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Saturday, November 13, 2010

FLY Leasing (FLY): Anyone Want a FREE Aircraft, Maybe a Boeing 757 or an Airbus A320? AND, You Don't Need to Manage It

Per our prior mention back in April, we own shares of Fly Leasing (FLY), which is a highly levered, asset heavy business like our Seaspan (SSW) and Global Ship Lease (GSL) (side note: we still plan on revisiting GSL in an upcoming post).

In our September post, The View from the Heartland, we mentioned that FLY Leasing was still trading at a meaningful discount to net tangible book value, even with ample demand for new and used aircraft (see link for interview with CEO Colm Barrington). FLY's fleet of 59 aircraft is approximately 86% "narrowbody" (percentage prior to recent sales) with an average age of just over 8 years. We shared additional commentary back in a July post, Perspective on the Global Aircraft Leasing Market.

For reference, here's an overview of FLY Leasing from an October management presentation (click to enlarge this and subsequent slides):

Our initial FLY thesis was similar to our container shipping thesis: stable long-term oriented business model with shareholder friendly management improving sector fundamentals trading at a discount to net tangible book value. But, in this case, there was less uncertainty over the book value of assets given a tight market for aircraft with limited new supply. Boeing (BA), for example, has a long backlog of aircraft to be delivered and the company's supply chain can produce only so many jets per quarter. Our original thesis remains true today.

The company reported favorable 3Q10 results the other week that again illustrated several important things: (1) the stability of the cash generating model, (2) very capable management, evidenced through gains on sale through fleet management, and (3) improving industry fundamentals. Pertinent commentary from management, thanks to SeekingAlpha.com:
  • The news from the commercial aviation industry continues to be positive. I can confirm that we are experiencing strong demand for aircraft lease product from virtually all global jurisdictions. The emerging market regions continue to exhibit very strong growth and passion to traffic, just as they have been for the past several quarters.
  • U.S. airline industry through consolidation and relatively good discipline and capacity growth has recently been profitable and cash flow positive. We continue to believe that there will be a combination of growth in the emerging market regions and the significant re-fleeting requirements of financially stabilized U.S. legacy carriers that will fuel growth in the aircraft leasing sector for the foreseeable future.
  • Our airline clients are making fleet planning decisions in a manner consistent with historical practice. That is to say, airlines have moved beyond the short term when thinking about capacity growth and re-fleeting and are now planning two to three years into the future. This is an important change from the prior 18 months and supports a traditional cyclical recovery.
  • Airlines and aircraft leasing companies are ordering aircraft in large numbers. Both Airbus and Boeing have substantial demand for the newer narrow body equipment, a particular focus for FLY. There are virtually no delivery positions available from either manufacturer on these aircraft types for several years.
  • Both Airbus and Boeing are increasing production rates in an effort to satisfy the demand but we still see a favorable supply demand dynamic that we expect to continue to underpin the recovery in aircraft values and lease rates.
  • Equity capital continues to pour into the sector. As mentioned on prior calls, much of the capital is coming from private equity community but the larger existing lessors are also allocating capital to grow their businesses.
  • As you would expect, this capital is creating more demand for aircraft to pursue prices higher. This demand for leased aircraft is creating more liquidity for FLY's aircraft.
  • We have taken advantage of this liquidity to rebalance the portfolio in the third quarter. And we sold three aircraft at premiums to net book value. We have another aircraft sale scheduled for the fourth quarter, a 21-year old 757. And we will continue to look for further sales opportunities.
  • The cash proceeds from these sales will be combined with the company's significant unrestricted cash balances to acquire new aircraft. We made some progress in this front in the third quarter with the flydubai transaction. And we expect more opportunities in the next 12 months to originate sale lease backs directly with the airlines.

We recommend listening to the conference call and/or reading the full transcript.

Now, taking a step back, below we share a handful of summary slides we pulled last summer (but never got around to posting until now) from various FLY Leasing presentations (then called Babcock & Brown Air Limited).

  • Shareholder friendly management (for more recent slide, please see October deck linked to earlier):
  • Here is a summary slide from the more recent presentation:
  • Improving sector fundamentals (from March, now dated, but most trends continue today - Y/Y gains for freight have been slowing, see recent IATA data here):
  • Favorable long-term trends (we're wary of forecasts, but global population growth is the major driver):

  • Close correlation for the airline industry with global GDP (so, macroeconomic conditions matter):
  • Historical and forecast demand for air travel (forecast is frighteningly steep from an air traffic control and natural resource standpoint!):

To summarize, we believe FLY Leasing should benefit from current and expected industry growth over time. Importantly, per the overview slide above, the company's fleet is relatively young at 8.1 years and carries an average remaining lease term of 4.4 years. Moreover, the business model is designed to pay dividends and generates significant "available" cash flow for distribution. The current annual payout of $0.80 (6% yield) -- reduced during the downturn -- is only a fraction of "ACF" (even when normalized for positive one-timers). As a result, cash continues to build on the balance sheet as the company retains excess cash flow to increase flexibility and potentially acquire new aircraft.

At $13.10, the company continues to trade at a discount to tangible book value of more than $16 per share despite improved industry fundamentals and a shortage of aircraft around the globe. Thus, as with our Parlux Fragrances (PARL), we're literally getting assets for free. In this case, cash and primarily narrowbody aircraft that are in high demand. We're more than willing to pick up (and hold) one dollar of fairly certain value for only 80 cents ($13.10/ $16.41) that currently pays us 80 cents per year (to boot).

One caveat: admittedly, a company that owns depreciating assets is different from durable retail/consumer franchises such as Starbucks (SBUX), which have brands and pricing power over time (what Warren Buffett calls economic goodwill). Yet, based on FLY's management track record, we're betting that they will skillfully refresh the portfolio and allocate capital to grow the business over time. Arguably, this might warrant a premium to net tangible book value.

There was a time when FLY Leasing traded at a premium to net tangible book value, in late 2007 shortly after becoming a publicly traded company (tough timing given subsequent macro events) - from Google Finance (GOOG):

We might just get back there one day.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long FLY, SSW, GSL, PARL.

© 2010 Jeffrey Walkenhorst
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