Fly Leasing Still Offers Upside On Air Travel Demand Recovery

Not all undervalued stocks are the same, and determining how much of a stock’s apparent undervaluation is due to sentiment, temporary headwinds, and longer-term structural/competitive issues are a big part of generating above-average long-term investment returns.

That brings me to Fly Leasing (NYSE:FLY), an aircraft leasing company that combines all of the above issues into one somewhat challenging situation to evaluate.

I do absolutely believe there is a “cheap for a reason” aspect to Fly Leasing, including a lower-quality customer base (reflected in weaker rent collection), less capital flexibility, a less advantageous corporate structure, and more limited growth options. On the other hand, I do also see a great deal of skepticism built into the share price ahead of what should be an emerging recovery in domestic/short-haul flights.

I don’t exactly like Fly Leasing, and I remain content to own AerCap (NYSE:AER) in my own portfolio, but I do believe that FLY should trade closer to the mid-teens than the low teens, and as vaccinations progress around the world and air travel recovers (starting later in 2021 and into 2022), I do believe the numbers and sentiment will improve.

 

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Fly Leasing Still Offers Upside On Air Travel Demand Recovery

Fly Leasing Still Holding Below Fair Value

Although Fly Leasing (FLY) is up a little from when I last wrote about the company, the performance over the last year still hasn’t been very compelling next to AerCap (AER) or Air Lease (AL), and the shares continue to underperform the S&P 500 over that span. At this point, there’s not much that management can do other than execute the plan in place and prove to the Street that the planes it will be acquiring from AirAsia will generate attractive returns. Fly Leasing deserves to trade at a discount to book value, but I believe a 30% discount is too large, and I think a fairer price is in the high teens today.

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Fly Leasing Still Holding Below Fair Value

Steady AerCap Continues To Offer Value

Aircraft leasing company AerCap Holdings (NYSE:AER) has done relatively well this year, with the shares slightly ahead of the S&P 500 on a year-to-date basis and slightly behind on a trailing 12-month comparison. The company has also continued to outperform its peers, with the shares outperforming Air Lease (NYSE:AL), Fly Leasing (NYSE:FLY) and Aircastle (NYSE:AYR) over the past year. Air traffic growth remains healthy on a global basis, oil prices are not yet at problematic levels for airlines, and rate increases give investment grade-rated AerCap an ongoing opportunity to take advantage of its better access to capital.

I continue to believe AerCap shares are undervalued, though the environment over the next couple of quarters may not be as conducive to outperformance. A shift away from significant asset sales is going to weigh on reported earnings, and a shift back toward portfolio growth is going to redirect capital away from share buybacks for a time. Even with that turbulence, though, I believe these shares are undervalued below the low-to-mid $60s.

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Steady AerCap Continues To Offer Value

Fly Leasing Looks Undervalued, But Value Creation Will Take Time

Aircraft leasing companies have done okay over the last few years (excluding Aircastle (AYR)) relative to the S&P 500, but there’s still a certain frustrating “watching paint dry” feeling with many of these stocks as they still often seem not to get their full due in terms of valuation. While AerCap (AER) and Air Lease (AL) have done a little better in that regard, Fly Leasing’s (FLY) weaker returns on assets, equity, and capital, remains a constraining factor to valuation.

The acquisition of AirAsia’s aircraft portfolio should allow Fly Leasing to start generating better results, with the influx of aircraft and revenue boosting operating efficiency and the nature of the portfolio and leases supporting a better return on equity. Successfully executing on the AirAsia transaction could support a fair value in the high teens, but a more modest set of expectations would still support a fair value 15% higher than today’s price.

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Fly Leasing Looks Undervalued, But Value Creation Will Take Time

FLY Leasing Has Little To Show For Meaningful Improvement

Although FLY Leasing (NYSE:FLY) has transformed in a meaningful way since 2015, you really wouldn't know it from the share price performance. The stock is down about 10% since my last write-up on the company, and even though the intervening period hasn't been very good for any of the publicly-traded aircraft lessors (companies like AerCap (NYSE:AER), Air Lease (NYSE:AL), and Aircastle (NYSE:AYR)), FLY has been the weakest performer of this bunch.

I believe some of the underperformance can be explained by the company's weaker lease rate factor, its lower adjusted pretax margin, and its lower adjusted ROE. It's possible that the market also sees FLY Leasing as more vulnerable to a tighter credit market and an aircraft market where sale-leaseback transactions are less profitable due to an influx of capital into the market. Still, FLY has been doing better of late, and while the entire sector has been strong over the past year, FLY's lagging performance doesn't seem entirely fair. While FLY Leasing's lack of a dividend will be a negative to some investors, reallocating the capital to buybacks makes sense in this case, and I believe these shares are undervalued below $16 to $18 a share.

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FLY Leasing Has Little To Show For Meaningful Improvement

Amid Multiple Market Worries, AerCap Holdings Seems Too Cheap

It wasn't so long ago that many companies were getting into the aircraft leasing space and Wall Street was cheering them along. After all, emerging market demand was supposedly going to have customers rushing to airports and buying tickets hand over fist to travel, and airlines were going to enjoy a prolonged period of blemish-free prosperity. Along the way, established operators like AerCap (NYSE:AER), Fly Leasing (NYSE:FLY), and Aircastle (NYSE:AYR) enjoyed a solid run as the likely beneficiaries of more airlines turning to leasing and an attractive spread between lease rates and debt costs.

And then along came reality.

Weaker economic conditions in Latin America, China, and Russia have certainly had an impact on emerging market air travel demand and there are now valid concerns about the impact of a glut of widebody aircraft. What's more, the low oil prices that once looked like a boon for airlines and air travel have become a challenge in their own right as they reduce the value of more modern, more fuel-efficient aircraft for lessees.

With all that, AerCap is off about 25% from its 2015 peak and has been trading below book value for some time. There are certainly valid concerns remaining in the leasing industry - will long-term air travel demand growth projections of around 5% hold up, will higher debt costs materialize and shrink margins, will the company continue to be able to successfully turn over its fleet? Even so, I believe that AerCap could liquidate its fleet for 20% to 40% more than today's share price, and I think that underpins a value call for risk-tolerant investors.

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Amid Multiple Market Worries, AerCap Holdings Seems Too Cheap

Seeking Alpha: FLY In Friendlier Skies, But There's Work To Do

Relative to AerCap (NYSE:AER), I wasn't very bullish on FLY Leasing (NYSE:FLY) back in August of 2014 and the shares have been nothing special since then. While FLY's high dividend payout helps close some of the gap in terms of share price performance, FLY Leasing hasn't really stood out from an increasingly crowded field in aircraft leasing.

Past may not be prologue in this case. I believe management at FLY is making good decisions; selling older planes out of the portfolio, acquiring newer planes, more actively managing its lease expirations, and looking to drive down its cost of capital. I am concerned that there is a lot of capital coming into aircraft leasing and that it will ultimately push returns down closer to the cost of capital - that would be bad news for AerCap, but particularly bad news for FLY Leasing given its higher cost of capital. That said, FLY Leasing seems to be undervalued today and does offer quite a bit more upside from restructuring/self-improvement.

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FLY In Friendlier Skies, But There's Work To Do

Seeking Alpha: FLY Leasing Still Trying To Close Its ROE Gap

Within the world of aircraft lessors FLY Leasing (NYSE:FLY) remains a more challenging investment prospect. Not only is FLY Leasing quite a bit smaller than AerCap (NYSE:AER), Air Lease (NYSE:AL), AWAS, and Aircastle (NYSE:AYR), its margins, ROE, and credit quality are all lower. Management has succeeded in boosting utilization to 100% and is continuing to expand the fleet as air travel demand increases, but Wall Street still seems rather skeptical regarding the company's real asset value and the likelihood that the company can achieve double-digit ROEs.

While I don't think FLY Leasing is ever going to generate results on par with AerCap or Air Lease, and I do have some concerns about leasing headwinds and risks to emerging market air traffic, FLY Leasing still looks too cheap. I wasn't exceptionally bullish on the company in January, and I'm still not today, but there does appear to be value here for investors who can accept the risk that FLY Leasing will fail to improve as much as management says it expects to improve.

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FLY Leasing Still Trying To Close Its ROE Gap

Seeking Alpha: FLY Leasing Looking To Shrink Its Performance Gap

Even though the market may not always make the finest distinctions, there are some meaningful differences between the various aircraft leasing companies. Avolon has the youngest large fleet out there, while Air Lease's (AL) large commitment book will send its average age down in the years to come. Elsewhere, AerCap (AER) has taken on a big commitment in the acquisition of ILFC from AIG (NYSE: AIG).

That brings me to FLY Leasing (FLY). This company has largely focused on sale/leaseback opportunities, and sports a fleet with a larger weighting towards Europe as well as a higher overall average fleet age. Due in part to lower asset utilization, FLY Leasing has trailed its peers in adjusted ROE and that would seem to explain why the shares generally trade at a discount to those peers. Although I don't expect the gap to vanish overnight, the underlying growth in air traffic and FLY Leasing's dividend yield make this a name worth a little extra attention.

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FLY Leasing Looking To Shrink Its Performance Gap

Seeking Alpha: AerCap Holdings At A Good Cruising Altitude

With commercial aviation demand continuing to grow quite well in developing markets and the funding environment in developed markets getting better with each quarter, this is a pretty good time to be an aircraft leasing company. It's not so surprising, then, that AerCap Holdings (AER) shares are up more than 65% over the past year.

As for the future, I would argue that AerCap is still looking at a multi-year period of strong operating conditions. AerCap's focus on smaller airlines in developing markets is in tune with where the growth is likely to be, and the company's focus on maintaining a younger fleet and demonstrated skill in managing credit/default risk (as well as selling aircraft to maximize portfolio value) should result in significant cash flows in the coming years. Valuation for leasing companies is trickier and more subjective than for many other types of companies, but I nevertheless maintain that AerCap is still about 10% to 15% undervalued today - not the most appealing bargain out there, but still undervalued and with the potential of a dividend in the coming years.

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AerCap Holdings At A Good Cruising Altitude