$AER has been our second largest position since July (average cost basis: $26/sh) when the likelihood that vaccines under development would be successful was looking increasingly obvious. At the time, we believed AER was trading at such a tremendous discount to intrinsic value

that even worst case scenarios wouldn’t be able to wipe out shareholder’s equity. For example, at $8b of tangible book value (~$60/sh) and $35b of aircraft assets – a write-down of $5b would be required to take the tangible BV below the share price at the time.

This would imply AER’s planes (avg. age ~6.4 years with 7.3 years of average remaining lease terms and a useful life of perhaps another ~14-18 years) were being valued by the market as having effectively ‘lost’ 1/7th of the value they otherwise would’ve provided from their

remaining useful life. For this to be right, AER’s customers would’ve had to violate their lease contracts en masse as they declared bankruptcy (presumably with the expectations they wouldn’t need the planes for at least several years) and then airline traffic would remain

so significantly depressed well through 2022 that AerCap would be stuck sitting on useless depreciating assets while struggling to service its debt. In reality, AerCap likely had a significant cushion to weather the storm, with:

1)~7 year avg. remaining lease terms on ‘hell or high water leases’ that many customers would be incentivized to continue paying (at least in part) despite bankruptcy due to an expectation of demand snapping back sometime in 2021

2)Over $750m in lease deposits (covering ~20% of a year’s worth of lease revenues)
3)Enough liquidity (from cash, unsecured revolvers, etc.) to easily cover all cash needs for 2+ years

4)Historically conservative depreciation schedules that likely undervalued their assets by between 5 and 10% on average

While total global air traffic was down ~65% in ’20, domestic passenger traffic in China had basically returned to normal by October.

It seemed obvious to us at the time that consumers throughout the world were anxious to travel, that extremely effective vaccines were on the way, and that come summer 2021 there would be a massive ‘snap back’ in demand for air travel that would send bookings and airline ticket

prices surging. 9 months later, we believe the market has validated these perspectives, with $AER shares now trading at ~$60/sh (up ~130%).

The question now is where $AER has to go from here and whether further upside can be realized. The stock currently trades at

~85-90% of BV. On a standalone basis – we think this valuation remains conservative. Trading at a discount to book implies airline lessors like AerCap have not only no platform value whatsoever (so all their aircraft purchasing scale, customer relationships, long term contracts

, etc… are viewed by the market as worthless) but also they’re so significantly risky that they need to trade at a significant discount. For a company:
1)That averaged $1b of net income for the 5 years from 2015-2019
2)That still did $500m of operating cash flow

less depreciation in 2020 through what was basically the worst year ever for the airline industry
3)That raised $1b of debt at a 1.75% interest rate in January ‘21
4)That is securing massive amounts of financing and market support for transformative M&A (more on this below)

This seems way too cheap. People have commented that on a DCF basis alone, these airline lessors should perhaps trade anywhere from 1.3-1.6x book value. We wouldn’t put a stake in the ground and say 140% of book value is our price target

and the effects of ’20-’21 will certainly have some permanent negative impacts on the value of Aercap (the company has already written down assets by ~$1b and some additional writedowns are still possible – but mgmt. noted confidence most writedowns are in the past at this point)

, but a 10% premium to book after this year going forward (having proved the resilience of the airline lessor business model) doesn’t seem all that crazy, which by itself implies a price pushing into the $70-80 range assuming no further asset writedowns.

As air traffic returns to normal in 2022, airlines look to deleverage their balance sheets by further relying on lessors for aircraft financing, and earnings for AerCap normalize – would fully expect the market to continue to reward $AER with a higher multiple of BV.

This brings us to the last, and currently most important thing to cover when thinking about $AER going forward – the recently announced acquisition of $GE ‘s GECAS (GE Capital Aviation Services). The deal itself would roughly double the size of AerCap’s fleet, creating a

combined entity with 2000+ aircraft, 900+engines, and 300+ helicopters. The deal involves AerCap paying $24b in cash, 111.5m shares, and $1b in AER notes – after which GE will own 46% of the combined company. GE’s assets are valued at $34b (after a ~$2b writedown).

The deal has been criticized by some ( @puppyeh1) who note AerCap is:
1)Potentially overpaying for less attractive assets
2)paying mostly in equity (vs. increasing leverage), and for being potentially less attractive to shareholders vs. just plain old buybacks

3)being a vanity purchase driven by AerCap executives desire to reunite an old industry giant (Guinness Peat) under the AerCap name

While we’re sympathetic to criticism that a good portion of major M&A like this is driven by irrationally ego-driven execs and their

fee-incentivized banker friends (and that anything involving GE Capital may be a bit questionable) – think the criticisms above aren’t totally fair in this case and the deal is at worst a bit of a wash for $AER shareholders and best-case offers very significant value

creation potential. AER is paying $25b and 111.5m shares for $34b of assets, during which it will increase its leverage from 2.6x -> 3.0x. It’s basically paying 111.5m shares for $9b in equity (assets less cash payments which will almost entirely be debt financed) – or $80

in acquired BV / share given up. If you believe the combined entity can realize any meaningful synergies (in financing costs, procurement due to greater scale, airplane vs. engine leasing segments, etc…)

AND the thesis that these businesses as a whole should trade at or perhaps a 10% premium to book value going forward, there is a world where you end up with a combined entity with well over $70 in BV/sh trading even higher.

Note: Long $AER. Not investment advice. DYODD.