Willis Lease Finance: Risk-Reward Balance Not Skewed In Favor Of Investors

I recommend a Hold rating on the shares of Willis Lease Finance Corporation (NASDAQ:WLFC). Shares trade at a premium to peers and the company's outlook is clouded by a lack of guidance, potential take-private transaction, and potential impact of rising interest rates on its funding cost.

Company and industry overview

Willis is one of the world's largest lessors of commercial aircraft engines with a portfolio of approximately $2.2 billion in assets as of 12/31/22 comprised of 339 engines, 13 aircraft, one marine vessel and other leased parts and equipment. Willis competes with SES (a joint venture subsidiary of AerCap (AER) & Safran), Engine Lease Finance Corporation, certain maintenance and repair organizations (MROs, that are sometimes clients) and various financial institutions that participate in the leasing and trading market for aircraft engines. They are also both customers and occasional competitors with the engine OEMs as well.

WLFC financials and projections

Willis's results have been volatile, with earnings of as much as $9-10 per share in its best year, and $1 or less in more lean times. Earnings have unsurprisingly been under pressure in recent quarters as the company has worked through the impact of COVID on its business and the broader aviation market.

Source: Author's own calculations

This implies that shares are currently trading at approximately 90% of year-end 2022 book value and approximately 14-15 times my estimate of 2023 EPS.

Interest cost and lease rentals

Approximately 60% of Willis's debt has been sourced through fixed-rate securitization vehicles, much of which is priced at very competitive rates in the current market. Interest expense for 2020-2021 was sub-4% and this should at least partially limit the company's exposure to rising rates. The company's WEST III notes may come up for refinancing next year, so it will be worth monitoring how the company handles this and whether there is any cash trap or sweep that occurs in 2024.

It has continued to draw on its revolving credit facility and now has $727 million drawn at a spread of 1.75% over LIBOR. The company wisely secured interest rate swaps in the first quarter of 2021 for a total notional amount of $400 million, which should go a long way towards mitigating interest rate increases, at least in the near term. However, the facility comes up for renewal in mid-2024, and the company will need to refinance or extend it without the protection of most of its hedges. This could potentially weigh on future results.

Level of share buybacks

At December 31, 2022, approximately $39.6 million was available to purchase shares under the plan. Their share repurchases have not been overwhelming and in some years have not even covered the amount of stock issued to employees as compensation. It would be interesting to see them repurchase more stock, but when the company is already more than 50% owned by the CEO and Chairman, it may not be in the cards.

Relative value against other lessors

Willis shares trade for a healthy premium to other publicly traded airplane leasing companies, as is demonstrated by the comps to AerCap (AER) and Air Lease Corporation (AL) below:

Source: Author's own calculations

Elevated expense ratio compared to peers

Willis's expenses are elevated when comparing to various other aircraft lessors. While these lessors benefit from economies of scale to a greater degree, and aircraft leasing can be more of a "low-touch" business than the leasing and trading of the engines themselves, the gap is significant nonetheless:

Source: Author's own calculations, Aircastle based on 9 months of results to November 2022, others reflect calendar year 2022

Large insider ownership a blessing and a curse

Management owns over 50% of outstanding shares, and the company has always been a closely-held entity, primarily amongst its founder, Charles F. Willis IV, and his son, Austin. On the surface, this is an extremely positive sign, as management has a very real amount of skin in the game. However, when this is accompanied by longstanding pursuit of management buyouts where the majority of shares are already owned by management, it at least gives some pause on how positive this may ultimately be. In addition, there appears to be a variety of connections between the company and other companies or assets owned by Charles Willis, including as relates to use of a corporate jet and company car, among other things.

Significant net operating losses

As of December 31, 2022, the Company had NOLs at the federal level of approximately $315.9. The majority of these were derived from losses incurred during 2020. This will serve as a tax shield for the next several years, reducing the company's cash taxes.

Risks to investment thesis

Potential takeover (takeunder?) in discussions

Since November 2022, an independent committee established by the Board of Directors has been reviewing and negotiating a proposal in a consortium led by CFW Partners, L.P. (“CFW”, which owns ~32% of common shares and is controlled by Executive Director Charles F. Willis IV), would acquire all of the outstanding shares of the Company’s common stock not already owned by CFW, Charles F. Willis, IV, Austin Chandler Willis and their respective affiliates. The last price that was mentioned was $45 per share, roughly 20% below current levels. This is not the first time that the company has considered a take-private transaction - indeed, in 2019-20 and in 2021 there have been discussions that would have resulted in management taking the company private with one or more partners. These offers have all generally been at, or at a very small premium to, the then-current trading price of shares. With the exception of the sale of ILFC and GECAS to AerCap, nearly all other M&A transactions in the space have taken place at or above book value. Shareholders would be wise to pay very, very close attention to any developments on this front, and can decide for themselves whether an at-the-market transaction below book value would be in their best interest.

Utilization ratio has deteriorated in recent years

Willis's performance in terms of utilization has lacked in recent years and has dropped from 90%+ into the low 80s. The historical ratio can be found below:

Willis generates the bulk of its revenues from engines being subject to lease, so the higher this ratio, the better, all else equal. This could be considered both an opportunity and a risk. Willis's ConstantThrust program may allow it to increase utilization, and the recent transaction with Air India is a good example of where Willis can utilize its sizable pool of spare engines to provide creative solutions that add value for its customers.

Conclusion

WLFC stock has recently outperformed the market by a sizable margin, gaining nearly 75% over the past year in what has otherwise been a challenging time for stocks. As shares approach book value, and given the fact that they're valued at a premium to peers, it is my view that the risk-reward balance is not skewed in favor of investors. The potential management buyout looms large in the background and likely also puts a relatively low ceiling on potential further appreciation. I would not be a buyer here.