Avation issued their 2019 prelims yesterday
The highlights were
• Fleet assets increased by 22% to $1.27 billion as at 30 June 2019;
• Lease rental revenue increased by 21% to a record $117.7 million;
• Net profit after tax for the year increased by 28% to a record $25.7 million;
• Earnings per share (“EPS”) increased by 25% to 40.3 US cents;
• Interim dividend per share of 8.5 US cents declared, taking total dividends for the financial year to 10.5 US cents (2018: 7.25 cents), an increase of 45%;
• Weighted average cost of debt declined from 5.0% to 4.6%;
• Net asset value per share increased 7% year on year to £2.95 per share;
Along with the commentary there were four items that drew my attention:
1) Why is the NAV increase so small given the strong growth in fleet assets/revenue and net profit?
2) How large is the new lease engine business planned to be?
3) What is the state of play with the ATR's?
4) Airbus A320/A321 Realisable ValuationsNAV
So why have the NAV only increased in 7% given the significant growth in revenue and fleet assets? The answer lies on page 8 (and 10) of the prelims. Under 'Other comprehensive income' is a charge of $18,009m representing a loss on the cash flow hedge.
Avation enters into fixed rate leases for its customers and in order to fix the interest paid against the cost of borrowing associated with the finance loans interest rate swap contract(s) are entered into. Over 90% of debt is at fixed hedged interest rates.. The big advantage is that it protects the risk of interest rates going up (requiring Avation to pay more to service the loans) and destroying net interest margin.
During FY 2019 interest rates decreased. Since an entry in the balance sheet, for accounting purposes is necessary, these liabilities are recorded as a book entry, mark to market, in this case a negative $18m.
The $18m is part of equity and since NAV is derived from Total Equity / Shares in Issue ($240,757,000/64,009,939) a corresponding reduction in NAV is derived. Had that interest rate swap $18m not occurred then NAV would have been $4.03 as opposed to the actual $3.76 an 11% increase over prior year. However, that's just fanciful thinking!
It should be noted that Avation have been using cash flow hedges forever. More information can be found in any Annual Report.
Given the length of the leases I suspect that interest rate swap contracts duration are of similar lengths and hence this $18m will reverse if interest rates go up over coming years. However consensus is that interest rates will be cut in the near term. This implies to me that increasing NAV for next year may become problematic given the need for annual mark to market re-valuation of interest rate contracts.
I do not see this having any substantive effect on Avation's business but as a shareholder who relies on NAV as the principal driver of the share price it is something of a concern for me.If anyone reading this has a reasonable grip on interest rate swap contracts can you please comment/reply. Am particularly interested in knowing what, if anything Avation could reasonably be expected to do in order to mitigate against decreased interest rates. Or is this something we just have to live with?Lease Engine
Personally I have been involved with lease engines for many years. When I first saw this in the prelims my first thoughts was 'administration'. Engines are subject to almost daily issued modifications, whether they be inspections, maintainability, performance, durability, configuration, safety and of course Airworthiness Directives (the only sought that get mentioned in the press). Then there is the need for tracking the hundreds of parts that get replaced/repaired/scrapped when in operation. Sometimes the airline will or will not want to do a modification or the lessor will have a different opinion and then enter into an argument as to who should pay for it. Then there are decisions to be made as to what should happen to it during shop visits. Leasing contracts, as well written as they are sometimes do not provide clarity as to who does what in a specific circumstance. Basically there is a LOT of administration required, much of it technical. Therefore I was pleased when Jeff Chatfield (CEO) specifically mentioned that they now have a technical team in-house
Engine leasing broadly falls into two categories. Emergency 'Aircraft On the Ground' (AOG) or long term leasing. AOG rates are HUGE. This is when an unplanned engine removal is necessary, often away from base maintenance, the airline does not have its own spare engine and therefore needs a lease engine shipped within hours to the aircraft. The lease rates are typically enormous and the airline will want to get that engine removed asap and returned to the lessor. The disadvantage for the lessor is that they may only end up leasing it for a few weeks/months a year.
Long term leasing rates are more reasonable. This is often when an airline is getting over a 'hump' in engine shop visits and need to lease a spare engine for a year or two.
Generally speaking the AOG engines are to a lower engineering standard than a long term lease.
The rationale for lease engine business is partly the fact that a lot of the residual value of an aircraft is in the engines. Avation say they will lease a small number of narrow bodied jet engines. However not a core part of business in the short term and relatively small in terms of money and engine quantity.
No specific details about Aviation lease engine is currently available but it has been confirmed that any lease engine business falls under the Singapore Aircraft Leasing tax agreement i.e. 8% tax rate.
Lease engines for A321's are in demand. However it is possible Avation's engine is for the A220. They have not indicated who they have done a SALB with. Could be an airline or a third partyCredit ratings
As mentioned before this a lynch pin in any aircraft leasing business. Of all the agencies covering Avation there is one 'laggard' which is Standard and Poor that has a corporate credit rating of B+ fro Avation with an outlook of positive B+
Avation are therefore aiming to get S&P to upgrade the rating in the short to medium term.ATR supply and Demand
II have written about this for sometime. Supply has been saturated because lessors ordered too many aircraft. Aviation indicate that the outlook for the ATR, in their opinion, is much better than in recent years. ATR are effectively the only game in town and the reduction in production numbers has helped considerably.
There are 9 ATR's ordered, 3 for delivery this year and 6 next year.Airbus A320/A321 Valuation
We now know that the 16 year old A320 and the 2 year old A321 were sold for $3.4 m and $5.2m representing in excess of 10% above book value. I find that A321 sale extraordinary. If that is typical of the VietJet fleet, which Avation is inferring is true, then that provides a level of reassurance for investors. It also provides something of an exit strategy for Avation should the interest rate swap contact take another hit!Conclusion
Results pretty much as expected except for the interest rate swap. Outlook for ATR's (surprisingly) bright. Further narrow bodied jet aircraft likely. Engine leasing business can be ignored for now. Dividends now becoming useful to have!