Willis Lease Finance Corp (WLFC US): An undiscovered engine leasing business.
Actionable pitch to invest in a commercial aircraft engine leasing business (similar to FTAI). Low turnover so suited to small accounts.
Description:
Willis Lease Finance Corp (WLFC US) is an independent and vertically integrated commercial aircraft engine leasing and servicing business. It is vertically integrated in the sense that it combines engine leasing, supply of parts/material, asset management and consulting services, and engine maintenance, repair, and overhaul (MRO) services. They have a diverse customer base of global airlines with 46% of lease rental revenue from the Americas, 33% from Asia, and 21% from Europe. They have a preference for large, stable, state-owned airlines that are financially stable.
The subsidiaries that provide these different services are as follows:
Willis Aeronautical Services (WASI): the materials/parts business, launched in 2013. Makes money on the sale of spare parts. Also a source of used serviceable material (USM, i.e. parts and material from stripping down run-out engines).
Willis Asset Management (WAML): the asset management and consulting businesses. Helps to predict the timing and cost of shop visits across the entire fleet. Also provides a modular shop visit service called ConstantThrust. WLFC gave an example in an investor presentation in May 2024 of a sale-and-leaseback transaction with Air India for 34 CFM56-5B engines that closed in September 2022, where WLFC would provide engine replacement for unserviceable engines.
Willis Engine Repair Centre (WERC): comprised of 145 repair stations (within larger shops) located in the US and the UK. Specialise in repairs and shop visits, and disassembles engines into parts/USM to use as inventory within WASI. Also provides support services for WASL customers.
Willis Aviation Services (WASL): comprises the aircraft leasing portfolio.
The business was founded in 1985 by Charles Willis, who is the current Executive Chairman of the Board. His son Austin Willis is the CEO. Charles and Austin collectively own ~59% of the business. WLFC was listed on the NASDAQ in 1996. Over time, the business has purchased, leased, and sold more engines than any independent competitor. They essentially pioneered the aircraft engine leasing services business.
Management has attempted three times in the past to take the business private (in 2023 for $50/sh, 2021, and 2015) at 0.8-1.1x GAAP book value. These offers were rejected by the board. Today WLFC trades on a P/B ratio of >2.3x so he opportunity is no longer as obvious, although the book value is likely understated as it records assets at the lower of appraised value or depreciated value while the market value of spare engines has been increasing due to high demand and constrained supply. Management recently commented that the gap between the book and market value of their engine portfolio is ~$400m, the largest it has ever been. It is because of these reasons that I have chosen to focus on earnings growth and use an EV/EBITDA multiple to value the business (more on that later).
The business model is similar to FTAI, another vertically integrated engine leasing business that is well covered by brokers and gaining attention within the commercial aerospace industry. I have included a basic summary of the benefits of this model in a section below.
As of FY23 WLFC owned ~$2.1bn of operating lease equipment, ~$93m of notes receivable, and ~$18m of other assets (maintenance rights and investments in sale-type leases). This is made up of 337 engines, 12 aircraft, one marine vessel, and other leased parts and equipment. These assets are leased to 74 customers from 42 countries. WLFC has disclosed that narrow-body engines are 54% of total portfolio assets, wide-body is 37%, and aircraft are 6%, with the remaining being regional aircraft. The CFM56-5B and 7B, the V2500-A5, and the PW100 make up the bulk of the engine portfolio. Total portfolio utilisation remains healthy at 85% in 2023 (and is likely to increase further, given was >90% pre-COVID).
The engine lease terms are 50% short term and 50% long-term. The shorter duration allows for more frequent re-pricing at higher lease rates (in an environment where lease rates are going up) and facilitates enough engine capacity to conduct regular engine exchanges with customers.
WLFC uses a triple net operating lease structure, whereby WLFC is responsible for conducting engine maintenance and repair instead of allowing airlines to arrange overhauls themselves. Customers pay a lease payment as well as a payment for all scheduled maintenance costs (even if they exceed the amount of maintenance reserves), as well as catastrophe and indemnity insurance. The overall maintenance cost is much lower (by ~50%) than if they were to manage the engines in-house or do shop visits at an independent MRO. WLFC will also retain the benefit and assume the risk of residual equipment value.
Business model:
Engine leasing is an attractive business because engines hold their residual value well with major overhauls that install new components/modules. The timing of engine repairs and maintenance is highly regulated and dependent on cycle times (i.e. flight hours).
When an airline customer needs an engine to be repaired, FTAI and WLFC are able to offer significant time and cost savings compared to a traditional shop visit through an independent MRO (e.g. Standard Aero, MTU, etc.). In a modular swap, an airline customer will exchange a run-out engine for a recently repaired engine (that is owned by the engine lessor). The engine lessor will repair the run-out engine (or scrap it for parts/USM), thereby refreshing their stock of engines and parts, and the process repeats. In a more traditional shop visit, the engine lessor will take a run out engine, repair it, and still achieve a time/cost saving through the use of their own spare parts, materials, and internal MRO capacity.
WLFC has recently commented that while module swaps aren't a core focus (due to the difficulty of sourcing certain modules, notably the HPT blades made by Howmet that sit in the engine core), they still perform them from time to time. They reported in Q2 2024 that they have done ~20 in the past year, compared to >250 for FTAI.
Both WLFC and FTAI are one of the only natural buyers of run-out engines. Both stand to benefit from current trends in the industry (more on this below). WLFC management said there "probably are similarities" with FTAI's business model on their most recent earnings call.
Industry dynamics:
Both WLFC and FTAI stand to benefit from current industry dynamics which are leading to heightened demand for prior generation engines. These include:
Engine fleet maturity and lifecycle: The prior-generation engines have decades of flight time and numerous shop visits left. For example, the average age of the CFM56 is only 12.7 years (engine platform lifecycles can be >30-40 years), with a fleet size of ~22k engines. 45% of the engines have not yet had a shop visit, and only 30% of engines have had 1 shop visit performed.
Delayed OE deliveries: due to production quality issues, lack of parts availability (such as HPT blades) and labour shortages. Now ~15k aircraft in backlog, representing >10 years of production, while air passenger traffic is growing (now at 107% of 2019 levels and has increased ~13% YTD).
Rising engine cost and complexity: due to increased use of specialty high-performance parts to withstand higher temperatures and harsh operating conditions. This is leading to a greater proportion of engines being leased vs. owned (historically has been a roughly 50/50 split).
Engine time-on-wing issues: The new GE LEAP engines have seen time-on-wing below that of the CFM56/V2500, largely due to elevated temperatures required to achieve 10-15% fuel efficiency gains causing certain parts (i.e. airfoils and LLPs in the engine core) to burn out more quickly. This is leading to the need for more frequent repairs, structurally lower asset utilization and constrained supply of parts.
The P&W GTF engine recall issue: Since September 2023 an estimated 30-40% of the installed fleet (~1.2k engines) of the PW110G-JM (an engine for the A320neo) has had to be recalled for inspection and maintenance due to a powdered metal contamination issue. RTX expecting 300-day average wing-to-wing turnaround time for shop visits. This represents the most severe airworthiness grounding defect on a new engine class over the past 2-3 decades. Note that only ~5-10% of the installed fleet is available for replacement from spares in certain geographies (as is required by the FAA in the US). This is having massive effects on the aerospace supply chain (new engine orders are being diverted towards affected engines of existing customers with a build rate of only ~50-100 per month that cannot be increased very quickly). The key constraints on processing these engines are MRO capacity and material availability (specifically structural castings and isothermal forgings), and neither of these issues are likely to be resolved in the very near term.
These factors are leading to a huge surge in demand for legacy aircraft engines. Instead of upgrading to the new generation engines, airlines are having to extend the life of their existing engines by conducting additional shop visits and extending lease terms. MRO capacity is already constrained and shop visit turn times have worsened to >120-180 days. There is also an acute shortage of spare prior-generation engines.
These conditions provide a fertile environment for engine leasing businesses to 1) re-price expired operating leases at higher rates and 2) expand their customer base by offering modular repair and maintenance services that deliver a time and cost saving to airlines.
If airlines are unable to extend their existing engine life or lease in spare engines they will have to ground their fleet, which is untenable.
Situation summary
My thesis is that WLFC may be a better trade with more upside potential for small funds and PAs than the larger and more well known FTAI.
Key differences between WLFC and FTAI:
Capacity for module swaps: Described above.
Engine purchases: FTAI exclusively focuses on the prior-generation CFM56 and V2500 engines. While these engines also make up the bulk of WLFC's portfolio, management indicated that they have recently started to modernise the portfolio with the purchase of 10 new generation engines (consisting of the P&W GTF and the CFM LEAP for narrow-body, and the GEnx for wide-body). FTAI recently commented that they will only start to modernise their portfolio in the next 3-4 years, after the new-generation engines come off their initial long-term service agreements and fix any teething issues.
Insider ownership and activity: The Willis family owns 60% of the business. There seems to be consistent insider selling from WLFC, although the amounts are relatively small. By comparison, FTAI's CEO bought $5m of stock from a block of shares being sold by Fortress Investment Group in May 2024 (selling down equity received after FTAI bought them out), otherwise there is no insider activity.
Unknown to institutional investor community: Has no broker coverage.
Access to management: Management don't have a history of doing regular earnings calls or analyst meetings. They don't give guidance. However, they recently conducted an earnings call (the first in many years), and provided an investor presentation in May-2024 to stimulate more dialogue with investors, so it seems like this is improving in the right direction.
Turnover is low (given low free float): WLFC daily average traded value was ~$550k in Jan 2024, rose to slightly over $3m by September. Only actionable for smaller funds or your PA.
Balance Sheet: Leverage is slightly higher for WLFC (~4.5x FY24 net debt/EBITDA compared to 4.1x for FTAI).
The other material difference is valuation. Below shows a comparison:
While the shares of WLFC are already up 250% over the past 1yr and 205% YTD, my estimate of intrinsic value is reasonably higher than the price of ~$149 today and implies a sufficient margin of safety.
Financials:
WLFC's pre-tax income grew at a 20% CAGR (from $20m to $89m) over 2010 to 2019, and revenue grew at an 11% CAGR (from $148m to $409m). The business has since recovered from the material impact of COVID-19 that affected the entire commercial aerospace industry.
Below is a high-level financial profile of the business. The most significant source of growth is maintenance reserve and maintenance services revenue, which represents engine exchange and MRO services.
Note that guidance for FTAI's Aerospace Products segment EBITDA (contains the module swap and parts sales business) implies a much higher CAGR of ~64% from FY23 to FY26, which implies a revenue growth CAGR of ~50-55%. The assumptions used here for WLFC are much more conservative, given the lack of guidance (and given the lower mix of module swaps in WLFC's business).
WLFC commented in Q2 2024 that the typical run-rate of gain on sale of leased equipment is typically in the low-teens in a normalised environment.
I conservatively estimate the intrinsic value of WLFC to be ~$400 per share. The DCF assumptions used are shown below.
For comparable valuation, FTAI is a much better comp than AER and AL which are both more weighted towards aviation leasing and don't have the same vertically integrated module swap and MRO capability. Engine leasing is also a much better business than aircraft leasing as engines have better residual value retention than aircraft, lower lessee concentration, lower transition costs due to portability and asset commonality, and less value and lease rate volatility during cyclical downturns.
This justifies the premium to those names (given a multiple of 11x used). I don't expect WLFC to trade on a similar multiple to FTAI while the stock turnover remains so low.
The commercial aerospace PMA/parts businesses (e.g. HEICO, TransDigm) are used as comps for FTAI given that FTAI has an emerging PMA business. I don't consider these businesses to be as appropriate a comparable for WLFC given that they don’t do PMA.
The FY25 comparable multiples for AER and AL use consensus EBITDA from Visible Alpha, while the EBITDA for FTAI of $1060m is my own estimate (vs. consensus of $1000m).
Risks
There are macro risks to air travel and passenger demand, although engine leasing businesses are somewhat counter cyclical (i.e. airlines will lease rather than own engines when under financial pressure). The low starting valuation means that underperformance on earnings growth is not a headline risk.
Otherwise, the outsized influence and control from the Willis family is something to pay attention to, especially their previous low ball offers to take the business private and the excessive executive comp. A read of the 2023 Proxy Statement shows that Charles Willis was paid ~$11.9m in total comp in FY22, ahead of $6.2m of planned compensation, due to material increases in the year-end fair value of unvested awards granted in the current and prior years. Despite arguably being overpaid (and the unnecessary corporate costs from private jets, a yacht, etc.), management have done a good job of steering the business through COVID and allocating capital, and this is reflected in the share price performance. Note that the share count has been reduced through opportunistic buybacks from 8.6m in 2012 to 6.7m today.
Catalysts
The main catalyst is continued module swap and engine exchange activity during upcoming prior generation engine shop visits. Current aircraft and engine OEM build rates, the P&W GTF issue, and lack of supply chain capacity mean that demand for prior generation engines is likely to remain high for the next several years.
WLFC has also disclosed in May 2024 that the book value of their portfolio of narrow body engines is ~$400m below market value. This spread has grown over time and is the highest it has ever been, positioning WLFC well to continue to realise outsized gains on the sale of leased equipment.
There is also the possibility of a take-out by private equity or another large commercial aerospace leasing business that doesn't currently do engine leasing (like AER). FTAI is another possible buyer.
My $0.02 https://seekingalpha.com/article/4726725-willis-lease-finance-liquidation-value-is-above-200-dollars
Great analysis...couldn't agree more