircraft and the benefits therein. Indeed, AerCap says the pace of activity they are experiencing with new technology aircraft is the same as when oil was at $100.
Regarding the types within the AerCap fleet how has the B787 in particular evolved during 2014 given its difficult birth? “Very successfully” according to the CEO because its operational efficiency is improving sequentially every quarter, the installed base is expanding and the product range is doing well. The -8 variant, which some had criticised, is showing customer traction as a valuable pathfinder on long thin routes that can be upgraded to -9s or -10s once the point-to-point economics are proven. AerCap sees the 787 as “with us, for the long term as a quality asset”.
With geo-political risk hovering over Central and Eastern Europe, and AerCap’s scale ensuring it has significant dollar assets in Russia, how have the macro-economic events in that geography affected the business ? “We see different levels of operators in Russia” Kelly argues. Aeroflot and one other scheduled carrier are the larger and strongest carriers, followed by a mid tier group of airlines and below that charter type carriers. The latter segment is the biggest challenge as they operate in demand elastic price driven markets. The lessor has engaged fully with that segment and worked out solutions including the extracting of aircraft from the market. With the larger carriers it is relatively sanguine about the challenges facing those.
At a group level AerCap assumes about 1% of revenues are at credit risk each year and 2014 was no different. The ability to rapidly move aircraft is a key attribute of this infrastructure asset class and AerCap’s experience in Russia is another validating feature of the asset class. Kelly cites other examples where it moved aircraft from customers who struggled including Kingfisher and Spicejet in India, and Mexicana as airlines where AerCap’s ability to shift assets quickly helped protect investor’s interests.
Focusing on the wider aspects of why aircraft do well for investors we enquired about how both the buy and sell side of the aircraft market helps investors compared to other hard transport assets including ships? Kelly is strident on the point “Ships have numerous manufacturers who enter and leave the market often and are prepared to cover just variable cost when markets are weak. Hence, asset volatility is huge. Large aircraft manufacturing is entirely different as it is dominated by two global OEMs that are ultra competitive but rational. When markets weaken OEMs engage with customers to manage delivery profiles. While that may cause upward pressure on prices for airlines it does help create an orderly supply dynamic when markets are challenged. It also should be remembered that the debate takes place against a backdrop of 5%+ CAGR growth in demand which has delivered a doubling in market size over the last decade. The same is probable in the next decade.”
Lessors are children of the financial services industry, so how do capital markets impact the business? As importantly, what does an elongated period of low interest rates and QE type liquidity mean for aircraft leasing? “On capital markets we know airlines can use EETC type products to self fund fleets but this tends to be concentrated in North America and limits fleet flexibility. We believe the 90%+ of airlines operating outside the US see leasing as a powerful option for accessing finance and the fleet flexibility needed to maintain cost and product competitiveness.”
On interest rates and QE “lease rates are a function of interest rates so we focus on net interest margin (NIM), defined as lease income less funding and credit costs. That was about 820bps in 2008 but has moved out to over 1000bps recently and post ILFC for us. We manage NIM closely and investors should understand that for this reason rising lease rates are not automatically positive as they could derive from higher funding costs. Overall, we are pleased with run rates on NIM and the liquidity available due to existing Central Bank policies globally”.
Of course AerCap, like the rest of the aircraft leasing industry, began life in the private equity universe and public equity exposure is a relatively recent phenomenon. With Avolon marking lessor No 5 on the NYSE how does AerCap view its investor base objectives ? “Work hard” is Kelly’s advice to spread the word about aircraft leasing fundamentals. “The addition of Avolon adds another dimension for investors which we welcome. Increasing the profile of lessors with the global investment community is a clear cut business objective as it helps attract interest in our shares and widen the investor pool for our business”.
We suggested that both airline and lessor management teams appear to be maturing in their attitude towards equity value creation. Kelly agrees, “You can see a clear focus on equity value among the consolidated US airline industry and that is developing in Europe too. Stockmarket listed lessors too have the discipline attached to having heavyweight equity managers owning their shares. Combined, these factors are helping the aviation complex to improve its standing in global equity markets in contrast to a history of overleverage and boom/bust cycles”.
And China? Is it a threatening new home for lessors or an enormous opportunity? “The latter. We are already very large in China, have a JV with the Chinese Government and an important office in Shanghai. China and the US are two hotspots for us currently.”
With oil at such low prices, what do you see developing among the Gulf carriers? “That question needs time to answer as the price where oil settles is a key input to any answer. Clearly, Emirates is located in a state with no oil resources so we expect its growth trajectory to remain unfazed. Other Gulf states have significant oil and gas revenues so a sustained low oil price could influence thinking about resource allocation around their airlines. However, the Gulf carriers remain potent and growing airlines on international markets”.
Mr Kelly is steering AerCap towards sustained growth in 2015 and beyond. Its order book alone ensures expansion while continued aircraft trading and potential fresh airline deals can propel the business further. It is clear he intends to advance the lessor as a highly regarded company in the airline, OEM and investor markets for many years.