A $3.8m gain on trading aircraft accounts for the outperformance, a point worth noting given the company has been able to accelerate the ramp up of its fleet from 29 to 38 aircraft in the 12 month trading period and offload aircraft above book value too. In fact, a revaluation of the fleet of mainly narrow body commercial jets and turboprop aircraft, including 24 ATR 72’s, five Fokker 100s and nine Airbus A321s and A320s, led to a below the line US$29.4m valuation uplift in the fleet to US$725m.
Another key take for me is that the company now has contracted revenues of US$95m for the current financial year to end June 2017, having ramped up fleet assets by two thirds in the 12 month period, most of which occurred in the second half. So, it’s worth looking at the quality of the airlines that Avation has lease agreements with given that it has net debt of $567m secured on the planes leased out.
Since the end of February 2016, the company has leased two new airbus A321-200 planes to Thomas Cook on a 12-year operating lease; three A321-200 new-factory aircraft to Vietjet, the leading domestic and international new-age carrier in Vietnam, with agreements in place for another two jets to be delivered by the end of 2016; and two new ATR 72-600 planes that are being operated by Flybe on behalf of Scandinavian Airlines (SAS) under a six-year operational contract arrangement. This means that a client base that already included Air Berlin, Air India, Condor, Fiji Airways, UNI Air, and Virgin Australia has been further diversified, thus mitigating the risk of an operator defaulting.
I would flag up too that the addition of newer planes, and churning the tail of the fleet, has improved the weighted age of the aircraft from 5.3 to 4.2 years, and lengthened the weighted average remaining lease term to almost seven years. It’s a very profitable business as highlighted by an operating margin of 64 per cent and an average lease yield of 12.1 per cent which is well ahead of Avation’s 4.8 per cent weighted average cost of debt. Around 92 per cent of borrowings are fixed, and the length of leases are matched with the term of borrowings to further mitigate financial risk.
True, newer aircraft have lower yields than older ones which is why Avation’s average lease yield was almost 2 percentage points lower on the previous year. However, new planes are lower risk and attract longer leases, so the quality of revenue is actually higher now than it was 12 months ago. That should be positive for the rating investors are willing to ascribe to the shares.
Upside potential to forecasts
Reflecting strong visibility on future revenues, Avation’s existing fleet and committed deliveries have total contracted future revenues of US$745.8m, of which in excess of $95m has been contracted for the 12 months to end 2017.
On this basis, Mr Cummins believes that Avation should be able to lift pre-tax profits from US$18m to $22.1m and deliver EPS of 35c, or 26.4p, in the current financial year. True, this is shy of previous forecasts of around $25m, but the $22.1m profit forecast is only based on contracted revenue, and does not factor in any profits from trading planes nor further additions to the fleet size.
This means that the shares are rated on a modest 5.5 times forward earnings estimates and offer decent yield attractions after the board hiked the payout per share from 3¢ to 3.25¢. Mr Cummins is pencilling in a dividend of 3.6¢ in the 12 months to end June 2017, implying a prospective dividend yield of 1.85 per cent.
Another reason for the strong expected uptick in profits is because the acquisition of aircraft in the past six months has been largely funded by bank debt and by utilising the $100m (£70m) of cash the company raised through a five-year bond issue in May 2015 and on which Aviation is paying an annual coupon of 7.5 per cent. So, with the company deploying the cash from that bond issue, its low yielding cash balances have been recycled into much high yielding lease assets. Given the timing of these aircraft acquisitions, the full benefits will be seen in the current year.
Furthermore, I feel that WH Ireland’s estimates are likely to prove low ball given the company’s positive outlook statement and industry trends which suggest that demand for aircraft is likely to remain strong. Over the summer ratings agency Fitch conducted a peer review of five publicly rated aircraft leasing firms and maintained or upgraded its credit ratings, noting the supportive market dynamics across the aircraft leasing industry. These factors include increased air travel, improved financial condition of airlines, growth in the adoption of aircraft leasing, low interest rates, accessible funding markets and the absence of external shocks.
Peer group comparison
Of course, by its very nature, this is a highly geared business as Avation’s net debt of US$567m equates to 75 per cent of the company’s total aircraft assets, and balance sheet gearing is more than three times shareholders funds of US$174m. Analysts believe that net debt will rise to around US$702m by June 2017 as free cash on the balance sheet is deployed and credit lines are tapped.
But as I noted there is clear visibility of future income to service the debt pile, pay dividends and reinvest retained earnings into the business. And this is exactly what’s happening as the company’s net asset value has increased from US$128m to US$174m (£131m) in the past 12 months. And this value creation for shareholders is not being priced in as Avation’s equity is only being valued at £82m, or 37 per cent below book value.
Assuming the company hits profit forecast in the current financial year, and I believe they are conservative, then net asset value should rise again to US$191m (£144m) by June 2017 after accounting for retained earnings. That equates to a sum just shy of 260p a share, or 75 per cent higher than Avation's current share price. A forward price-to-book value ratio of 0.56 times and a prospective multiple of 5.5 times earnings are very low ratings for a company generating a double digit post tax return on equity and one with a substantial contracted revenue base.
To put Avation’s undervaluation into some perspective, Singapore-based leasing company BOC Aviation floated on the Hong Kong Stock Exchange earlier this summer and is rated on a price-to-book ratio of 1.1 times, or double that attributed to Avation, and on 9.6 times earnings estimates for 2016, or 80 per cent higher than Avation's rating. It’s not an isolated example either as BOC Aviation joined China Aircraft Leasing Group as the second aircraft lessor listed in Hong Kong. China Aircraft trades on a price-to-tangible book ratio of nearly 3 times, and on 12 times 2016 earnings estimates.
Moreover, there is potential for consolidation in the sector, as highlighted by Bohai Leasing’s acquisition of Avolon earlier this year. That’s worth considering given Avation’s low absolute and relative valuation and its focus on markets in Asia Pacific and Europe.
Target price
So, no matter which way I look at it, and even after applying a small cap liquidity discount, Avation’s shares are far too lowly rated given the positive market outlook, and company specific profit drivers I have outlined above.
In fact, I feel that the target price of 200p I outlined in my article a few months ago when I recommended buying the shares at 145p could prove conservative (‘Get ready for take-off’,2 Jun 2016) as it only equates to a price-to-book value ratio of 0.8 times for the 12 months to end June 2017 and a rating of around 7.5 times conservative looking earnings estimates.
Offering 36 per cent upside potential, I rate Avation’s shares a buy on a bid-offer spread of 146p to 147p.
Valuation gains
Avation is not the only company on my watchlist that’s been posting significant valuation gains. Aim-traded insurance sector investment company BP Marsh & Partners (BPM:195p) has just issued a pre-close trading update ahead of interim results in mid-October and they are likely to make for a good read.
The company owns a substantial stake in Besso Insurance, a top 20 independent Lloyd's broking group, and one that appointed investment bank Cannacord Genuity to carry out a strategic review in the summer. As a major shareholder, the board of BP Marsh have been active in the ongoing discussions with potential investors with a view to a sale, or investment in Besso.
Bearing this in mind, Besso has just reported strong trading results in the first half of this year, continuing a trend from last year and which will undoubtedly lead to a sharp increase in the carrying value of the stake. The value of BP Marsh's 37.96 per cent holding (excluding a 7.03 per cent stake held in BP Marsh's accounts at cost of £1.5m, and subject to a buy back by Besso) was £18.1m at the January 2016 financial year-end. This implies a value of around £48m for Besso's equity, or eight times likely cash profits of £6m in 2016, up from £4.8m in 2015.
However, deals in the sector have been at far higher valuations. Robert Fleming Insurance Brokers, the international Lloyd's insurance and reinsurance broker, sold a majority share in its business to private investment firm Calera Capital, valuing its equity at 10 times cash profits. Attributing a similar cash profit multiple to Besso's earnings for 2016 would increase the value of BP Marsh's 37.96 per cent stake from £18.1m to £22.8m and give a valuation of £24.3m for its 44.97 per cent holding, or the equivalent of 83p per BP Marsh share, up from 67.6p at the end of January 2016. BP Marsh's net asset value per share was £70.8m, or 243p at the end of January 2016, so this is a significant holding.
I also expect an uplift on BP Marsh’s investment in LEBC, an independent financial advisory firm that has been growing strongly in the post Retail Distribution Review (RDR) environment. The stake has a carrying value of £11.6m, or 40p a share. There was positive newsflow from some of the smaller holdings in the portfolio too, and on the cash position which has been buoyed by the disposal of a stake in Aim-traded Randall & Quilter (RQIH) for £1m, or 25 per cent above carrying value, and the receipt of £7.3m from its final stake in privately-owned global insurance broker Hyperion Insurance. BP Marsh currently has net cash of £6.6m, or 22p a share, available for future commitments.
So, with the shares priced on a bid-offer spread of 192p to 195p, valuing the equity at £56m, this is a solid asset backed investment and one that has performed well since I initiated coverage at 88p ('Hyper value small-cap buy', 22 Jan 2012), during which time the company has paid out 11.17p a share of dividends. Expect a 10 per cent hike in the payout per share to 3.76p in the current financial year to January 2017. I last advised buying at 179p (‘Assured gains’, 27 Jul 2016) and have tweaked my target price up from 215p to 225p. Buy.
