Widebody Aircraft Investment Funds 06 February 2020

Pure Play A380 Exposure - A focus on the DNA Investment Companies

Recent precipitous falls in share prices, has prompted us to take a closer look at the widebody aircraft investment funds exposed solely to the A380. In many ways, widebody aircraft resemble a commercial property investment, yet offer significantly higher yields. Whilst aircraft are a depreciating asset, this risk can be partially mitigated by having amortising debt finance which is not typically used in commercial property transactions. In this note, we attempt to demystify what is a less well-known asset-class and understand what has driven prices down – and prospective returns up.

Widebody aircraft such as the Airbus A380 often benefit from limited supply, as well as high quality lessees and excellent visibility of income via operating leases. These funds own one type of wide body aircraft, the Airbus A380, and have relatively simple business models. They rent aircraft to internationally recognised ‘flag carriers’ on fully repairing and insuring leases, and finance them with structured, currency matched, fully amortising debt. Leases are fixed for 12 years^[1] with no break clauses or rent reviews. The rent that the airlines pay goes to service the debt (both the interest cost and paying off the principal) and also enables the funds to deliver high levels of income. The majority of the leases provide that at the end of the 12-year term the assets must be returned in ‘full-life’ condition or with monetary compensation, equivalent to a full ‘nut-and-bolt’ rebuild and affording the highest level of value and/or re-marketability (re-sale) to the asset. As such, with existing seats and configuration, once repainted into new livery, these assets could be ready to fly again under a new operator in the event they are returned at the end of their initial lease period.

The widebody aircraft industry is characterised by a duopoly (Boeing & Airbus) which means that demand and supply should be balanced, and there is visibility over the production of new aircraft types. In terms of demand, air passenger traffic has, on average, roughly doubled every 15 years. Worries about rising nationalism (more visas) and climate change (carbon taxes) aside, air passenger traffic is expected to nearly double again by 2036 (Source: IATA). All of these factors make investing in widebody aircraft, specifically the A380, a unique proposition but, of course, not without risks.

There are a small number of LSE listed funds which offer exposure to widebodies, the majority of which have significant exposure to the Airbus A380. This makes meaningful comparisons between them possible. Here we focus on the Doric Nimrod Air (collectively DNA) companies. The first of these investment funds launched from the depths of the financial crisis, and with subsequent launches, the three companies that have a pure exposure to the A380 are Doric Nimrod Air One (DNA1), Doric Nimrod Air Two (DNA2) and Doric Nimrod Air Three (DNA3). These funds now represent a significant pool of assets with a combined market cap of c. £420m.

Until 2019, these three funds delivered solid and relatively consistent share price total returns since launch. However, uncertainty about the implications of the cessation of A380 production in 2021 has weighed on market sentiment; they all currently trade at share prices well below IPO. As we discuss in the portfolio section, the DNA Boards have noted that the market for the A380 is not currently balanced between ongoing users and those that are likely to or discontinue use of the aircraft. The situation is expected to continue to be fluid and will depend on a number of factors including the position of manufacturer deliveries of new widebody aircraft to airlines (including Emirates) and passenger traffic generally.

So far, none of the DNA funds has missed any of the chunky dividend payments offered at launch. In view of the specialist nature of the risks underlying each fund, these funds have perhaps been considered by some investors to be in the “too difficult” camp. Yet at the current prices, all three of the aircraft investment funds offer the potential for attractive total returns including very high annual cash dividends. As at 31 Jan 2020, share prices imply dividend yields of 13.6% for DNA1, 14.1% for DNA2 and 12.3% for DNA3. These are clearly significantly higher than for property and other alternative income funds.

These funds are not without risk: assuming the lessee (Emirates) does not go bankrupt, a significant part of the returns from these funds depends on the final value of each aircraft when their initial 12-year leases mature. Uncertainty on this point is the main reason they offer such high yields. However, there are several catalysts on the horizon which could help provide more certainty on these valuations in the next year or so. The share prices currently appear to factor in that each aircraft will be broken up for spare parts when the leases come to an end. In each case, this represents a considerable discount to the last financial year-end portfolio appraisal values.

^{[1] The companies have determined that the operating leases on the assets are for 12 years based on an initial term of 10 years followed by an extension term of two years. Should the lessee choose to exit a lease at the end of the initial term of 10 years, an early termination payment equal to the present value of the Sterling rent that would have been payable for the extension term of 2 years would be due. For the purpose of this report the leases are all referred to as 12 year leases.}

With these funds now offering very high running yields, and the potential for capital growth from current share prices, we believe they merit closer attention. The DNA funds are largely comparable to each other in that they all own Airbus A380 aircraft, employ very similar financing arrangements and have Emirates as the sole lessee.

Given the specialist nature of these funds, they must be considered higher risk. However, in reality, the main risks for investors are represented by the credit risk of Emirates, and the residual value of the A380 when the initial lease terms expire. Emirates decisions on its leased A380s will have a significant effect on returns for shareholders in all of these funds.

With the Emirates first lease of an A380 (not owned by any of these companies) due to expire in December 2021, and the lease in DNA1 ending in December 2022 the time for a clear catalyst is soon approaching. In recent interviews, Tim Clark, the President of Emirates, has committed to using A380s for the foreseeable future. Clark stated a near-term fleet size of roughly 115 aircraft before declining to roughly 80-100 A380s by the middle of the next decade. This compares to a current fleet of 113 A380s with a further 10 deliveries outstanding by 2021. Based on lease expiries alone, the fleet size will remain in excess of 90 aircraft until 2027. On the surface therefore, it seems unlikely that Emirates will re-lease the DNA aircraft. However, Clark has also said that any slight uptick in demand might see Emirates find themselves needing to keep many leased A380s.

Another complication is that Emirates has announced that Tim Clark will be retiring in June 2020, and the new President may have differing views. As such, it is very difficult to assess what Emirates intentions will be with regard to specific A380s, whether leased or owned. How, and by exactly how much, they decide to downsize their fleet is still uncertain, which presents risks to fund investors, and explains the current level of share prices. However, it seems clear that if Emirates are to re-lease their A380 aircraft, it will be a negotiation and Tim Clark has already started to publicly position for his side of the argument.

Our analysis suggests that the last financial year-end independent appraisal values (at March 2019) imply very high double-digit returns for investors at current share prices. However, it is also true that Emirates holds many of the cards. As such, appraisal values might increasingly be seen as more hope than certainty. Updated appraisal values for March 2020 should be announced in the next annual report. A possible scenario whereby the aircraft are not re-leased, but rather broken up for spares and the companies receive an amount of lease-end cash compensation, totalling a discount to appraisal values of some 50% - at current share prices and USD exchange rate this would translate into potential IRRs of 23.4%, 17.6% and 15.5% for the three DNA funds. If the aircraft are re-leased, depending on the terms negotiated, it is possible that shareholders return profile would look different to this.

Recognising that these funds are not diversified and that the prospects for each A380 at end of their initial lease is difficult to assess; investors are right to apply a discount to the average of the independent appraisers’ values. However, the current breakeven values, (i.e. in order to achieve the current share prices back through a combination of capital and income) are well below 25% of the latest appraisal values. This means that a very significant downside is already being priced in by the market, and potentially offers investors a hefty margin for error.

The unique nature of the A380, and Emirates (which is a wholly state-owned flag carrier) as a credit risk, mean that investors are exposed to a fairly narrow range of eventualities in our view – for good or for bad. Certainly, as time passes, and the leases underpinning each fund come closer to their expiration, the risks – as measured by share price volatility – may increase. However, as we show, the funds have provided a source of high and secure income and returns likely uncorrelated to investors’ other holdings. Although they have to be viewed as a higher-risk investment, these aircraft investment funds have the potential to deliver attractive returns. Much of the bad news is priced in at current levels, and as the day of reckoning approaches – should the market start pricing in eventual realisation values of only 50% of those forecast by the independent appraisers, shareholders could make strong returns based on current share prices.