After Dart's rather spectacular success recently, I'm casting my eyes over a rather less beloved aeronautical stock - Avation, the £35m market cap aircraft leasing company. I should note that a company being unloved, in this sense, is almost a prerequisite for it being an interesting investment. That was exactly the position Dart found itself in a few years ago - a company thinly traded (though not as bad as this one) and with a rather lowly apparent valuation, and explains both my and Richard Beddard's slight unease at a company which has gone from that position to being far more discussed, tipped, followed and - more importantly - richly valued. Still, I'll come to Dart in a later post.
Avation is an interesting group to me particularly because valuing it should be quite easy. An aircraft leasing company does something very simple in the world, and there's not a huge amount of room for differentiation. Their role, it appears to me, is twofold. Firstly, they allow companies to shift some assets off balance sheet. I suspect this is an attractive proposition, but also appears to be one that's liable to come to an end in the next decade with improving rules on operating lease accounting. That's far from the only value they provide, though - more importantly they allow for everything that's positive about leases generally. They allow companies to expand more rapidly than they otherwise could, without the need for huge amounts of capex up front. They also mitigate completely the risk related to holding an asset which depreciates fairly quickly (at least compared to the other big ticket leased asset that comes to mind, property).
I don't know how liquid the market is for second-hand aircraft, but if we assume it is fairly liquid, valuing Avation should be easy. After all, the operations are soothingly straightforward - they buy an aircraft, financed with debt and equity, pay interest on the aircraft over the next x years, lease the aircraft over the x years, and then can either sell the aircraft at the end, lease again if it was for a short term and so on. Since their customers - big airlines (notably Virgin Australia) - will nearly always have the option of buying the aircraft themselves, their isn't much room for predatory margins. If/when they acquire reasonable scale, they should basically earn about or just above their cost of capital.
Risks seem fairly well managed. Leases are mostly signed for 10-12 year periods, and the fleet has an average lease term of 7.8 years as of the previous annual report. In respect of the fact that we usually capitalise operating leases for companies which as lessees, if we wanted to we could rather easily capitalise the operating leases for Avation, only this time with them as lessor and not lessee:
So there's another potential way of valuing them at baseline - tot up the discounted value of their future lease payments, work out the residual value of the aircraft at the end, and deduct operating and finance costs in the interim. I hope I'm not missing anything major by saying I think the equity here is, even with a significant debt load that might appear offputting, pretty safe here. The company has committed cash inflows, and again assuming aircraft have a reasonable secondary market, other liquid assets on lease expiry.
The problem, it appears to me, is that valuing a business like this - and saying it will basically be worth the value of its assets, since the market is competitive and there's not a huge amount of value to be added - puts a lot of stock in precisely one thing; the carrying value of those assets. The value of an aircraft is impossible for me to determine, so I have to go by the company's book value - but that's a figure that's essentially an accounting construction and not a reality. I note that when the company disposed of an Australian subsidary to 'reduce exposure to older aircraft', there was a loss on disposal - implying the aircraft were held on book for more than they were worth. I also see the following in the notes to the financial statements:
The Group’s older aircraft were revalued in June 2012 by independent valuers, on the basis of lease encumbered value as of 30 June 2012 and the carrying value of the aircraft is reduced to its recoverable value. Impairment losses were recognised as an expense immediately
Which I suppose matches up with the £3m revaluation loss this year. To be fair, there was a revaluation gain last year - so it's not all one way, and it's unfair to suggest so - but it does highlight that things aren't quite as simple as I'm making out.
My best guess is that it's a little undervalued here. Directors are rather keen to grow - and I suppose there probably are some small but reasonable advantages to scale, which explains why the company was keen for an equity raising at a premium of 20% to the closing market price when it was announced. The annual report also, I seem to remember (though can't find the quote, so can't be sure), mentioned something about the fact that both growth and better investor relations will help to drive down the cost of capital, which is basically the be-all and end-all for a company which leases big-ticket assets (think REITs).
It does make for quite an interesting comparison with other leasing companies, though, and I've just remembered an interesting discussion on exactly that topic - see the comments here. Leasing companies have lots of ways of adding value. Northgate do so in a few ways, but most obviously by buying vans at a far better price than most of their customers could manage, and selling them again at a much better price. That's scale. Do Avation have that advantage over their customers, the airlines? Not at this scale, I suspect. Interested to hear your thoughts, as ever!