How This Overlooked Aviation Firm’s Stock Could Soar

More than two-thirds of Fortress’s revenue comes from aviation, which, needless to say, is under pressure. But sales are expected to jump 74% from $492 million in 2021 to $857 million next year, according to Wall Street estimates. Profits are estimated at $1.44 a share in 2022, up from a loss of 91 cents this year. The stock, which pays an annual dividend of $1.32, yields 5.0% at a recent price of $26. It trades at 18 times earnings.

What really makes it intriguing, however, is a catalyst that has worked wonders for other limited partnerships: Fortress plans to convert into a corporate structure. And it’s splitting into two separately traded stocks—one for aviation, the other for infrastructure.

“A pure-play aviation story will be easier to understand than one coming with four infrastructure assets,” Fortress CEO Joe Adams tells Barron’s. “We think we’ll reach investors who wouldn’t buy the stock now because they don’t understand or know the other sector.”

Pending regulatory approval, expected to come in January or February, the $2.6 billion firm will split into separate aviation and infrastructure companies. The conversion will eliminate the need to file K-1s—complex tax forms that keep many hedge funds and mutual funds from owning LPs directly. Index funds that aren’t eligible to own LP units may also buy shares of the companies, further expanding the investor base.

The conversion playbook has been a hit in private equity, where several firms made the switch in 2018 and 2019. Private-equity stocks gained an average 22% in the 12 months after a conversion, against a 4% return for the S&P 500 index. Some energy master limited partnerships have also seen a bump in share prices after switching to a corporate structure.

Fortress leases 450 engines, including equipment on 120 planes that it owns. Two-thirds of its engines are the industry’s workhorse—a narrow-body model known as the CFM56, with 22,000 commercial units in circulation worldwide. Fortress buys used engines, overhauls them, and then leases them to passenger or freight carriers; about half its business comes from European airlines, with the rest dispersed globally.

Airlines often turn to leasing because it reduces capital expenditures. That’s especially crucial now that many carriers are flying on shoestring budgets, with travel deeply depressed. Fortress recently did deals with Avianca and ITA Airways, for instance, buying 35 aircraft from the carriers and leasing them back.

Lease terms average 18 months on engines and 36 months on aircraft, followed by a required overhaul for an engine to go back into service. Rates typically run $60,000 a month, plus maintenance. About 74% of Fortress’s stand-alone engines are in use. Lease rates are rising and terms are being extended as flying time increases. There’s also a supply crunch of aftermarket engines due to airlines deferring overhauls to conserve capital.

The aviation business should be more profitable as Fortress vertically integrates parts and maintenance services. The company has a new joint venture with parts maker Chromalloy to build five critical aftermarket parts for CFM56 engines (four are pending regulatory approval). Fortress can buy those parts at cost from Chromalloy and receive a cut of sales to other aviation companies. Fortress also has a new maintenance-services deal with Lockheed Martin (LMT), and it’s working with AAR (AIR) to repair and resell parts.

The partnerships should make Fortress the industry’s lowest-cost operator of CFM56 engines, says Compass Point analyst Giuliano Bologna. “They’re the only ones that can source parts at cost,” he says. “That’s a significant improvement and return they can earn.” Fortress expects to save $3 million on a $6 million average engine overhaul, giving it more cash to reinvest, finance equipment, or pay dividends.

The parts and services deals should also ramp up operating profit. The company expects its aviation segment to generate $550 million to $600 million in earnings before interest, taxes, depreciation, and amortization, or Ebitda, next year, up from an estimated $370 million in 2021.

Fortress’ infrastructure assets should also start generating positive cash flow, after years of development and acquisition costs. Its Ohio power plant recently started operating with an average 8.5 years of contracted power at fixed prices. For its Texas energy terminal, Fortress signed a 10-year deal with Exxon Mobil (XOM) this past summer, starting in 2023. It also has two other projects—a railroad for moving steel in Indiana and Pittsburgh, acquired from U.S. Steel (X) this year, and a 1,600-acre site in New Jersey that it’s developing as a liquid natural-gas storage and export/import hub.

What’s it all worth? Bologna gets to $41 in combined equity value after the split, with the aviation stock worth $32 and infrastructure at $9. He values both sides at nine times 2023 Ebitda of $821 million, with three quarters of that in aviation. “There’s execution risk in the story,” he says, “but if you peel back the onion, the complexity will be vastly reduced and that will open up the stock to more investors on each side.”

Some hedge funds see value in the stock. Jacob Rubin, portfolio manager at Philosophy Capital, expects shares to reach $40 to $50 by the end of 2022, eventually getting to $80 in an “upside scenario.” One hitch would be regulatory delays in approving more aviation parts, he notes. Still, Rubin says, even if the stock makes it to $40, “it would be a terrific return.”

Brian Smoluch, co-manager of the Hood River Small-Cap Growth fund, holds 3.2 million Fortress shares through his firm. “There are lots of ways to argue why this thing is cheap,” he says. “It’s just waiting for a catalyst.”

Write to Daren Fonda at [email protected]