Aircastle - Cheap or Catching a Falling Knife?

Probably both - the story of all my stocks so far! They all seem to be great values, fundamentals aren't changing or even become stronger, but yet the prices keep going down. This phenomena is starting to make me a convert of the momentum theory - you can outperform in the short term just by buying up recent winners and shorting losers. And behold - just this weekend I've read somewhere that this strategy is statistically a winner in the 3-6 month span, outperforming the indexes by 10%. Now, this may explain why Fool's CAPS data is what it is (highest rated stocks outdo lowest rated ones).

And now for the original topic of the post, which is Aircastle. The company generates ~$400M in revenue and ~$350M in EBITDA through leasing passenger and cargo planes to airlines all around the world. Currently the company owns +100 planes worth $4.1B and is committed to $1.6B more. Essentially the company leverages its own balance sheet to buy planes and then rents them out. Of course as a result it has a substantial amount of debt on the balance sheet - $2.5B, however given $350M in EBITDA this doesn't look so bad.

Normally I'm typically ultra wary of the airline space - too many macro factors to predict (fuel prices being on top of the list, however the traffic also has major implications - small slowdowns can have massive impact on profits due to high fixed costs). Aircastle of course is also exposed to these factors - its customers are airlines, so the industry's financial health determines how much and if at all they can pay for Aircastles planes. However due to the long-term nature of the contacts, short-term macro fluctuations don't put a dent in Aircastle's numbers, making it a much safer investment

Business description. Company was formed by Fortress in 2004. At the time the industry was distressed, with many airlines selling used crafts at firesale prices, and Fortress started the company to gobble those up. It went public in 2006, and continued acquiring planes. The stock started trading at $29, eventually went up to $40, however has recently dropped on fears of recession/looming troubles in airline space and disasters in the financing world, which made investors question whether the company can continue acquiring planes. Indeed, the company is planning to cut down on acquisitions, but are those necessary to make the stock a good value? Not at all, the company currently already has a 12% dividend yield, and that number will go up next year once leases on new planes take effect.

Key profitability driver. How much money the company makes is simple: total airplanes x lease rate per plane. The planes side of the equation is set, what about the lease rates? Some caution is warranted here: lease rates did half in the U.S. in 2002-2003, when a lot of the airlines were nearly bankrupt. However the leases are not renegotiated year by year: average lease length is ~9 years, and the company has claimed to have already renewed all 2008 leases. So in the worst case scenario we're in a deep recession that touches not only the U.S., but all airlines that AYR deals with and lease rates half in 2009 and 2010. If average lease rate is 9 years, then this would have impact on 22% of AYR leases, or have negative 11% hit on EBITDA. Even in this scenario, the valuation is very attractive. However, there are several factors that make me believe this scenario will not play out (despite me being ultra bearing on the U.S. economy).

Customers. Aircastle leases its planes to airlines in Europe (44% of net book value), Asia (26%), Latin America (7%), NA (12%). Almost by definition its customers are the airlines that are not too well-off, that can't afford buying planes on their own. This is of course a risk - if the s*** really hits the airline fan, those customers will default. However this is no subprime mortgage market and the company will keep its valuable planes as opposed to giving away foreclosed houses. High exposure to emerging markets where the rates of air travel are rising very quickly is a big plus.

State of the industry. Important dynamic for Aircastle is the supply/demand for leases planes. The supply side is driven by a) new planes coming to market b) available old planes. On both a) and b), dynamics for Aircastle are favorable. Boeing and Airbus are sold out of planes, and are supplying ~1100 total a year for the next three years. Given continued delays, I wouldn't be surprised if this number is lower. Demand on the other hand is higher: air traffic is growing at ~5% a year, and with 17,500 planes currently in operation worldwide, this implies a demand for 875 planes. However the old fleet also needs to be replaced, and assuming an average life of 40 years (which is very high!) results in 17.5K/40=437 replacement demand. When demand outstrips supply we typically have higher prices, and I believe this dynamic will be enough to offset U.S./Europe economic weakness.

Valuation. For a company in a growing industry that generates attractive ROIC, 6% yield seems fairly conservative, however I'll assume just that. Implied valuation? $40 a share or around twice where we are right now. And while we wait for the price to appreciate, I'm not forgetting to collect my fat dividend.

Oshkosh - Brace yourself for falling earnings

Latest earnings report is just the beginning.

I somewhat feel bad for Oshkosh. Prior to JLG acquisition, the company used to be a fairly stable business selling trucks and ambulances to the government/defense department. However after acquiring JLG in 2007, it’s getting almost half of its revenues from a highly cyclical aerial platform and telehanders business that’s about to fall off the cliff.

While Terex, its main competitor in the segment, can nurture a hope of being saved by international markets (of which I’m skeptical given Europe should promptly follow the U.S. into the recession club), Oshkosh derives 75% of its access equipment revenue from North America.

Simple statistic: JLG telehandler unit sales in 2000 were 15K. In 2002 they were around 8K, where they stayed until 2004. Same story for the overall aerial work platform U.S. market: 60K units in 2000, 25K in 2002. The industry sales for 07 stand at around 70K. Morale: this is an extremely cyclical market which is significantly above its long-term average and is bound to revert back to earth, while painfully hitting the ground on the way.

Valuation. Valuation is 13X 07 EPS which seems reasonable if you believe a) we’re at normalized revenue levels b) we’re at normalized margins. Both of those are unfortunately not true. Margins for Oshkosh prior to acquisition have historically averaged 8%, while Terex (closest proxy to aerial segment) also averaged 8% (with variation between 10% in 1999 and 3% in 2003). Right now the margins are at 9.4%. Revenue growth going forward should be GDP-like, however with normalized access segment revenues around 20% less than now. That means normalized EBIT is around $450M. At 11X multiple, TEV is ~$5B. Subtract company’s massive $3B of debt, and we get $2B of equity value, or ~$26 per share. However I wouldn’t even regard this number as the stock’s absolute bottom: as margins get squeezed on decreased access equipment sales, with large interest payments, I wouldn’t be surprised if we see the stock at $20 in a year.

Archon Corporation - Get 500M Worth of Assets for 300M

Ok, this one is really simple: Archon's enterprise value is $300M while its real estate is worth $550M.

I am typically not a fan of real estate plays because this paper value might take eons to unlock, however this is not the case with Archon. Its main property, 27 acres on the Strip, is expected to be sold to a Texan real estate developer for $475M, $40M of which have been put for down payment this summer. Archon also owns wwo buildings in Massachusetts and Maryland bought for $82M and $63M each back in 2000. In addition company runs a small casino in Nevada that has lost $2M in 2007 - probably the factor that accounted for the stock reaching the levels we're at right now.

Applying a long-term capital tax rate to the Strip property gives $400M income once transaction is consummated. Assuming that other properties are worth what Archon paid for them gives another $145M. What is the casino business worth? It generates $30M in revenues, but because it lost money recently lets just ascribe it a 0 value. Altogether company's value is $550M, or backing out the debt - $79 per share vs $39 right now.

The catalyst here will obviously be the property sale which should happen this or next year. However even if the sale falls through, Archon still owns a piece of property in an incredibly fast-growing market, that even at a discount of 20% to currently agreed purchase price implies a very handsome upside to the stock.

Infosys: Strong Position in a Still Growing Market - Concerns Overblown

Industry leader with 25%+ revenue growth prospects trading at 19X this year's earnings on concerns about 1) slowdown in tech spending 2) weak dollar vs rupee 3) rising wages in India. To address each concern:

1) Company managed to maintain 30%+ growth rate during the last tech spending downturn. To be fair, pricing did go down, eating into the company's operating margins which went from 33% to 28%. Management believes the pricing will be more sustainable now given the more established nature of offshoring model and extremity of tech bubble burst. I think the recession scenario for 08-09 is ~20-25% revenue growth combined with 200bps margin contraction

2) I don't really think anyone can predict what currencies will do in the short term, but company does engage in active hedging to mitigate any potential impact

3) Wages are indeed growing driven by shortage of qualified employees. However I believe India still offers a very attractive and cheap offshoring destination, and Infosys should be able to pass through the wage increases to the customers in the long term, although U.S. recession would create temporary pressure.