My latest addition to my funds trading list is one that I think can fairly be described as controversial. It is Doric Nimrod 3, ticker DNA 3. I’ve written before about the small fleet of listed aircraft funds, usually favouring the more diversified AA4 vehicle. I freely admit that many of those earlier observations have been over taken by some obvious , brutal, events – the CoVid emergency. This has blown a hole through any valuation metrics and completely reshaped any calculations. Obviously there had been a host of challenges to the A380 business model even before the emergency but now the game is up – the A380 is as dead as a dodo. As with the Jumbo jet I doubt we’ll see many more gracing our skies over the next decade.
The CoVid emergency has also introduced a new headwind – the base business case for the long-haul hub model. There is now a very legitimate debate to be had about whether the old Emirates business model can ever rebooted. I’m not an out and out sceptic but I do worry that the business class and premium economy offers of old might be fatally flawed in our new nervous normal. That said, Emirates has a strong business model and the government of Dubai has indicated that it would “financially support Emirates during this period through a variety of measures including an additional equity injection if required.” Currently Emirates’ unsecured debt yields around 5.5%, certainly don’t indicate junk status but that yield does suggest there is some nervousness on the part of bond investors.
The aircraft leasing firms thus face myriad challenges. But my gut suspicion is that these current challenges are more than in the share price. Matters could change drastically for the worse of course and one has to recognise that a second wave breaking over Europe and the Middle East could cause mayhem. But on balance I think the share price of the three funds is already discounting this possibility.
The three Doric Nimrod vehicles are currently are detailed below:
DNA 1 39p, £15m
DNA 2 61p, £105m
DNA 3 32p, £80m
My marginal preference is for the second vehicle – Doric Nimrod 2 which listed on the SFM in July 2011. This currently owns seven Airbus A380-861 aircraft which have each been leased on twelve year terms to Emirates Airline and pays dividends of 4.5p per share per quarter. The shares listed at 200p a share and the last time I looked had debt of $265m left. The average remaining lease duration is 4 years and 1 month which means that by Autumn 2024 this fund should be close to being wound up. Crucially its worth noting that that debt is in the form of what’s called an enhanced equipment trust certificate (originally $587m was issued) which makes quite a big difference. Because they are traded on an exchange, any renegotiation or default might trigger wider repercussions in Emirates main corporate debt, which means that the airline might be reluctant to signal too obviously its in distress by triggering a credit event.
So, why might now be the time to buy shares? We have recently had the quarterly reports which for the first time incorporated what are called ‘soft market’ estimates for the planes residual values, designed to reflect current (dismal) market conditions. In effect this means that the base case appraisal values for DNA, DNA2, DNA3 have been reduced by 31.5%, 32.6%, and 33.5%, respectively. The table below from fund analysts at Numis sums up the numbers form the Doric Nimrod quarterly reports.
Matt Hose, funds analyst at Jefferies, has been digging around in these numbers and I suspect he’s probably right when he says we need to anchor realistic valuations off the 75% base case scenario. According to Matt, “under this scenario, current share prices would generate IRRs of 18%-29%, based on per aircraft A380 residual values of $11.7m-$15.” Matt Hose also observes that “these projected residual values are clustered around the level of the $12m compensation payment due in the event that Emirates returns an aircraft in half-life, as opposed to full-life, condition, which is the only real anchor point for values. As such, we feel this level of haircut is likely to represent the true base case.”
So, using Doric Nimrod’s own numbers if we assume 75%, we’d still expect to see income distributions of 77p, plus a return of capital of 52p making 129p over next four years, versus the current share price of 61p. But we can get one step further and assume that the resale value of these planes will be a big fat ZERO. That means there’s no scrap value for the aircraft which is unlikely, but I suppose not impossible. With DNA 2 and DNA 3 if we assume zero end value, we get to an IRR of roughly 12% per annum. Analysts at Numis offer this alternative, slightly more optimistic assessment : if the soft market was borne out, “shareholders investing at the current share price would achieve capital returns of 399p and total returns of 480p, assuming a £1 / $1.2401 exchange rate and no unexpected costs incurred or income lost.”.
Now, these are all estimates and they don’t assume that Emirates tries to renegotiate its leases. As they’re not using the planes, they could decide to play hard ball in which case those dividend payouts could be jeopardised. But that exercise in hardball might be risky for a previously successful airline and might have some impact on the pricing of its mainstream debt. So, on balance I think that that outcome is unlikely the current depressed share price levels for the Doric Nimrod vheicles are telling you that investors think this is a distinct possibility. I think Numis analysts sum up the prevailing sour mood when they observe that all “ three companies are currently trading at significant discounts to estimated NAV, and we would not expect a meaningful re-rating until greater clarity emerges for the industry and Emirates”. But if and when that clear picture emerges, I’d expect the share price to correct markedly upwards.
So, on balance, I think the chance to take a 10 to 12% return for the next four years – assuming no terminal value – is a decent risk worth taking and I add DNA 2 to my trading list at 61p. One caveat though – I’m sure we’ll see more twists and turns in the aviation sector and if investors start to panic again, we could see further weakness in the DNA share price. In that case I wouldn’t be surprised to see that price come down closer to 50p before rallying again.