Aerocentury Internalizes Management – ACY

I have another interesting idea in the aircraft leasing industry: Aerocentury Corp.

Aerocentury is a tiny aircraft lessor headquartered in California. The company owns 25 aircraft, all smaller regional jets and turboprops, plus one engine. Aerocentury focuses on aircraft worth $10-25 million and attempts to lease them for periods of 3-7 years. Lessees tend to be small regional airlines worldwide.

Aerocentury’s operating history is lackluster. Over its 21 year corporate existence, the company has always struggled to earn its cost of capital. The company’s profits have been wildly inconsistent year-to-year, with periods of strong results followed by mis-steps and losses. The company has occasionally had leases go bad, and recently suffered after buying a few aircraft for which demand proved elusive. But the biggest reason that Aerocentury has always struggled to earn sufficient profits is its relationship with Jetfleet Management Corp. Jetfleet is responsible for managing leasing activities for Aerocentury, and gets paid handsomely for the task. From 2013 through 2016, management fees paid to Jetfleet amounted to nearly 28% of Aerocentury’s total operating lease income. Jetfleet is controlled by Aerocentury’s largest shareholder.

This onerous external management structure and the resulting depressed profitability is likely the reason that Aerocentury trades at such a gigantic discount to its asset value. At $16.80, Aerocentury is priced at 50% of book value. (And this is after a pretty decent upward move in the stock. For much of 2017 and before, shares traded at under 35% of book value.) However, the company is in the process of unwinding this structure.

Aerocentury is in the process of buying Jetfleet and fully internalizing its management. The company will pay Jetfleet’s owners $3.5 million in cash and 129,286 shares of Aerocentury stock. This is a good deal for Aerocentury. At $16.80, the purchase price for Jetfleet works out to $5.7 million, which is 3.4x Jetfleet’s estimated 2017 operating income. The company estimates Jetfleet’s 2019 operating income will be $2.0 million. Assuming a 30% tax rate for Aerocentury, this would add 91 cents per share to Aerocentury’s annual net income. The resulting increase in profitability might convince investors to value Aerocentury shares closer to book value.

The successful completion of the acquisition is not in question with Jetfleet’s controlling shareholder in favor. The transaction has taken a little longer than expected. Aerocentury had not expected to bring the issue to a shareholder vote, but was ultimately required to do so by law. That accomplished, the acquisition should be completed this year. Integration risk is minimal, given the existing close relationship.

Internalizing management will unquestionably benefit Aerocentury’s profits and clean up the company’s principal-agency conflicts. However, investors should still view the company with a skeptical eye given its history of poor results (even after adjusting for Jetfleet’s fees) and its operating model. As I mentioned before, Aerocentury’s lessees are regional airlines worldwide. Many of these are not “investment-grade” carriers and there is a risk of non-performance. The airline industry is cyclical and these carriers are at the end of the whip, feeling the effects of fuel costs, local recessions, and other headwinds most acutely. Aerocentury is also feeling the effects of rising interest rates, paying much more than before to finance its fleet. The company lends long and borrows short, so spreads will be compressed until leases reprice at the end of their terms.

Aerocentury is ultimately not for me, but more enterprising readers may find the company’s shares too cheap to resist.

Alluvial Capital Management, LLC does not hold shares of Aerocentury Corp. Alluvial Capital Management, LLC may hold any securities mentioned on this blog and may buy or sell these securities at any time. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.

Alluvial Capital Management, LLC manages a value investing partnership, Alluvial Fund, LP. If you are a qualified investor and would like more information, please contact us at info@alluvialcapital.com or visit alluvial.capital.

 

Doric Nimrod Air One – DNA:LN

Remember OTCAdventures? I’m still here, just very busy with Alluvial Fund, LP and all the fun of a young family. I found an intriguing investment idea, but be warned: I don’t know how to buy this. Futhermore, I cannot provide any advice on the tax implications of owning this investment or related securities. But here it is: Doric Nimrod Air One. “DNA One” is a Guernsey-domiciled closed-end fund that trades on the London Stock Exchange.

This fancifully-named fund could hardly be simpler. It was formed in 2010 for one purpose:  to acquire a single aircraft, lease the aircraft to an airline for an extended period of time, then to sell the aircraft at the conclusion of the lease and liquidate. Payments received over the course of the lease would be used to amortize acquisition-related debt and to pay an investors a steady quarterly distribution. DNA One acquired an Airbus A380-681.

The A-380 is the world’s largest passenger aircraft, able to handle extremely long flights. Over 200 of these aircraft have been produced and delivered, with many more in production. The UAE’s “Emirates” is the largest operator of these aircraft, with over 100 in its fleet. True to form, DNA One leased its A380 to Emirates for a period of 12 years.

The original debt associated with the purchase of the A380 was $122 million. In the seven years since the acquisition, DNA One has reduced the balance of that debt to $43 million. Meanwhile, the fund has paid a quarterly distribution to investors of 2.25 pence. The lease with Emirates is scheduled to terminate in December 2022, after which DNA One will sell its aircraft. Emirates has the right to purchase the aircraft at fair market value. If Emirates declines to purchase the aircraft, the fund will put the A380 up for sale in the general market. The global market for modern wide-body passenger aircraft is liquid, so I don’t anticipate any issues in achieving a quick sale.

So the question becomes “How much can investors expect to receive as a liquidating payment?” Fortunately, the fund helps us out with that. The fund orders an annual appraisal of its aircraft from multiple appraisers and provides this information to investors. As of March 31, the average estimated value of the A380 at lease expiration was $101 million.

Using the $101 million figure and June 30 exchange rates, the fund projects a capital return of 178 pence per share when the aircraft is sold at the end of its lease. Between now and then, investors will continue to receive 2.25 pence each quarter. Shares of DNA One recently closed at 100.50 pence, indicating potentially excellent return potential. If the quarterly income and capital return estimates hold true, investors purchasing shares today stand to earn an IRR of a little more than 21% between now and the end of 2022. The fund spells things out in its quarterly report.

Now for a look at what could go wrong. The biggest risk Doric Nimrod Air One faces is the possibility that its aircraft could actually be worth substantially less in 2022. Aircraft values are affected by supply and demand, which in turn is driven by the activity of airlines and the pace of production and technological advances by aircraft producers. A look at the trend in recent appraisals does show a downward trend. In 2017, appraisers valued the A380 at $104 million. In 2016 the figure was $107 million. A 10% decline in aircraft value from the current $101 million estimate wold reduce liquidation value for shareholders by 18 pence. Still, it would require a very large decline in the value of DNA One’s A380 to create a truly adverse scenario for investors. By my calculations, the value of the aircraft at lease expiration would have to plunge 40% to $60 million for investors’ IRR to fall to 10%.

Then there is counter-party risk. Let’s not forget that DNA One has only a single asset, and a single lessee. If Emirates encountered financial difficulty, the stream of lease payments could be interrupted and suddenly DNA One would find itself with no revenue and bills to pay. However, Emirates has long enjoyed strong profitability and the firm support of the UAE’s ruling family, so I consider the airline a high quality counter-party. There is also the fact an early lease termination could even be a good thing for DNA One’s shareholders. Even after paying off the remaining acquisition debt, the fund’s net asset value would be substantially in excess of its trading price and shareholders could receive a large payment several years earlier than planned.

So why does DNA One appear so cheap? My guess is the usual suspects: size and illiquidity. The fund’s market capitalization is only £42.7 million and less than £20,000 worth of shares change hands daily. I also suspect that only a small sub-set of investors is willing or able to invest in a Guernsey-domiciled closed-end fund.

Could be an opportunity.

I should also note there are two other related funds: Doric Nimrod Air Two and Doric Nimrod Air Three. Each is substantially larger than DNA One, more diversified, and has a longer time remaining in its aircraft leases. DNA Two appears to offer an IRR of 16% at current exchange rates and appraisals, while DNA Three offers 14%. Each fund owns the same type of aircraft and leases mainly to Emirates, so the huge divergence in prospective returns is a little strange to me even with Doric Nimrod Air One’s tiny size and asset base.

I would really like to hear your thoughts!

Note: I have already received some good comments highlighting the difficulty that the A380 may face down the line given its limited acceptance from major carriers. Residual value is a more serious concern than I had indicated in this blog post. That’s what’s fun about investing: the learning.

Alluvial Capital Management, LLC does not hold shares of Doric Nimrod Air One, Two, or Three. Alluvial Capital Management, LLC may hold any securities mentioned on this blog and may buy or sell these securities at any time. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.

Alluvial Capital Management, LLC manages a value investing partnership, Alluvial Fund, LP. If you are a qualified investor and would like more information, please contact us at info@alluvialcapital.com or visit alluvial.capital.