On Monday, top insurance idea AIG (AIG) announced that it would sell International Lease Finance Corporation (ILFC) to aircraft leasing firm AerCap Holdings (AER) for $5.4 billion, consisting of $3 billion in cash and the balance in newly-issued AerCap common shares. Though we think ILFC was one of the crown jewels of AIG’s business particularly considering the prospects for global air travel demand in coming years, the price is fair and opportunistic, especially since AerCap is risking its investment-grade status to facilitate the deal. We don’t think better terms could have been had by either party, given financial constraints, and shares of both entities are moving higher on the news. The combined AerCap-ILFC will be #2 on the world stage in aircraft leasing, trailing that of only General Electric (GE) Capital Aviation Services. AIG will own approximately 46% of AerCap once the deal closes in the second quarter of 2014, an equity position that has only been enhanced with shares of AerCap up 30% since the announcement of the transaction. Based on the current value of AerCap shares at the time of this writing (~$33), AIG is sitting on approximately a $3.2 billion position, bringing the total value of the sale to roughly $6.2 billion. AIG remains one of our favorite ideas in insurance.
Monday also brought news of a reassuring deal for Alcoa (AA) shareholders. The primary long-term concern within the aerospace industry for aluminum producers has been the increased use of composite technology on next-generation aircraft, prompted by the success of Boeing’s (BA) revolutionary 787 Dreamliner, which is made mostly of composites (a far cry from the mostly-aluminum predecessors). The aluminum giant’s new long-term agreement with Boeing-rival Airbus (EADSY), announced today, which stipulates a multi-year supply agreement for value-add titanium and aluminum aerospace forgings on the A320neo, the next-generation narrowbody aircraft from Airbus that competes with Boeing’s workhorse 737, was quite encouraging. Alcoa was sure to remind readers in the press release that, in 2012, the firm also signed multi-year supply agreements with Airbus for aluminum sheet, plate and hard alloy extruded products, which use the firm’s advanced-generation and aluminum lithium alloys.
We think the deal with Alcoa is significant for two reasons. First, it reveals a potential competitive win against Best Ideas portfolio holding Precision Castparts (PCP) within the forgings market. Though this may not seem like a positive for the portfolio constituent, we think it highlights yet another area for growth at Precision Castparts via acquisition or by competitive means that was not baked into current forecasts. Precision Cartparts is currently very busy integrating Titanium Metals, but carving out a piece of Alcoa’s business in coming years may be possible, especially if Alcoa seeks cash-raising initiatives during the next downturn. Second, the deal confirms the importance of higher-end, value-added metals on next-generation aircraft, which plays into the hands of Precision Castparts’ higher-end metals portfolio. Though composite use will continue to proliferate, the higher-dollar content of advanced metals on aircraft will pose significant opportunities for metal benders in the years ahead, particularly considering the development of brand new aircraft and the expectations for the proliferation of aircraft deliveries across the globe. Precision Castparts remains one of our best ideas to capitalize on this trend.
Consolidation in the airline industry is nothing new. The group has been shrinking for survival for the better part of the past 10 years. American Airlines Group (AAL), a combination of US Airways, previously traded under the ticker symbol LCC, and AMR Corp, the former bankrupt parent of American Airlines, started trading on the Nasdaq earlier this month and is the latest example of domestic airline combinations. Though optimism is running wild across the airline business on hopes of reduced capacity and more rational pricing, the business models of airlines still leave much to be desired, as both unit revenue (the competitive dynamics of Internet price transparency) and unit costs (jet fuel)—and by extension, profits—remain largely out of an airline’s control. Though Delta (DAL) has expanded into the refinery business with its purchase of the Trainer refinery in Philadelphia from ConocoPhillips in 2012, feed costs are still highly variable, and operating expenses of the refinery may eat into any competitive edge acquired versus peers. Still, we applaud the innovative thinking in the airline business, which has sent more operators to bankruptcy than any other in history.
In part, it is what makes airline business models so bad that attracts many speculators, not investors, to their shares. The operating leverage within an airline’s profit and loss statement is incredible (small unit revenue or unit cost changes can have profound implications on an airline’s profits), and when economic times are good, equity prices can fare extremely well. However, when economic times are bad, shares inevitably suffer as load factors (capacity utilization) and unit revenue (ticker prices) falter. Airline shares hardly ever trade at mid-economic-cycle expectations, which are ever-changing and very difficult to forecast (given the volatility of jet fuel costs). In 2013, airlines are expected to generate a global net profit of $12.9 billion, according to the International Air Transport Association (IATA), and post an even better $19.7 billion net profit in 2014. The net margin for the industry, however, is expected to remain a pitiful 2.4% in 2014. The IATA also spoke to the troubles of the industry:
We must temper our optimism with an appropriate dose of caution. It’s a tough environment in which to run an airline. Competition is intense and yields are deteriorating. Cargo volumes haven’t grown since 2010 and cargo revenues are back at 2007 levels. The passenger business is expanding more robustly. Some airlines will out-perform our estimates and others will under-perform. But, on average, airlines will only make a net profit of about $5.94 per passenger in 2014.
We think the combined US Airways-AMR Corp, or the new American Airlines Group, is much better-positioned than the former AMR Corp (see here) or US Airways, which itself is a product of the old US Airways and America West merger, on a standalone basis. The prospect for cost synergies certainly makes the deal worth completing, but the combination will do nothing to change the core economics of the airline business. Barriers to entry are nil, while barriers to success are nearly insurmountable. If we were forced to own an airline, it would be Alaska Air Group (ALK), which is in part insulated from much of the cutthroat competition in the contiguous 48 states.
Valuentum’s Take
Our theses on the aerospace and airline industries are quite different. In the aerospace industry, the proliferation of new aircraft builds and aircraft deliveries across the globe will result in increased profits for parts suppliers like Precision Castparts to the airframe makers themselves, Boeing and Airbus. We very much like the long-term growth dynamics of the aerospace industry and what it means for industry participants. The airline industry, on the other hand, is one of the worst from a structural standpoint. With ticket and oil prices changing as they do, an airline’s outlook issued today will have already changed by the following morning. Consolidation may aid the airline group to a degree as it right-sizes capacity and mitigates declining yields, but we won’t be putting new money to work in an airline anytime soon. Though it will be parting with ILFC, AIG remains our top insurance idea as the company continues to trade at a nice discount to book value, while Precision Castparts retains its coveted place in the Best Ideas portfolio.
Aerospace Suppliers: AIR, ATRO, COL, HEI, HXL, PCP, SPR, TDY, TXT