Avation (AVAP) - What to Expect in the Prelims

I have posted about Avation (LON:AVAP) on several occasions e.g. a post largely about the industry and how Avation sits in that market: https://www.stockopedia.com/co...

Today Avation (LON:AVAP) has issued their interim management update https://www.investegate.co.uk/... which I will come on to a little later.

Looking at the list of RNS's over H2, not a lot appears to have happened (as expected in another post of mine from last September https://www.stockopedia.com/co... ) but in actual fact a lot has been happening behind the scenes.

At the very end of H1 the company acquired a B777 and an A330. This made a huge difference to the fleet asset value but practically no additional revenue due to the timing of the aircraft deliveries i.e right at the end of the financial year.

The company stated maximum net debt to equity ratio is x4 and their minimum EBITDA to interest ratio is x2 with a unsecured to secured debt ratio of 30% (Page 90 http://infopub.sgx.com/FileOpe... However, the credit rating agencies have indicated tighter requirements if Avation are to keep their recently improved ratings, namely less than x1.5 EBIT interest cover and Funds from Operations to debt of >7% to 9%.

I think these credit limits were reached at the end of December 2018 and therefore there were  very limited additions to the fleet in H2; providing the appearance of not a lot happening.

FLEET CHANGES

Over the last year we have had the following fleet additions (costs are my best guess):
* Airbus A330-300 delivered Dec 2017 at a cost of $97.6m
* Boeing B777-300ER delivered Dec 2017 at a cost of $150m
* Bombardier CS300 delivered June 2018 at a cost of $32m
* Airbus/Leonardo JV ATR72-600 x 3 Nov 2017 (1), Dec 2017 (2) Total ATR cost $56.5m

(Already announced but yet to be delivered in 2018/19 is another CS300 and x1 ATR both for delivery in July and another ATR later in the FY.)

So, in actual deliveries that's a total of $336m of new assets compared to $744m last year. I now calculate total NAV for the fleet to be $980m (not 336+744; difference due to depreciation). Thats around a 40% increase!

REVENUE
Of course we are also interested in the impact these aircraft will have on revenue. My view was  that we can expect $106m but todays IMS indicates $109 making me think they are getting a tad more from the wide bodied aircraft and the repositioned A320 to easyJet than I had allowed for. 

There will be additional of around $12m from other income (mostly relating to the Air Berlin aircraft; although most of that will be absorbed by a one-off impairment charge on the same aircraft); so headline lease revenue will represent nearly 15% increase over the period.

The increase in revenue is also marginally ahead of forecasts but given the nature of the business I would say revenue forecasts should never ever be more than 1-2% away from actual as it is so highly predictable.

What is of additional note is that if we assume no further fleet additions to those already expected and allowing a full years revenue from the widebody aircraft then we can expect Dec 2018 (H1) revenue to be $62m against comparatives of $41.7m; a 48% increase in revenues.

It is also, for fun, worthwhile noting that we can forecast 2019 lease revenue to increase to $127+m (+20%) without any further change to the fleet. Great visibility.

PERFORMANCE
Whilst revenue is a nice headline item the real investor questions could be summed up by answering the following:

EPS and P/E
Gross Yield
Book Value
ROE
Exchange rate
Cost of Debt


EPS and P/E
This is the one that I have been mulling over for months. Forecasts call for EPS of $0.26. I just do not understand anything like that figure. My estimate is nearer $0.40. That's a huge disparity and I cannot see why. Historically over the years I have been there or thereabouts but never have I miscalculated to such an extent that is implied by the forecasts! maybe there is some very large one-off financing charge I have missed(?) or perhaps something else? Or maybe MIFID II has simply meant forecasts have not been updated for many many months??

If I am correct then Avation will stand on a P/E of 7.2

GROSS YIELD
This is Lease Revenue divided by Fleet Book Value and I reckon is roughly an acceptable 11%. Will go down if the asset values are reappraised and increased (as I expect they will) and will go up if you choose to include 'other income' e.g finance leases. But as a ball park I would stick with 11% which is in line with the industry.

BOOK VALUE / P/TBV
I have always said that the share price should reflect the NAV of the company. In fact it can be argued that given the historic and future growth potential of the company it should be trading at a premium to book. Only as recently as 18 months ago Avation were approached by outside interests that acquired 6 ATR aircraft above book value.

Book value is the acquisition cost of the aircraft less depreciation and annually adjusted for current market valuation. These figures, well the first two, are easily identifiable from prior interims and finals

By my estimation fleet book value is $980m. However there is potential upside to this number if the annual reassessment of the fleet is positive. Given current worldwide trends there is a possibility for a positive revaluation.

Ultimately with 62,760,246 shares in issue that equates to £2.58 versus current share price of £2.25 giving a P/TBV of 0.86 (it also ignores cash). That is just wayyy too low

RETURN ON EQUITY
At the last interims total equity was $207,173,000 and with my estimated total profit of $26.4m I make that an acceptable ROE of 12.7%. However, the total equity value has almost certainly increased since the last interims but by how much, I do not know. Will just have to wait and find out. Hopefully ROE will remain above 10% though.

GBP/USD EXCHANGE RATE
Airline business is conducted almost exclusively in USD's in the western world. Therefore the impact of of GBP/USD exchange rate is material to investors since we are buying shares in Sterling. There has been no material change in the exchange rate on 30 June 2018 compared to last year. Hence it is currently of no concern to investors.

COST OF DEBT
Cost of debt is largely a function of the credit rating which the company has. This has improved over the last 12 months. Fitch assigneda rating from B+ to BB- (a one notch improvement - see https://en.wikipedia.org/wiki/... )

If cost of debt decreases then that makes a significant improvement in terms of profits. For example a a 1% improvement on a debt of $750m is a saving of $7.5m/annum which theoretically would drop down straight to the profit line. In practice this saving would be leveraged up for the next aircraft purchase.

In practice there is a mix of borrowings; Secured Borrowings (interest rate of 4.5%?), Junior Secured Borrowings (6.7% interest) and unsecured borrowings (was 7.5% but now 6.5%, I think). Overall I am expecting cost of debt to be between 4.8 - 5.2% for this FY. Next year I do expect this to be reduced as a consequence of improved credit ratings and a full 1% reduction for the unsecured borrowings

Management of debt is critically important to the company.

STRATEGY?
An interesting development occurred toward the end of the financial year which I would like to comment upon. Historically Avation have seeked to obtain aircraft which are in high demand. This allows flexibility to easily reposition aircraft with other airlines if needs be and provides liquidity that assists with maintaining asset value. The rapid repositioning of the bankrupt Air Berlin A320 demonstrated those points very well.

Toward the end of the FY Avation entered the C300 market. This aircraft is a narrow-body, twin-engine, medium-range jet airliners designed by Canadian manufacturer Bombardier Aerospace. From all public reports it has proven so far to be very reliable and operationally economic. The CS300 is aimed to compete with the Boeing 737 MAX 7, Airbus A319neo and Irkut MC-21-200. This is a very competitive market albeit the market size is seen as some 6000 new aircraft over the next 20 years.

Furthermore it has been fraught with political interference with the Americans imposing a 300% import duty from Canada; effectively making it unable to sell the aircraft in America however this was somewhat circumvented by Airbus recently taking a majority stake and an assembly plant being constructed in USA although deliveries will not commence until 2020 from this plant.

However Boeing are taking the fight to Bombardier as, for example, Boeing reportedly gave US based United Continental a massive 73% discount on a 737 deal to lock out Bombardier, dropping the price of the B737 to $22 million per aircraft, well below the CS300 market value at $36 million.

Just what the real selling price is of the CS300 is a guessing game. The 'list price' is $89.5m but huge discounts for American customers eg Delta Airlines at around 65-70% off may make the final price to be around $24.6–28.7m.

With airBaltic being the launch customer and a major customer to Bombardier I can only assume they have substantial discounts too but perhaps not as great as Delta Airlines obtained. So for now I am assuming a sale price of some $32m generating a revenue of say $2m per annum for each aircraft.

Depreciation however could be problematical. Aircraft in this sector tend to only be around for 17-20 years and with it not being a Boeing or Airbus product the market for them is going to be limited and lowly priced. It would not be a major surprise to me to find some impairment statements regarding the NAV of the aircraft in years to come.

No doubt Avation would point out that airBaltic are the largest CS300 customer (but there are very very few aircraft in service) and it is, effectively a government owned airline so perhaps entering a 12 year deal is not so risky, since the expectation would be that the aircraft would have been paid for through lease income by 12 years. Furthermore the Canadian government have historically been extremely supportive toward Bombardier and Airbus are now (July) the principle shareholder and able to market the aircraft etc (although it should also be remembered that Airbus have got it very wrong with the A318 a 'similar' market to the CS300). 

Anyway, I think it is quite feasible that Avation do not consider the CS300 aircraft as being of such high risk that it could significantly affect Avation if things went wrong with the ability to lease the aircraft in years to come.

What can we surmise from this deal? Well, it has to be remembered that Avation are a very very very small player in the field of aircraft leasing. Further improvements in their credit rating are unlikely to occur until they have significantly more aircraft in the fleet. So cost of capital is unlikely to get any cheaper than they are now (other than by changing the mix of financing options e.g. Secured, Unsecured debt). 

Competition form a plethora of new leasing companies, especially from China means Avation cannot differentiate themselves in the market and perhaps the margins they can now obtain are weaker than anyone else's. It must be remembered that when Avation started out, Jeff Chatfield used his Australian contacts to secure business but now those contacts are unable to support future growth (and indeed detract from future growth because the credit rating agencies are demanding more customer diversity). Avation made it's mark by becoming something of a specialist leasing company by being in a position to become a major player in ATR aircraft leasing.

It therefore follows, to my mind, that an opportunity to establish a beach head, be the preferred leasing company of choice with the CS300 and maybe CS100 would, in fact, be a sensible way forward. The larger leasing companies would probably want significant margin on the aircraft which Avation can live without.

There are potentially long term upsides to all of this. Firstly Avation may be able to get financing or more likely credit guarantees through Airbus/Canadian government and even Latvian government to some extent for the airBaltic aircraft. Secondly if Bombardier can start to deliver the contracted aircraft then aircraft liquidity will improve and that reduces the risk of asset impairment charges in years to come. Thirdly, if by some miracle the aircraft is seen to be gaining traction in the market then the asset values can markedly increase in 5-7 years. Current market values are extraordinarily low so there is already some downside protection.

Technically the CS300 is, according to all reports, a very desirable aircraft to fly for both airlines and passengers. So there seems to be no concern over the aircraft capabilities, operational revenue/profitability or passenger appeal.

If I am correct then Avation would probably not want to publicise this way of thinking in the medium term because investors may see this move as a negative in the short to medium. For now Avation can claim they are expanding into additional aircraft/manufacturer/airlines/geographical areas to reduce exposure to any one aircraft/market etc; something that credit rating agencies have been encouraging Avation to do.

If Avation continue with ATR's and CS300 aircraft then in years to come the company would be ideally placed to be a bolt-on acquisition for one of the numerous larger leasing companies which are far more likely to acquire the company at well above NAV.

Of course, I could be completely wrong!

SUMMARISING
In my view Avation is a rapidly growing leasing company trading well below its valuation. Has reasonably solid downside protection. Should be viewed as a long term (highly unusual for most readers of these boards, I suspect!) investment where share price performance is aligned with NBV. This year there is potential for an (unusual) positive surprise when the results are announced on 6th September.