In this episode of Industry Focus: Energy, Nick Sciple and Motley Fool contributor Lou Whiteman bring you an update on what’s going on in the airline sector, including what’s going on with Boeing‘s (NYSE:BA) 737 MAX and how air travel is faring.
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This video was recorded on October 22, 2020.
Nick Sciple: Welcome to Industry Focus. I’m Nick Sciple. This week we’re checking back in on the air travel industry with an update on Boeing’s 737 MAX and a deeper look at our favorite way to invest in an air travel rebound.
Joining me to help break it all down is Motley Fool contributor Lou Whiteman. Lou, thanks for joining me once again on the podcast.
Lou Whiteman: Glad to be here.
Sciple: So, we last talked about air travel back on September 10th. What’s new? We’re, kind of, in the middle of airline earnings right now,
Whiteman: We are, and the biggest thing that’s new is that we finally had the CARES Act aid end, which also included a limit on involuntary separations. And sure enough, this industry needs to get smaller and we have seen tens of thousands of layoffs, mostly focused on a few carriers. But yeah, we are in the middle of a very bad period and we’re, kind of, finding out now how long it’s going to last or getting a feel for how long it’s going to last.
Sciple: Right. A lot of uncertainty around how long it will take for the air travel recovery to play out. But airlines appear to, at least, be getting their feet underneath them a little bit, getting their cost structures under control, so that they have some ability to continue into the future. When we look at an air travel story that’s really been dominating the news, even back before the pandemic, that’s the Boeing 737 MAX saga. The plane has been grounded since March 2019 following crashes in Ethiopia and Indonesia that killed 346 people.
However, it appears that the 737 MAX may be ready to return to the skies soon. Earlier this week, American Airlines announced plans to return the 737 MAX to its flying schedule on December 29th, assuming Federal regulators approve the aircraft to fly.
Lou, when we look at this story, we’ve been talking about the Boeing 737 MAX, when it is going to return, for over a year now. How significant is this news for Boeing?
Whiteman: Oh, it is the story. And let’s just, to underline it, American would not be doing this if they didn’t have strong confidence that they can be doing it. The FAA has finished their review, the Europeans have said it’s about time, we’re ready, it’s going to happen. Boeing burnt through almost $10 billion in the first half of this year. Some of that was COVID-related, but a lot of it is penalties, support payments for suppliers, costs from maintaining planes that have been built but are still parked. This is the first step toward Boeing’s recovery. Once you can stem that bleeding and also get the cash coming in the door from new plane sales, as they start making deliveries, this is the first step of a turnaround, and so it is the biggest story for Boeing out there right now.
Sciple: Yeah. You talk about 737 MAX. You know what, here’s a question for you, Lou. The 737 MAX plane is returning, would you be willing to hop on that airplane on that first flight?
Whiteman: Yes. I would be thinking about it on that first flight. I do believe in the power of the software, I do believe in the regulators giving it a — this time around anyway — giving it a really, really thorough look. Yes, I would. I would certainly [laughs] be thinking about it, though, if I was on that first flight.
Sciple: Absolutely. And I think when we look at the positioning of Boeing for air travel recovery, I pulled a quote from Air Lease CEO John Plueger, where he said, basically, [laughs] we need the MAX, whether folks are concerned about it or not, Airbus simply doesn’t have enough manufacturing capacity to meet all the single-aisle needs that are coming forward in air travel. And it’s worth noting that, on the backend of this aircraft, this aircraft will have been through more regulatory hoops than probably any aircraft in history. So, if there’s another wreck, then we really need to be blaming our regulators for making a huge mistake, I think, because there could not have been more scrutiny on what’s going on here.
So, we look at Boeing 737 MAX coming back; that’s an important move for them. However, they still need that air travel rebound to get the business back going. Folks have to buy these planes. We got some news today about Southwest that thinks that some of the concerns about coronavirus on air travel are subsiding, they’re going to add middle seats to airlines beginning on December 1st. Do you think airlines provide an interesting way to invest in a recovery here?
Whiteman: So, I think, yeah, Southwest, it’s interesting, because you have to hear everything they’re saying. They’re both adding back seats because they believe there’s confidence that’s growing, but they also, Gary Kelly, the CEO, on CNBC wouldn’t fight back when they said it could be 10 years before [laughs] there’s a full recovery, and he didn’t really predict 10 years, but he didn’t yell at that question, so that’s where we are right now.
I think, for me so far, the most interesting earnings call has been United Airlines, they were probably the bluntest company back in the beginning of this. While everybody else was celebrating the relief, they said, we’re glad we got it, but we’re probably still going to do layoffs. You know, they have just been the most candid. Scott Kirby, their CEO, who I’m a big fan of, in his call, he said 12 to 15 more months of pain and sacrifice. And let me read, it’s a great quote, because I think it really sums up where we are, “The light at the end of the tunnel is now visible, it’s a long tunnel, it’s going to have twists-and-turns, but we’ll begin to move back toward normal. With what health experts are telling us, there will be a widely available vaccine at the mid next year.” So, that’s where he is, he is at the end of the beginning, but it’s also — I mean, he says, 12 to 15 months, I think that’s a minimum, we are still a long way from healthy, we’re still years away from healthy.
Sciple: Right. And so, we look at air travel, the recovery is on, but to your point, it’s still going to take a long time before we even get back to where we were a year ago. So, you need a lot of “ifs” to go your way to invest in airlines right now. Is there a better place to invest in an air travel recovery in your opinion?
Whiteman: Well, I think that’s a really interesting way to look at it. If you believe that air traffic will recover, but you’re nervous about picking a favorite or picking an airline that will still be there, the aircraft lessors are a really interesting thing to look at. These are the companies that are providing planes, they buy the planes and lease them back to the airlines, it’s a way to bet on the industry without necessarily saying this company will not get in trouble or this company will.
Sciple: Yeah, let’s talk about the lessors, we’ll dive into that a little bit here. A surprising thing to a lot of folks will be that airlines aren’t the biggest owners of aircraft in the world, there are these aircraft lessors. And there’s a lot of reasons for that, it’s cheaper for airlines to lease these planes, at least in the short-term, than to buy an aircraft outright. In addition, these aircrafts have lifespans of up to 30 years, often an airline will like to refresh their planes on a quicker basis then that, so it gives airlines flexibility to keep newer planes in their fleet. And then thirdly, you look at a lot of these smaller airlines, they just don’t have significant scale in purchasing. And so, what a lot of these lessors allow folks to do is they have bigger scale, they can get better purchase terms from Boeing and these manufacturers. And so, it benefits the airlines. How do the lessors make money in this transaction?
Whiteman: It’s just to that point, I mean, buying an airplane is a lot like buying a car, where nobody pays sticker. But I’ve heard cases where some of these big lessors are rumored to get 70% off list price on their bulk orders, so that is a huge advantage that only the biggest airlines, only maybe the Middle East Airlines or Singapore could get. So, yeah, there’s value on both sides.
The lessors are going to make their money basically as a finance company, it’s a spread business like the banks. They’re going to borrow money, buy the planes and hopefully be able to charge rates that exceed their borrowing costs. In good times they usually can, and you know, [laughs] in bad times, it can be a struggle.
Sciple: Right. And so, like a bank, these companies are going to carry significant amounts of debt in the way they make their money. They’ll borrow at rate X, and then they will lease the plane out at implied rate X + Y. And that Y is the spread that they’ll make, and that’s how they earn their margin. So, that’s how they play into this industry. Why do lessors look more interesting to you than airlines today, why is now a good time to look at this space?
Whiteman: Well, anyone who is hearing us talking about this can probably figure out the risk here. You know, you were carrying, as you said, tens of billion dollars in debt at a time where your product, the planes that you’re trying to lease, are less in demand. And sure enough, AerCap, a company that we talked about briefly. You know, they had a deferral balance, as of June 30th, of over $430 million. Those are lease payments that they’ve just told their customers they could differ for now. So, there is huge risk, and with this risk, you have seen the stocks actually fall more than the airlines. The case for them, though, is the diversification, the relatively healthy balance sheets, the prudence they have shown, plus the opportunity that there is a light at the end of the tunnel, and some of the assets they have will hold value even if the individual airline fails. I think that’s the real intriguing thing right here is that there’s so much fear baked in, and there’s good reason for the fear, but I would argue that fear is very much overblown right now, and it’s creating an opportunity.
Sciple: Yeah, I think we’ve talked about in the past, with the airlines running the equity side of this business, and so if air travel doesn’t recover and airlines aren’t able to support their business, they might have to go bankrupt. And so, while the airline may disappear, the equity holders will be left in a tough spot. However, those assets that the airline uses to carry out their business, those airplanes will still hold value, and that’s what companies like these lessors hold. They hold these actual assets they will be able to recover if an airline declares bankruptcy. Also, when a company declares bankruptcy, often it will be Chapter 11, this is the reorganization bankruptcy, you’re trying to keep the company in operation to preserve the value of the business. What that means is, if you’re an airline, you’re probably going to try to keep doing flights, [laughs] keep maintaining flights to keep the business in operation. And that means you’re going to keep paying your lessors.
So, even if these businesses go bankrupt, given the necessity of these assets that aircraft has to the continued operation of the business, there’s less likelihood that they’re going to lose the business even if a bankruptcy occurs. They might have leases cancelled, they might have things altered, but they’re in a position where they hold the assets that are necessary for this industry to continue operating.
One other important thing too, as you mentioned, Lou, the debt that’s on these businesses, is that, there’s been a significant amount of capital that’s flown to AerCap and some of these other businesses, that has allowed them to refinance. Just this past week, you saw PIMCO make a deal with GE Aviation Services, GE Capital Aviation Services is another big lessor, to develop an aviation leasing platform and to support up to $3 billion in aircraft asset financing. This is someone who hadn’t been involved in the industry before, PIMCO, very significant in fixed income now pumping $3 billion into the space, shows that there is still capital willing to invest in these lessors. So, the likelihood that access to debt is going to lock up for them appears low.
Whiteman: We’ve seen a lot of examples. We were talking off the air about AerCap just doing a refinance too, where they pushed some of their debt back. Every indication is that the financial markets are very much open to these guys. That eliminates one very, very bad thing that could go wrong. Most of them are pretty healthy too in terms of unencumbered assets and assets they could borrow on if things really got bad. Yeah, we’d be in trouble if there was really a freeze here, because it’s a tough time to be in this business short-term, but there is nothing to suggest the financial markets are closing up and there’s nothing to suggest that they could get into that trouble right now.
Sciple: Yes. So, we’ve mentioned AerCap a few times, that’s ticker AER. [laughs] When you see AER, it’s Ireland, right, Aer Lingus is a significant airline in Ireland. When you look at a lot of these aircraft leasing businesses, they are based in Ireland, what’s the reasoning behind that?
Whiteman: Actually, there is a great story behind this. This actually dates back to The Troubles, which for those who aren’t as old as I am, the sectarian violence that went on in Northern Ireland, it peaked in the late ’70s. Aer Lingus, the Irish national carrier, had two Boeing 747s that they had bought to try and figure out a booming demand for tourism business from the United States. Because of The Troubles that wasn’t happening, they were losing money, they needed to do something with these two 747s. They had the idea of placing them. I believe both ended up in Thailand or at least Southeast Asia. And someone at Aer Lingus said, hey, there’s a business here.
From that became something called Guinness Peat Aviation, which was the industry for a long time. There’s a lot of Guinness Peat alums still running these companies. And it kind of just built up as a niche industry in Dublin. You have a lease law expert, you have sales accounting experts, Ireland has very, very good tax treaties with countries all over the world. It is, kind of, becoming a cottage industry now. And all because of what was going on in Northern Ireland in the late ’70s and Aer Lingus’ desperate need to get rid of two assets that they couldn’t make money on.
Sciple: Yeah. And so, it’s like one of these accidents of history where Ireland has been this hub of aircraft leasing, AerCap is based there, Air Lease and other publicly traded companies based in Ireland as well. We’ve mentioned AerCap a few times, so that’s the one I want to really drive into more on this podcast. I own it, you own it, I know some other folks at The Motley Fool own it. So, it’s really our favorite of this bunch. Why does AerCap stand out among this group?
Whiteman: So, AerCap, for me, is the perfect combination of the two things you need in this business. For one, you need size and scale, and they have it. Depending on how you look at it, they are the largest. They are largest by asset value of commercial aircraft. They aren’t the biggest fleet, but they are the most valuable fleet. They also have, I believe, 200 customers in 80 countries, so they have a lot of geographic diversity too. At the same time, they also have a very young fleet. A lot of what we’re talking about here, what could go wrong is, if an airline goes bankrupt, they return the plane, you need to find a place for it. That is much easier to do in this environment if you have a young fuel-efficient plane that has value versus a 25-year old plane that is less valuable even in good times.
AerCap is the combination of the size and it also has, I believe — just a couple of numbers for you, more than half of their fleet is so-called next-gen technology, which are these new fuel-efficient planes. 90% of the fleet are the new A320s, the neos, the 787 Dreamliners, the 737 MAXs even. These are the planes that are in demand. They are the world’s largest lessor of the A320neo and the 787. They have strong access to capital, good scale and planes that are in demand if things go south, it is a great way, if you’re interested in lessors, to get involved. They have the best risk profile out there, and yet they are still trading at, I believe, what, 30% of book right now.
Sciple: Yeah, we’ll get into the valuation a little bit later. Yeah, that significant fleet shows. Right now a lot of the concern is, until air travel recovers you’re going to have some of these assets sitting and not flying, these younger assets are going to hold up their value longer and be more marketable than some older assets when you look at, like, GE Capital’s aircraft asset is much older relative to AerCap.
Another significant point for them is a disproportionate, I believe, 70% is what I have down, of their fleet is with U.S. and Chinese flag carriers. That means that they have less risk with some of these smaller airlines. So, a lot of the big risk is going to be with Virgin was one of those who went bankrupt earlier this year, much smaller airline, much less risk in these flag carriers. Also, these flag carriers are going to have more access to capital. So, they’re going to be able to refinance.
So, when you’re looking at AerCap, what are the key metrics that you pay attention to? You mentioned the fleet size, you’ve mentioned the diversity, what about their access to capital, what can you look at to track that?
Whiteman: Well, so, you could see what they are doing. I mean, one thing they’re good at too, just to kind of follow on your point is, one of the reasons they had the youngest fleet is they are among the most active traders of aircraft. And this is important, it can go wrong for you, but frankly, in my mind, they’re just better at this than we are. They were selling 787s when this was still the hottest game in town, in anticipation of a move toward smaller aircraft focus, and they proved right there. They keep their young fleet, in part, by doing deals. And importantly, as I look at this company this year, they have continued to find buyers and continued to do the sale and purchase of aircraft through this time.
I think for the year, and we don’t have numbers through the third quarter yet, they have 18 purchased and 34 sold. A lot of what they’re selling is the older 747 and there are a couple of older generation 777s, but that is how you keep the portfolio young, which in this environment is very important. In terms of looking at their financial profile, you look at their debt.
They have $30 billion in debt, but very little of it, less than $2 billion is due before 2023. They have access to capital. We’ve just seen some refinancing. They have unencumbered assets of nearly $30 billion, we’ll get an update on that number soon. So, if things go wrong, they can go, they can raise more money. Now, granted in that situation probably the book value is a bad thing to look at, and maybe that unencumbered assets is, maybe it’s half of that, $15 billion, that’s still a lot of liquidity in a pinch. If they’re not going under and if aviation is coming back, the stock [laughs] really, really looks cheap. And that’s kind of my argument for buying it, and that’s why I do own it.
Sciple: Yeah, I mean, let’s talk about the valuation now. You mentioned earlier, I’ll just run through a few of these numbers. About 5X forward earnings, about 40% of book value. I know a lot of folks push back at book value. For a company like AerCap, it’s relevant. Heavily capital heavy business in a financing type industry, that’s where book value is relevant and you’re trading $0.40 on the $1 there. You’re also looking at 0.7X normalized sales. But again, you look at these numbers, book value depends on what the value of these assets are, when you look at normalized sales, it depends on the pace of recovery of this industry. So, you look at this valuation, and it looks very appealing, what could go wrong?
Whiteman: So, what could go wrong? I mean, the bear case is, you can probably picture it in your head, I mean, if the sluggish travel demand prolongs, leads to fall in lease rates, as planes come up for renewal, there’s a glut of aircraft out there. So, the supply and-demand issues. Airlines, post pandemic at least, are likely going to rely on their partners for international travel, so that’s going to be fewer aircraft needed even in recovery. Meanwhile, Boeing and Airbus are desperate to keep their production lines running, so they’re willing to cut deals, they’re willing to finance internally. To some extent, the AerCaps of the world can get in on this, but also, it’s a good time to maybe go bypass the middleman, if Boeing is really trying to make deals.
So, you could have a world where it is really hard to place assets and earn a return on and pay your bills at a time when residual values are plummeting and it’s tougher to sell older planes. Now, a lot has to go wrong there and they do have some coverage. And we mentioned earlier, AerCap has about $430 million in deferrals. And again, I’m really looking forward to their earnings reports; we can update these numbers. They have reserved about $1 billion against that. So, they are conservative, it doesn’t keep me up at night, but it’s hard to imagine this industry coming back much before the airlines. And if the airlines are going to be in trouble for a while there is at least a risk of dead money, so you better be getting it cheap. And look, this is a highly leveraged business. We’re in a pandemic, it’s really hard to predict the future of a virus, so there is inherent risk just until we know what the other side looks like.
Sciple: Right. And so, really just you have to believe that air travel is going to recover, that’s a key part to this thesis. You know, if you’re investing today, what time horizon would you be thinking on to wait for this thesis to play out?
Whiteman: I’m a terrible […] because I hate selling stocks. [laughs] So, everything I buy, I’m thinking very long term. But this one, I think you have to. I think that we didn’t get into this, and I really want to get to, but there are some other levers to pull too with these businesses too. If we get into an extended rut, without getting too much into the industry term of art, but there are dry leases, there are wet leases, and there are what they call these damp leases where the leasing company picks up some of the maintenance, maybe makes a little margin on that. There’s a lot of levers to pull, so I’m hopeful that even if air traffic isn’t really back until the middle part of this decade, we’ll see these companies — as the markets get more familiar with them, I’d like to think some of the valuation will go up. But I think you better count on holding this for five years at least.
Sciple: Right. At the end of the day, these are the companies that control the assets that will be driving that recovery, right? [laughs] These are the planes that will be flying on an increased rate. And so, these lessors provide a little bit less risk to invest in that recovery, where you hold the assets versus the equity on the side of this business. Yeah, any last thoughts here before we go away, Lou?
Whiteman: Well, I would just say, and again, I mean, I am more bullish on the airlines than most. And even I am, I feel a lot better about this than I do about the airline. I mean, there is a lot of danger here, be careful. Some of these other companies, you may get a little bit more on sale, but there are some, kind of, warts there that I don’t see with AerCap. Be very careful, this should be a small part of a diversified portfolio. But there are moments where fear causes things to be mispriced. And, yeah, I don’t get them in my industrial areas often as, kind of, tech does. And this really feels like one of those moments with AerCap.
Sciple: Yeah, I agree. This is one of those where it looks like the market has overreacted, but we won’t know until we see how quickly this recovery takes place, and we’ll be on this show tracking it as it happens.
Lou, thanks so much for joining on the podcast, once again.
Whiteman: Glad to be here.
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 Lou Whiteman, I’m Nick Sciple, thanks for listening and Fool on!