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OPINION

Get on board for blue sky gains

Get on board for blue sky gains
September 11, 2014
Get on board for blue sky gains
IC TIP: Buy at 159p

What caught my eye is the planned ramp up in the company’s aircraft fleet over the next 15 months and one that will be funded from the debt markets and internal cash flow. Having just taken delivery of a new ATR 72 aircraft which was immediately leased to UNI Air, the largest regional domestic airline in Taiwan, Avation now has 18 of these 68 to 72 seat aircraft on its books. These planes and another nine, mainly Airbus A320 family aircraft and Fokker 100s, are leased to customers including US Airways, Virgin Australia, Thomas Cook, Condor and Fiji Airways.

In addition, Avation has options over 27 new ATR aircraft and there are a further nine planes scheduled for delivery between now and the end of calendar 2015. Of these orders, two new planes will be delivered in the final quarter this year, another five in the first half of 2015, and the remaining three in the second half of 2015. As a result the current fleet of 26 aircraft is set to grow by almost 40 per cent to 36 planes in the next 15 months. This reassuringly offers clarity to the robust earnings estimates from analysts over the next couple of years.

To put the growth profile into some perspective, in last week’s preliminary results release for the 12 months to end June 2014, the company reported a 24 per cent increase in pre-tax profits to $17.2m (£10.7m) on revenues up 22 per cent to $52.3m. After factoring in the aforementioned aircraft deliveries, analyst Ian Berry at house broker W.H. Ireland predicts a similar ramp up in turnover and profits in the current year too, pencilling in revenues growth of 20 per cent to $63m to lift pre-tax profits by 22 per cent to $21.2m.

On this basis, EPS rises from 28¢ (17.4p) in the year just ended to 34.2¢, or the equivalent of 21p at the current exchange rate of £1:US$1.61. If achieved this means that Avation shares are trading on less than eight times earnings estimates. Moreover, having just raised the full-year dividend by 13 per cent to 2¢ a share, analysts expect the board to maintain the progressive dividend policy by declaring a 10 per cent higher payout of 2.2¢ in the current financial year to offer a prospective yield of 0.9 per cent.

The respective forecasts for fiscal 2016 are revenues of $76m, pre-tax profits of $23.2m, EPS of 37.2¢ (23.1p) and a dividend of 2.4¢ (1.5p). On this basis, the shares are trading on less than seven times fiscal 2016 EPS estimates and offer a forward dividend yield of around 1 per cent. Clearly, there is execution risk to these forecasts, but from my lens the 33 per cent ramp up in EPS over the next two financial years doesn’t seem unreasonable once you factor in the addition of 10 new aircraft, most of which will be added to the fleet in the next nine months. The robust growth expectations also reflect the low-cost debt funding of the planned aircraft acquisitions which means that shareholders capture a sizeable chunk of the earnings from these planes when they are leased out. I am happy with the risk profile, but it’s still worth noting the risks facing the business.

Understanding the risks

With these new planes being added to the fleet, and older aircraft being disposed of, the average age of the fleet (currently 9 years) is set to drop sharply. Bearing this in mind, the company’s ongoing fleet renewal and tight financial management aims to ensure the value of its assets is optimised which is critical in maximising both shareholder value and net earnings.

Avation has some decent form here as the company successfully booked a $1.4m profit on two new planes it had options on last November. That’s well worth noting because the company owns a series of delivery options on the 27 new aircraft which it can either lease out to commercial passenger airlines by debt funding the purchases, or otherwise sell them onto third parties. It’s worth pointing out too that these options are being attributed no value in the balance sheet at all and according to analysts at brokerage W.H. Ireland could be worth around $38m.

Worth considering too is the requirement to match debt funding maturities with the lease terms (average term 6.1 years) being offered to Avation’s customers so that the company is not exposed to owning unleased planes sitting idle. In fact, this is critical because the current fleet had a book value of $368m (£221m) at the end of June (prior to the latest ATR aircraft acquisition) on which the annual finance charge was $16.9m (£10.5m). In other words, finance costs accounted for half the company’s operating profit of $34.2m last year.

Clearly, the creditworthiness of clients is a major issue too for a small cap company using leverage in order to grow its fleet in this way. That’s because, net of cash, the company’s net borrowings of $251m at the end of June 2014 were the equivalent of 226 per cent of equity shareholder funds of $111m, so the balance sheet is already quite highly geared. Not that there are any concerns on either the credit quality of the company (critical when funding aircraft orders in the debt markets), nor its clients, but it’s worth flagging up these risks nonetheless when assessing the investment case.

It’s also worth pointing out that debt facilities on existing aircraft are primarily asset based and matched to the leases being offered to customers in terms of currency, term and loan servicing requirements. This is sensible as it ensures there is no "through lease term" re-financing risk on the above borrowings.

Other risks worth considering are the significant balance sheet exposure to Australian based aircraft, albeit these planes are all leased out. However, this increases the risk profile as the company is more heavily exposed to the Australian economy. That said the company is seeking to actively diversify its economic and geographic risk away from the region by marketing to new airline customers.

And the company does have other airline interests through a 68 per cent stake in Aim-traded Capital Lease Avation (CLA: 18p), a company that reported a fall in profits last year. That said, this was mainly down to one off costs and analysts expect an earnings recovery in the current financial year. This shareholding is worth around £10m at current market values.

A fairer valuation

So having assessed all the risks, I feel happy initiating coverage with a buy recommendation on Avation’s shares. Not only is the company lowly rated on an earnings basis, but on a price-to-book value ratio of 1.2 times it is being valued below the sector average of 1.3 times. However, factor in the potential ‘hidden value’ on the delivery options on the 27 new aircraft and realistically the company could be trading on a discount to book value.

Furthermore, for a business projected to grow net earnings per share by 33 per cent over the next two financial years, it seems anomalous that the shares should be trading on such a deep discount to US peers. According to the Wells Fargo Leasing Letter, the sector average is between 12 and 17 times forward earnings. True, some discount should be factored in for Avation’s smaller size, and the debt funded growth driving the earnings growth as this raises the risk profile, but even so there is no way the shares should be trading on 8 times current year prospective earnings. In my opinion, a multiple nearer 10 times earnings estimates is far more realistic, implying a target price around 200p.

So with the shares being offered in the market at 159p, and the price taking out January’s all-time high of 150p, I feel Avation is poised for a share price ascent into blue sky territory over the next six months. My target price is 200p.

Please note that Netplay TV (NPT: 11p), SeaEnergy (SEA:38p) and Fairpoint (FRP: 133p) have all issued half-year results today. I will be updating my views on all these compnaies in due course.

■ Simon Thompson's new book Stock Picking for Profit can be purchased online at www.ypdbooks.com, or by telephoning YPDBooks on 01904 431 213 and is being sold through no other source. It is priced at £14.99, plus £2.75 postage and packaging. Simon has published an article outlining the content: 'Secrets to successful stock-picking'