Willis Lease Finance: Year End Update

(Author's note: This article is one in a series of articles I intend to publish over the final two weeks of 2013 in which I will review many of the companies I have written about over the past year in order to give an operational update to readers and determine if there has been any significant change to the original investment thesis. All companies covered in this will be ones I currently hold in my portfolio.)

Company Overview

Willis Lease Finance Corp (WLFC) (referred to as "Willis" for the balance of this article) is a leasing company that focuses solely on aircraft engine leasing. The majority of engines they lease to airlines are used as spares which are necessary due to the requirements around inspections and maintenance of the primary engines, unplanned mechanical failures and a variety of other reasons. More and more, airlines prefer to not tie up capital by owning these engines outright and choose instead to lease them from companies such as Willis.

Willis has been around since 1975 and went public in 1996. Since the IPO, company head and founder Charles Willis IV has grown assets under management at an impressive clip:

Mr. Willis has demonstrated a strong grasp of financial markets along with a deep knowledge of technological developments in the aircraft industry to build what can be considered the premier player in the engine leasing space. Willis has been recognized in past by trade publications such as Airline Economics and Global Transport Finance for their industry expertise.

Operational Update

Willis turned in a solid performance in Q3 with portfolio utilization increasing to 88%, a 31 month high and a 5% improvement over the Q2 level. This is a very positive development for the company and most likely speaks to the airline industry responding positively to the improving global economic recovery.

The airline industry feels the impact of the global economy more than most; when economic conditions deteriorate people tend to cut back on air travel on both a professional and personal level as flying is one of the easier expenditures to cut back on. The growing strength in the global economic recovery should translate into continued high utilization levels and, in time, higher lease rates as contracts roll over.

In addition to the positive news regarding utilization levels, the company's book value continues to march inexorably higher, ending at $24.31/share. We can see below that company shares continue to trade at a heavy discount to tangible book value:

(click to enlarge)

The company also announced the purchase of the other 50% of the WOLF JV and of JT-Power LLC, a leading provider of after-market engine and services and leasing services. The WOLF JV partner was bought out for $1M, a $12.7M discount to the partner's initial equity investment. This discount is unsurprising when you consider that the assets of the WOLF JV consisted entirely of two A340's, an aircraft type that is one of the most fuel inefficient ever to hit the skies and one that technological developments has rendered increasingly obsolete. Today there is no market for A340's so Willis is parting out the plane and adding the engines to their lease pool.

The JT Power acquisition could prove to be an interesting one, especially if Willis continues to build out its service offerings through other tack-on acquisitions. The low purchase price ($5.9M total) means that this is a relatively low risk proposition for investors. Given management's track record, I am confident that this will prove to be an accretive acquisition.

How Repurchase Shares of a Finance Company

One of the major catalysts with Willis is the company's $100M share buyback program that allows them to purchase their own engines at a ~30% discount to their book value. This buyback becomes even more significant when you consider that Willis has a market cap of $140M.

Proving that this buyback program was not merely announced for shock value, $5M worth of stock has been repurchased in 2013 YTD with virtually all of these purchases occurring in the third quarter.

The fact that Willis is a finance company means that their repurchase program must be approached differently when compared against non-finance company programs. To understand this, think about what happens from an accounting point of view when a company repurchases stock. They take cash (an asset) and use it to retire public shares (paid in capital - equity). The net effect of this is that equity and assets are both reduced by an equal amount. By decreasing equity, Willis is effectively increasing its leverage ratio as debt becomes an ever greater proportion of its total funding structure.

Like all borrowers, Willis has various debt covenants with its lenders that contain among other things, leverage thresholds which currently stands at 4.75:1. Given that the company is currently hovering around that limit, Willis does not currently have the ability to repurchase a significant amount of stock even as it produces an ocean of free cash flow.

So where does that leave us? In order to Willis to continue to repurchase shares, we need to see positive net income which will then flow through into retained earnings and effectively increase equity. The company can then use this increase in equity to repurchase shares, thereby keeping the overall leverage ratio constant.

Through the first three quarters of 2013, Willis has booked $9M of net income but almost all of that is due to a non-recurring tax revaluation. After stripping out that out, Willis has essentially broken even in 2013. While I believe that we should begin to see positive net income as the company's utilization rate climbs higher, this needs to be proven out in the financials. Until we start to see positive net income, the company will not be able to repurchase a significant amount of shares.

How Accounting Can Disguise Value

The main thing I look when valuing Willis is book value as I believe that in an industry where the company's assets can be sold into a relatively liquid market, this is good yardstick to measure the worth of the company.

With that being said, GAAP accounting may be causing Willis's book value to be understated. To better understand this, we must first consider how the company depreciates its assets. When Willis buys an engine, it must estimate its useful life and what its ending residual value will be in order to come up with a depreciation schedule. At the end of the day, these two key inputs are "best guess" estimates. No one can ever be 100% accurate in these estimations due to the constantly shifting nature of the aircraft and engine market, a market that changes based on factors ranging from technological developments to fuel prices to interest rates.

Willis regularly reviews these depreciation schedules to determine if they have to be adjusted based on new modeling assumptions. According to GAAP, if they determine that an engine is worth less than its depreciation schedule indicates, then the company must write down the asset to its fair value. However, if they determine that an asset is worth more than the schedule indicates then the company must do precisely nothing. There is no "writing up" of the assets.

This is known in accounting as booking assets at Lower of Cost or Market (LCM) and it almost certainly creates a situation where book value is understated in a company like Willis if management is effective in allocating capital. Given this management's team long track record of building book value and its overall industry expertise, I am confident that this is the case.

Risks

Technological Obsolescence: This is one of the biggest risks confronting companies in this industry. Willis has to position its portfolio to deal with the fact that the new aircraft variants being developed by Airbus and Boeing can lead to reduced demand for certain types of engines that they own. If the company's management team is unable to effectively manage obsolescence risk then we could see large write downs in book value in the future.

Economic Slump: As discussed previously, the airline industry is levered to a recovery in the global macro economy. Should economic conditions begin to deteriorate then less people will be flying, leading to a reduced demand for aircraft and engines.

Conclusion

In sum, I continue to hold my shares of Willis as I believe that the continuing global economic recovery should act as a powerful tailwind while the substantial discount to book value should act as a floor on the share price. As the company increases utilization and begins to generate sustainable positive net income, the company should be able to execute on its substantial buyback program which should act as another strong tailwind for the stock price.

Source: Willis Lease Finance: Year End Update

Disclosure: I am long WLFC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)

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