In 1970, only 17 of 4,000 commercial aircraft globally were on lease. Today, over 40% of commercial aircraft (~25,000) are leased by airline operators and there are no signs of growth slowing. The two major publicly listed lessors, AerCap and Air Lease share attractive characteristics: both are run by owner operators, consistently grow their fleet and market share generating a healthy amount of earnings at ~12% ROE. However, for one reason or another, the market doesn’t assign much value to either company beyond the tangible book. We interviewed a Former CFO of Air Lease who has over 30 years experience in the industry as a lessor, lender, and an airline customer to explore the AerCap / GECAS deal and whether such assets are undervalued by the market.
Leasing is a simple spread arbitrage business. Lessors borrow capital to acquire aircraft forward from OEM’s and then sell operating leases to airlines for a marginal spread. This leasing income is also relatively predictable. We know how many planes Boeing and Airbus are making 10 years out and ~75% of the lessors’ revenue is typically booked up to 5 years out. After adding a few turns of leverage, lessors earn a sustainable 12-15% ROE depending on the age of the fleet.
The return on equity is mainly driven by two variables:
A typical commercial aircraft has a 25-year life which depreciates to a 15% fixed residual value. This amounts to 3.4% depreciation per year throughout the life of the plane. The depreciation curve is steepest in the early years of fixed assets which reduces the return relative to later years where depreciation is slower. The older the lessor's fleet, the lower the depreciation relative to the leasing income which drives a higher ROE for every turn of leverage.
Historically, lessors have earned 10-11% lease yield plus 1% maintenance revenue. After deducting the 3.4% depreciation and SG&A, the public lessors have earned around 6-7% ROA. After adding a few turns of leverage the ROE is sustainably over 12%. So given the structural tailwinds, advantages of buying planes at scale, and the sustainable economics, why do the public lessors always trade at a discount to book? Even Buffett agrees and called aircraft leasing a ‘scary business’:
‘Some people have done well by using short-term money to finance long term assets which have big residual risks. That just isn’t for us’.
We're not too sure if the asset-liability potential mismatch is a real risk for the big public lessors today. AerCap and Air Lease have years of experience raising credit and the likes of Air Lease are experts at churning through their portfolio to constantly reduce the age of the fleet by selling midlife assets.
So is it the residual value risk? Maybe the market can’t get comfortable with the value of such long-life assets? On the other hand, lessors would argue that due to their scale and persistent re-sale gains, they mitigate residual value risk by purchasing planes from OEM’s at 5-10% discount. This suggests the accounting book value is constantly marked 5-10% lower than the true market value. But maybe the public market believes the lessors only sell those ‘good’ planes which leaves the residual value of the rest of the book far more uncertain?
Either way, there are two interesting dynamics that add to potential future residual value risk. The life of an aircraft is getting shorter and airlines are adapting their fleet portfolios. The Former CFO of Air Lease highlighted the changes as follows:
I mentioned this convention where we have this 25-year economic life for an airplane. If that isn’t a discussion, coming out of Covid, that forces the issue that it’s not really a 25-year economic life asset anymore, people really have to think about that. I think the fleets are going to get younger. They are clearly going to get smaller, in the short run. I think you are going to see a rationalization and a smaller range of sizes. You will see a compression, at the top end, of the biggest airplane types and an upgauging at the lower end.
In a world of cheap money and ‘tourist capital’, smaller leasing companies are offering ultra-low 50-60bps lease rates for commoditised sale-and-leaseback deals with airlines. This pressures pricing across the sector. However, this doesn’t mean the public lessors are pure commodities. Lessors need a strong capital structure and deep fleet portfolio to serve large airlines like Delta or United. If lessors can’t realise the true value of the company in the public market then maybe they just shouldn’t be public?
We continue our exploration into UK automotive with an executive who has over 12 years experience in digital automotive ranging from running motor classified sites, to selling new and used cars online.There are two insights that we feel are important to understand the competitive dynamics of used cars online in the UK:
Traditional franchise dealers earn money by selling new cars for a very small margin while earning higher margins on aftermarket services, financial products, and part-exchanged used cars. The franchise relationship defines the economic model. New and used car margins are limited which typically leads to over two-thirds of the gross profit coming from aftermarket services and financial products.
The used car dealership business is different. Firstly, there is no direct OEM relationship which gives the dealer more freedom to price vehicles. Given the inventory is typically out of warranty, there is usually no aftermarket business. Used car dealers earn most of their money selling cars and financing the sale to retail customers. Some dealers focus more on the metal margin, others more on the financing portion.
In the US, Carvana seems to be focused on selling used cars for a relatively low margin to drive a higher volume of sales to earn high margin finance revenue. Carmax is focused on used cars plus financing prime customers only. Cazoo is replicating Carvana in the UK but likely without the expertise in financing. Motorpoint, the UK-listed used dealer, is unique in that it has a relentless focus on the metal margin only.
Motorpoint only sells nearly-new vehicles. As we explained above, in the early life of fixed assets, the depreciation is highest. As a rule of thumb, new cars with 10,000 miles driven per year have a residual value of 40% of its new price after three years. Given nearly-new vehicles are on the highest point of the depreciation curve, Motorpoint’s inventory is depreciating the quickest compared to other dealers. The faster an asset depreciates, the quicker you have to turn the asset to earn a profit. This is why the Motorpoint model has a relentless focus on turning inventory as quickly as possible to maximise the metal margin. Anything that could add friction is eliminated.
Could Cazoo take market share in nearly-new from Motorpoint? Firstly, it’s likely Cazoo could procure the inventory easily enough. Lessors and rental companies want to shift depreciating assets off their balance sheet as soon as possible. As long as the price is fair, lessors will sell to any willing buyer of scale. With Cazoo’s deep pockets, they could acquire the same inventory as Motorpoint but likely not turn the cars as quickly.
If we assume a £15,000 new vehicle that depreciates 20% per year for 3 years, the depreciation per day in year 1 is over £8. Motorpoint turns inventory 8.5x per year or every 42 days. If Cazoo turns inventory 4x per year, this will cost an extra £397 per vehicle in depreciation per year. Motorpoint earns just below £1,000 gross profit per unit so an extra £400 in depreciation cost will destroy the unit profitability for slow-turning dealers. This relentless focus on turning inventory potentially gives Motorpoint a deep competitive advantage in nearly-new vehicles.
However, Cazoo, like Carvana, can potentially afford to turn inventory slower if they capture enough margin on financing or other older vehicles. Time will only tell.
The big difference between the UK and US used car market is one company: Auto Trader. A good way to explain the company’s role in the auto ecosystem is bolded in the quote from our recent interview:
Let’s take Auto Trader as an example. They are trying to present a full market view of every car that is available for sale. It doesn’t have a full market view but it has one of the closest that anyone has got in the UK. Motors.co.uk, similarly, has that same sort of ambition. Cinch and Cazoo are not trying to do that. They are trying to present the vehicles that they think will make them money, by selling. They are coming at the market from two different angles.
Auto Trader provides a complete view of used car inventory for consumers. The company was founded nearly 50 years ago as a print magazine and has been online since 2000. Auto Trader has over 10,000 dealers using the platform, +4m unique visits per day and over 93% brand awareness in the UK. This is the result of 20 years of network effects.
Auto Trader’s scale presents a higher hurdle for Cazoo to aggregate consumer demand online compared to Carvana in the US where there isn’t a full market view of inventory. Cazoo needs to offer much better quality vehicles and service to drive demand online. This is a much harder network effect to kickstart. It’s not impossible. After all, the problem Cazoo and Carvana are solving is one of trust. Consumers largely don’t trust auto dealers. This is true whether you’re purchasing on a physical lot or online. So maybe if Cazoo offer such a great experience with high-quality inventory, the experience will be sufficiently differentiated for them to aggregate enough demand to kickstart their own network effect. However, the presence of Auto Trader means comparing Cazoo and Carvana is certainly not apples to apples. And whether Cazoo’s opportunity is worth $8bn is a different question.
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