Widebody Aircraft Investment Funds

Last updated 06 February 2020

News and sentiment leaves the London-listed aircraft-leasing funds offering high prospective yields to investors...

Disclosure – Non-Independent Marketing Communication

This is a non-independent marketing communication commissioned by Doric Nimrod Air One Ltd, Doric Nimrod Air Two Ltd and Doric Nimrod Air Three Ltd. The report has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on the dealing ahead of the dissemination of investment research.

Widebody Aircraft Investment Funds

Summary

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 are 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.

Kepler View

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. Even 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 stand to make strong returns based on current share prices.

bull bear
High dividend yield, and potential for attractive total returns depending on Emirates' decision on acquiring or releasing A380s and/or their residual values Shareholders exposed to a narrow range of significant risks: Emirates credit and also A380 residual values
Much of the A380 uncertainity is "in the price", reflected in the breakeven analysis showing discounts in excess of 75% to the latest appraisal values As time goes on, more of the shareholder total return is determined by residual value, meaning potentially higher volatility depending on the outcome
Low correlation to equity markets, with aircraft on fully repairing and insuring leases to state owned flag carriers Worries on climate change and a rise in nationalism could negatively impact passenger traffic growth

Portfolio

Investing in widebody aircraft has historically proven a successful strategy. Although, as with all investments, timing and the nature of the underlying assets as well as financing can be key determinants of the final outcome.

In terms of supply, the widebody aircraft industry is characterised by a duopoly (Boeing & Airbus) which means long production lead times with 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). This background has served aircraft leasing investors well in the past.

In this analysis, we examine the DNA stable of aircraft investment funds, the three of which were designed as primarily “fixed life” listed funds (DNA1, DNA2 and DNA3). Each aircraft is placed on a fixed term fully repairing and insuring 12 year lease (at the outset) to a single counterparty (Emirates). The financing arrangements have no LTV covenants (except in the event of an Emirates default). Whilst each fund has the mechanism to sell any aircraft (and associated lease) during the course of the initial lease, it is fair to say that this is unlikely, and as such these might be considered relatively static funds.

Each fund has been launched sequentially, with DNA1 serving as a “proof of concept” and only owning a single A380, with subsequent funds being launched in the form of DNA2 which grew using C-shares, followed by DNA3 in 2013.

table comparing dna aircraft investment funds


dna1
dna2
dna3
Portfolio
1 x A380
7 x A380
4 x A380
Lessees
Emirates
Emirates
Emirates
Average time till lease expiry (yrs)
2Y 11M
4Y 6M
5Y 9M

Source: Quarterly fact sheets, Kepler Partners estimates as at end-January 2020

As the table above illustrates, all of these funds own A380 aircraft which are leased to Emirates. As such, the main risk factors that each fund faces are broadly similar:

  • Credit risk – Emirates needs to remain solvent to ensure debt amortisation and dividend flow
  • Residual value risk – of the A380 aircraft portfolios, when aircraft reach the end of their initial leases

We examine each below:

Credit risk

In some ways, for non-specialists like ourselves, Emirates credit risk is the easier of the key risks to analyse because the airline has sold bonds to fixed-income investors. It is worth noting that Emirates Group is 100% owned by the Government of Dubai. Using Bloomberg, we find that Emirates has bonds maturing in June 2025 (six years) which at the time of writing trades at a spread of c. 187bps over Treasuries. The bonds are not actually rated, but we observe that they are trading in the range of a BB bond (ie top of high yield). Emirates bonds display a higher yield compared to similar maturity dollar debt instruments issued by IAG, which have consistently traded c. 100bps tighter than Emirates. This is a simplistic analysis, but it does highlight that Emirates is perceived as a credit-worthy counterparty by the fixed-income markets.

Residual value risk

In our view, residual values are the main risk that investors are currently focussing on. As we discuss in the dividend section, each of these funds has eliminated the foreign exchange risk to shareholders’ dividends. Each aircraft is bought using fully amortising debt, which is fully repaid by or before the end of each respective assets initial lease term. Aircraft are typically priced and traded in US dollars, meaning UK investors have exposure to a dollar asset at the end of the life of the lease.

The appraised residual value published by the companies (i.e. the estimated value of the respective aircraft at the end of its lease) is clearly an estimate, and rests (much like a property) on third party evidence of transactions, and/or independent appraisers’ assessments. At the outset, investors at launch in these funds stood to get their initial purchase prices back via dividends, whilst at the same time each company would fully repay the debt (both principal and interest) - both assuming that the lessee remained solvent throughout the lease term. At such point the aircraft will be unencumbered and owned outright. As such, as the lease expiry date approaches, a greater proportion of the potential return is determined by the residual value of the aircraft. In this way, it might be imagined that the volatility of returns may increase as the lease-end date approaches, depending on changes to valuation expectations.

Appraisal values are therefore of most importance and relevance to shareholders in DNA1 which launched first and whose aircraft lease comes to an end first, although clearly there will be knock-on effects to the other funds. Several factors specific to the A380 make any valuation fairly theoretical at this stage, but there is a substantial history of evidence for other large widebody aircraft, which we delve into below. However, the good news – for the sake of clarity – is that there are several catalysts coming up within the next 24 months which should (for good or for bad) provide a much clearer assessment of what value shareholders might realise at the end of a lease. Recent comments from the President of Emirates (the largest user of A380s globally) have provided some clarity. In the interviews – which were widely reported – Tim Clark highlighted Emirates utilisation of the A380 for the foreseeable future, stating that they will still be using the model in 2035. Specifically, he stated that “the fleet will stabilise at about 115” before declining to “about 90-100” or “80 to 90” by the end of the next decade.

Emirates have a current fleet of 113 A380s with ten further scheduled deliveries by the end of 2021. Assuming Emirates do not renew any A380 operating leases or purchase the aircraft the fleet size should remain in excess of 90 aircraft until 2027. It is very difficult to assess what Emirates intentions are with regard to specific A380s, whether leased or owned, therefore how and when they decide to downsize their fleet is still uncertain. However, given the costs associated with the lease return conditions, if there is any appetite for keeping some A380’s, then on balance it seems more logical that Emirates may re-lease aircraft from lessors and use their own (fully amortised) A380s to provide any spare parts for their fleet (i.e. requiring limited further cap-ex). Assuming this is the case, this could be good news for the listed funds that lease A380s to Emirates such as DNA funds. However, Tim Clark also highlighted “probably 40 to 50 of the current A380s are leased and will go back to lessors. There is no second-hand market. If we decide we need them, then we will pay them a price we can afford.” It seems clear that if they are to be re-leased, it will be a negotiation and Tim is starting to publicly position for his side of the argument. In the same interview he also however acknowledges “when there is an uptick in demand from 2022 onwards with annual growth of 4-6% in passengers again, we might find we would want to keep those A380s, as, without them, slot constraints will become even worse.” Source: www.airlineratings.com

The specifics of the A380

The Airbus A380 was a bold move by Airbus to build a replacement for the Jumbo-Jet (B747) era of aircraft. The A380 is the only aircraft currently capable of carrying up to 853 passengers, designed to support the expansion of capacity constrained airports around the world – indeed, 10% of the 78m passengers that travelled through Heathrow in 2017 were carried by an A380 while the aircraft represented less than 4% of daily flight movements at the airport. The A380 compares well to even the most environmentally friendly current generation widebody aircraft in the air today, producing only 75g CO2 per passenger kilometre (assuming an 800-odd seat configuration) while emitting significantly less noise. We note that this is around the same carbon emissions per kilometer as a single person taking an Uber ride in a Toyota Prius hybrid (Source: Toyota). Aside from environmental considerations, the A380 is also a response to the “winner takes all” phenomenon of mega-cities attracting aircraft traffic. The huge size of the aircraft means that it can transport large numbers of people within existing infrastructure, which in most cases cannot keep up with the rising demand for visitors to mega-cities such as London, New York, Los Angeles and Hong Kong – all of which have existing slot constraints for aircraft.

Whilst the A380 is undeniably an impressive plane and loved by travellers, it has not been a commercial success for Airbus, who in early 2019 announced that they would cease production in 2021. Only 252 A380s will now ever be produced, of which Emirates will take delivery of 123 – the largest customer globally. The next largest fleets around the world are a fraction of this number, with Singapore Airlines operating 19, Lufthansa operating 14 and British Airways with 12. The dominance of Emirates in its use of A380s is noteworthy, because it is of strategic importance to the airline, but also perhaps because of the negotiating position it may hold with its lessors when its leased aircraft come to the end of their initial terms. That said, the A380 currently represents more than 50% of Emirates seating capacity and the airline has publicly stated that the aircraft is a “pillar of their fleet” and will remain in service well into the 2030s. Further, Emirates have also highlighted load factors as high as 93% on their high capacity (615 seat configuration) A380s travelling through London. The possibility of whether Emirates will want to purchase or re-lease A380s, and the value of these aircraft to other operators is, in our view, the key component to each of the DNA funds’ value and returns from this point onward. On the surface, it seems unlikely that Emirates will re-lease the DNA aircraft. However, as we note above, comments from the President of Emirates mean that everything remains a possibility. The recent announcement by Amedeo Air Four Plus that it has received a reconfiguration request for two of its A380s to install premium economy seating is a demonstration that Emirates continue to invest in the aircraft model if nothing else.

In terms of the wider market, the first A380s to reach the end of their leases have seen a mixture of outcomes. Widebody aircraft tend to trade much less frequently than narrowbodies, and only a single A380 has been re-leased to date. As such, and given the relatively young age of the A380, flimsy transactional evidence is not unexpected. However, it has been well publicised that five A380s, operated by Singapore Airlines, were returned to their lessors at the end of their leases. It is also worthy of note that Singapore replaced these five older aircraft with five new A380 deliveries, thereby maintaining their fleet of A380s at 19 aircraft. One plane, managed by Doric (the Asset Manager of DNA1/DNA2) has found a new lessee (Hi Fly), while two remain in storage and two are being broken-up for spare parts with the engines currently leased to Rolls Royce. Historically the Boeing 747 Jumbo Jet saw more than 80% of deliveries stay with their original operator for their entire working lives and British Airways continues to be the largest operator of this model with an average age of well over 20 years. We understand that Hi Fly is considering the acquisition of a second plane, but nothing has yet been confirmed. Dr Peters Group is the leasing manager responsible for the two A380s in storage and those being broken-up for spares. According to recent reports, estimates of $45m in revenue per aircraft from component sales alone have been forecast. Dr Peters has estimated eventual total revenue as high as $80m per aircraft (though this is generally thought of as a very high figure). This compares to the current average appraisal value (at end of lease) of the A380 in DNA1 of $99m (as at 31st March 2019).

Qatar Airways has stated plans to retire its fleet of ten A380s from 2024 in favour of the incoming Boeing 777X. Emirates could be considered a different case to Qatar given the former’s reliance on the A380, taking delivery of 123 and representing 46% of their total fleet of 270 aircraft (more than 50% by total seat capacity). The first Emirates A380 lease expiry comes up in December 2021, and the first for the DNA funds (in DNA1) in December 2022. This decision, and consequences therein, will prove very important to the share price ratings and IRRs that shareholders may receive over the next few years. We believe that despite many competing arguments each way, it is very difficult to predict exactly what will happen, which is why in the returns section we analyse a breakeven analysis, enabling an analysis of potential returns under different scenarios. Certainly, with Emirates and the A380 as key variables, investors have significantly less diversification than they would typically experience in many listed alternative income funds. The flip-side to this is that a comprehensive sensitivity analysis can be undertaken given the limited number of variables.

Gearing

At launch, the basic premise for each company featured in this report is that the aircraft purchase was financed by roughly 30% equity and 70% debt. Each loan is assigned against each specific aircraft (or group of aircraft in the case of the Enhanced Equipment Trust Certificates (EETCs – a form of securitisation financing) which feature in DNA2 and DNA3) and is fully amortising over the life of each lease. Debt is dollar denominated with a portion of lease rental paid in USD to service the interest and principal repayments. As we discuss in the returns section, this means that at the end of the life of each fund, shareholders own each aircraft outright. For these funds, the absence of debt at the end of each lease means that investors can take a relatively simple view on the value of each aircraft at the lease-end date. It is worth reiterating that each loan is assigned to each aircraft (or group of aircraft for the EETCs), and there are no LTV covenants or requirements to increase the rate at which loans are repaid, other than in the event of a default by Emirates.

summary of loan terms as at 31 January 2020


dna1 dna2 dna3
Debt type Commercial bank Commercial bank and Listed debt security (US) Listed debt security (US)
Amortising loan at outset (% of purchase) 68% 70% 69%
Loan outstanding (as % of initial loan) 19% 31% 31%
All in interest rate 5.50% Commercial Bank: 4.56%-4.78%
EETC: 5.125% - 6.50%
EETC:
5.25% senior;
6.125% junior

Source: Company prospectuses and factsheets

Returns

DNA1 launched in 2010, which was the first London listed aircraft investment fund. Since then, DNA2 and DNA 3 launched, together comprising around one-third of the aircraft leasing funds by market capitalisation. Since listing, the funds have delivered annualised total returns, comprised heavily of dividend income, which until recently had been only marginally behind the FTSE All Share’s total return. As we illustrate further down, they have exhibited relatively low correlation and (until recently) a fraction of the volatility of equity markets.

share price total returns since launch (to 31 january 2020)


DNA1
DNA2
DNA3
Share price capital gain %
-34.0
-36.0
-33.0
Annualised total return % p.a.
3.6
2.6
1.8
FTSE All Share total return % p.a.
7.1
7.1
6.8
Fund launch date
13/12/2010
14/07/2011
02/07/2013

Source: Bloomberg

As the graph below shows, until 2019 shareholders had enjoyed relatively consistent share price total returns each year since launch. At launch each fund had a targeted annual dividend distribution of between 8.25% (DNA3), and 9% (DNA1 and DNA2) based on the launch price. Given all of these dividends have been paid on target and on time, a large proportion of the total returns so far generated have come from these dividends. However, as each lease approaches the end of its term, the more the prospective returns for shareholders depend on the capital value realisable from aircraft. This has important implications for investors, not least that in our view, the share price volatility of each fund may increase, all things being equal, as that date gets closer.

historic share price total returns

Source: Morningstar, 31 January 2020

As the graph below shows, the DNA funds have demonstrated share price total returns that have been reasonably highly correlated with each other since inception. As the graph below illustrates, all of the funds have had a more difficult time of it since the start of 2019, which we examine in more detail below.

share price total returns

Source: Bloomberg, to 31 January 2020

On 14 February 2019, Airbus announced that it would cease production of the A380 in 2021. This led to some uncertainty for the aircraft investment funds with exposure to the A380, with share price declines on the day of roughly 10%. As we highlight above, the fact that the A380 is ceasing production is a potentially a double-edged sword. If the aircraft model is in demand, then the fact that there are no new aircraft being produced means that the secondary market is the only source and second-hand values should remain underpinned. On the other hand, many airlines achieve economies of scale by operating a fleet of the same aircraft. As such, Airbus ceasing production could mean some operators may seek to retire their use of the model – such as we have seen based on statements from Qatar. However, with the A380 representing 46% of Emirates’ fleet by number and over 50% by seat capacity, the airline has stated that “The A380 will remain a pillar of our fleet well into the 2030s”. Amedeo have cited estimates that Emirates will require 80 to 90 units, in line with a recent broadcast interview with the President.

Assuming Emirates do not renew any A380 operating leases or purchase the aircraft, the fleet size should remain in excess of 90 aircraft until 2027. However, given the costs associated with the lease return conditions, if there is any appetite for keeping some A380s, then on balance it might seem more logical that Emirates may re-lease aircraft from lessors and use their own (fully amortised) A380s to provide any spare parts for their fleet (i.e. requiring limited further cap-ex). As such, it is difficult to assess what Emirates intentions are with regard to specific A380s, whether leased or owned. Therefore how and when they decide to downsize their fleet is still uncertain, but it is clear that a re-lease of the DNA aircraft is by no means guaranteed which helps to explain why share prices have reacted as they have during 2019.

one-year share price total returns

Source: Bloomberg, to 31 January 2020

Each of the board of DNA1 are required - six months before the end of the term of the aircraft’s lease (June 2022) - to propose to shareholders that the company proceed to an orderly wind-up at the end of the term of the lease. Similar resolutions are proposed for DNA2 (June 2025) and DNA3 (November 2026). The directors will consider (and if necessary, propose to shareholders) alternatives for the future of the company, including re-leasing the asset, or selling the asset and reinvesting the capital received from the sale of the asset in another aircraft.

In the tables below, we analyse the prospective IRRs based on the current share prices, USD exchange rate and the last financial year-end appraisal values of each fund’s portfolio. Clearly, if Sterling depreciates from the current level, then IRRs will improve, conversely if the dollar weakens relative to GBP then they will fall. Overall, in any scenario aside from a greater than 75% reduction to the latest appraisal values for the A380, shareholders stand to receive attractive returns. In such a scenario, much of the return would be in the form of capital.

We are not aircraft experts by any stretch of the imagination, but one expects that the credibility of independent appraisal community would be badly dented should their estimates prove to be so far off. Indeed, the reported experience of Dr Peters Group’s break-up exercise of two A380 aircraft may provide some reassurance on this front. Each set of four engines is reported to be fetching c. $480k pcm, for a period just short of 2 years (so some c. $11-12m of income) in rental back to Rolls Royce before the potential for the engines to be purchased. It should be noted however, that the DNA A380s all operate with Engine Alliance engines (a JV between GE Aviation and Pratt & Whitney) which at this stage have yet to see any leasing transactions put in place. Dr Peters Group have previously disclosed an $80m estimate for the total recovery value, which would equate to only a c. 20% haircut to DNA’s appraisal values. In our view, this suggests that a 50% haircut would imply attractive high ‘teen IRRs or more for DNA1, DNA2 and DNA3 – all at the 31st January 2020 share prices and USD exchange rate.

projected shareholder returns at 100% appraised value


dna1
dna2
dna3
Share Price (p)
66.0
128.0
67.0
Latest Factsheet residual value $m (31 March 2019)
99.0
762.4
497.8
IRR
51.6%
36.1%
27.7%
Income (£ per share)
0.27
0.81
0.48
Capital (£ per share)
1.75
3.36
1.71
Total return (£ per share)
2.02
4.18
2.19

Source: Company fact sheets, Kepler estimates

projected shareholder returns at 50% of appraisal value


DNA1
DNA2
DNA3
Share Price (p)
66.0
128.0
67.0
50% discounted residual value $m
49.5 381.2 248.9
IRR
24.5%
21.0%
16.8%
Income (£ per share)
0.27
0.81
0.48
Capital (£ per share)
0.89
1.74
0.88
Total return (£ per share)
1.16
2.56
1.36

Source: Company fact sheets, Kepler estimates

projected shareholder returns at 25% of appraisal value


DNA1
DNA2
DNA3
Share Price (p)
66.0
128.0
67.0
75% discounted residual value $m
24.76
190.60
124.45
IRR
4.2%
9.5%
8.4%
Income (£ per share)
0.27
0.81
0.48
Capital (£ per share)
0.46
0.93
0.47
Total return (£ per share)
0.73
1.75
0.94

Source: Company fact sheets, Kepler estimates

Looked at another way (a share price breakeven analysis), in order to achieve cashflows that add up to the current share prices, the realised values of the aircraft when they reach the end of their leases is more than 75% below the current appraisal values. We model the implied discount to appraisal values based on current GBP/USD exchange rates and the 31 March 2019 appraisal values in the table below. We believe that these statistics show that there is plenty of downside protection at the current prices/ exchange rates, particularly with reference to the break-up values being mooted by Dr Peters Group (between $45m – $80m, and assuming some Engine Alliance engines can also be leased).

implied residual values based on 31 january 2020 share price (assuming all dividends paid)


Implied discount to appraisal value (%) Implied aircraft appraisal value (M)
DNA1 -78 $21.9
DNA2 -86 $15.4
DNA3 -89 $14.2

Source: Bloomberg, Company Fact Sheets, Kepler Partners, GBP: $1.3206

Dividend

The primary objective of each fund is to pay a high dividend. At launch, each had a target dividend distribution of between 8.25% (DNA3), and 9% (DNA1 and DNA2) of the issue price. Given the fixed nature of the lease agreements, there was no expectation that these dividends would increase. As we note in the portfolio section, each of the DNA company’s leases are structured that for the dividend paid to shareholders, the lessee must make fixed GBP payments which cover the dividends payable and the running costs of each company. As such, shareholders in the DNA companies bear no FX risk as regards the company’s income and dividends. It is worth noting that lessees also bear all costs (including maintenance, repair and insurance) relating to the aircraft during the lifetime of the lease.

Since IPO and once fully invested, each fund has paid its quarterly dividends on time and in full, with no variation from projections at launch. In fact, the large majority of the annual returns that shareholders have enjoyed since launch have come via these dividends. The current share prices imply attractive dividend yields, of 13.6% for DNA1, 14.1% for DNA2 and 12.3% for DNA3. These are clearly significantly higher than many other alternative income products.

As we note in the Returns section, the total return that shareholders will receive – if they hold their investment until the end of each company’s life, will reflect the relatively high level of dividend distributions followed by proceeds from the sale or re-lease of the aircraft (after the end of the initial 12-year lease term)– translated from dollars into sterling. It is worth noting that investors today have a notably higher exposure to the capital value (specifically DNA1 and DNA2 which are now more than half-way through their lease terms) on their investment returns, than those investors at launch. This is because income now represents a much lower proportion of potential future returns, simply because of the fewer outstanding dividends payable over the remaining term of the lease(s). As such, and as time passes, investors should expect a greater focus on residual values – which may result in higher share price volatility than has been experienced in the past.

Management

Doric is the asset manager of DNA1 and DNA2. It is a leading provider of products and services for investors in the fields of aviation, shipping, renewable energy and real estate. Doric has an international presence, with offices in Germany, Hong Kong, the United Kingdom, and the United States. The aircraft portfolio currently managed by Doric is valued at $7bn and consists of 44 aircraft. These include commercial aircraft ranging from ATR 72-500s and the Airbus A320 family, through the Boeing 737, 777, 787 and Airbus A330/A340 family, up to the Boeing 747-8F and Airbus A380.

Amedeo is the Asset Manager of DNA3. It is primarily involved in the operating lease and management of wide-body aircraft. The aircraft portfolio currently managed by Amedeo, includes forty-one aircraft under management and an additional eight airecraft under oversight. The value of assets under management is c. US$7.5bn, which include commercial aircraft including A380, A350, A330, B777 and B747-F.

Discount

The NAVs published by the DNA funds’ do not reflect well the true value of the underlying investments. As such, it is hard to establish what each fund’s “discount” to NAV in the traditional sense is. The reason the NAVs are of limited use is fundamentally because of the GBP denomination of the shares alongside the IFRS accounting treatment for the lease and associated debt. Further, since the 2018 Annual Reports, the portfolio appraisal values have been stripped of expected inflation assumptions, which form part of the standard aircraft appraisal process. These appraisal values are still reported on each of the funds’ quarterly fact sheets reflecting an exercise run annually (as at 31 March) and reflects the average of three independent appraisers, including inflation.

Charges

The asset manager for each fund charges a flat management fee per aircraft (adjusted annually for inflation at 2.25% - 2.50% per year). Nimrod are also paid a fee as Corporate and Shareholder Advisor. The latest KID RIY costs are 1.38% for DNA1, 1.37% for DNA2, and 1.14% for DNA3.

Doric (DNA1 & DNA2) and Amedeo (DNA3) will also receive a fee for their sales and remarketing services upon “disposition” (aka sale) of assets and subsequent winding up of each company. This will be payable out of the proceeds of sale and will follow an incentivised structure. The asset manager will not be entitled to the disposition fee (but will be entitled to reimbursement for properly incurred costs and expenses) if shareholders do not recover capital equal to (or in excess of) the IPO price (100p for DNA1 and DNA3, and 200p for DNA2) net of all costs, fees and expenses upon the winding up of the Company. For DNA1 and DNA2, if shareholders receive capital of between 100% and 150% of the IPO price per share (inclusive, and net of all cost, fees and expenses) upon a winding up, the asset manager will be entitled to receive a disposition fee of 2% of the realised value of the assets. If shareholders receive capital more than 150% of the IPO share price (net of all costs, fees and expenses) the asset manager will be entitled to receive a disposition fee of 3% of the realised value of the assets. This fee clearly aligns the manager with shareholders to find the best value for each aircraft once its lease period ends.

ESG

Related Research

Key facts

Investment objective

The Companies’ investment objectives are to obtain income returns and a capital return for shareholders by acquiring, leasing and then selling aircraft

Disclaimer

This report has been issued by Kepler Partners LLP.  The analyst who has prepared this report is aware that Kepler Partners LLP has a relationship with the company covered in this report and/or a conflict of interest which may impair the objectivity of the research.

Past performance is not a reliable indicator of future results. The value of investments can fall as well as rise and you may get back less than you invested when you decide to sell your investments. It is strongly recommended that if you are a private investor independent financial advice should be taken before making any investment or financial decision.

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