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Which Stocks Benefit As Air Carriers Trend Toward Lease Vs. Own?

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Major aircraft leasing franchises are scheduled to begin rolling out first-quarter earnings reports in the coming week, providing investors a look at some vital signs across the international airline trade.

Los Angeles-based Air Lease ( AL ) and Stamford, Conn.-based Aircastle ( AYR ) report on Thursday. Netherlands' AerCap Holdings ( AER ) and Ireland's Fly Leasing ( FLY ) report the following week.

The short-term indicators for the industry have been healthy. The longer-term expectations appear to be even stronger.

Air travel demand jumped nearly 5% in February and capacity was up nearly 3%, according to data from the International Air Transport Association (IATA) earlier this month, following a strong report in January, as lower fares and improving global economics lift air travel.

Increasing traffic is the leading metric driving demand for aircraft lessors like Air Lease and AerCap, which buy planes and then lease them out to airlines.

"At the end of the day, if people aren't traveling, planes aren't getting leased," said Christopher Nolan, senior VP of financial services equity research at FBR Capital.

Another key driver is an industry shift toward leased, rather than owned, aircraft. Nolan points to Boeing ( BA ) data showing that 42% of the global aircraft fleet was leased in 2015, up from 20% in 1995. The aerospace giant expects that number to hit 50% by 2020.

AerCap became the world's largest pure-play aircraft leasing firm when it paid $7.6 billion to acquire International Lease Finance Corp. from insurer American International Group (AIG) in 2014. AerCap and industry leader GE Capital Aviation Services make up 40% of the market, according to Stephens analyst Vincent Caintic.

But General Electric (GE) isn't trying to compete with leasing firms, Caintic said. Instead, the company is focusing more on financing their engines. He said Air Lease is the fastest-growing of the pure-play leasing companies.

The Commercial Services-Leasing industry group ranked No. 37 on Thursday among the 197 industry groups tracked by IBD , down from a No. 12 position three weeks ago. In addition to aircraft leasing firms, it is also home to equipment rental names like United Rental (URI) and transportation equipment lessors such as Triton (TRTN).

Leveraging Strong Credit Ratings

Airlines aren't the only lessees in the skies. Shipping companies like FedEx (FDX) and United Parcel Service (UPS) also lease air freighters. Others, like e-commerce giant Amazon (AMZN), are also gaining incentives to lease cargo planes as more consumers and businesses shift to shopping online.

Leasing companies typically have better credit ratings than airlines. Last year Delta Air Lines (DAL) became the first U.S. carrier to get an investment-grade rating. The difference in ratings helps lessors offer better deals on aircraft than airlines might be able to nail down through direct purchase from manufacturers.

While every airline portfolio is a mix of purchased and leased planes, 60% of leasing revenue comes from emerging markets, according to Nolan. That increasing opportunity also creates challenges.

"You're diversifying your revenue growth, but the negative is that you have more exposure to emerging markets," which can be more volatile, he said.

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Deals in India carry especially high risks, said Robert Mann, president of aviation consultancy R.W. Mann & Co.

"Air India is a big leasing customer, but they are kind of constantly on the brink of insolvency. Growth rates are high, but the industry is so fragmented."

Unlike real estate - with fixed assets like hotels - planes are mobile, which can be a headache for lenders. But as long as carriers follow the Cape Town Convention - a 2001 treaty that regulates the purchasing and leasing of movable assets - leasing firms have an easy time repossessing aircraft if required.

Even well-financed airlines have incentives to lease. That is because leasing firms typically get preferential treatment from manufacturers on specific types of popular models, whereas many carriers have to get in line and wait for their deliveries. These is particularly true for newer aircraft that fuel efficient or offer technology benefits.

"Leasing a plane is similar to leasing car," Nolan said. "The technology does change, especially in terms of efficiencies, and airlines don't want to get locked into aircraft (for) their full 25-year life. They want a shorter commitment."

Among the popular aircraft, Nolan said lessors have been buying Boeing's 787-9 model of the Dreamliner, whose design tweaks have improved range and payload over the 787-8 version. Boeing's 737 MAX and Airbus ' (EADSY) A320neo and A350 models are also current favorites among leasing firms due to their "good demand and good residual value," he said.

Nolan said the new single-aisle planes "could do interesting things" in terms of altering airline routes. Trans-Atlantic carriers could shift to the narrow-body aircraft.

"Suddenly, you have a new type of airline business model emerging," Nocaln said.

Airline leasing companies also often provide consulting services on types of aircraft that would fit a carrier better. And, as major customers, they can sway decision-making on new planes at Boeing and Airbus. Boeing is shopping around its new midrange passenger plane to customers, but Air Lease Executive Chairman Steven Udvar-Hazy told Bloomberg earlier this year that he's not sure Boeing has figured out the right mix of price, performance and costs for the new plane.

Will Travel Restrictions Influence Demand?

But the established industry is facing growing competition from Asia.

Air travel and traffic are soaring in Asia, especially China. Boeing estimates that cumulative demand for new commercial planes in China will climb beyond $1 trillion over the next 20 years. Chinese lessors are looking to grab a piece of the market.

China's HNA Group bought Ireland-based Avolon Holdings, with its 259-jet fleet, for $2.6 billion. HNA then expanded Avolon last year, adding the aircraft leasing unit of CIT Group (CIT) for $10 billion. The move expanded Avolon's fleet to 910 aircraft, the third largest in the world.

But Nolan said he hasn't seen that much of an impact so far from Asian lessors.

Other factors may also affect international trade. President Trump's proposed border wall won't stop airplanes, but the invisible barriers created by the move - along with travel restrictions from certain Middle Eastern countries - have analysts watching for any changes in demand for aircraft.

"I think overall geopolitical instability is a headwind for aircraft leasing and aviation in general," Nolan said. "Not that the overall geopolitical environment is unusually unstable, but these things can be unpredictable."

So far the travel ban is having little effect on air traffic, according to the IATA.

"Although we remain concerned over the impact of any travel restrictions or closing of borders, we have not seen the attempted U.S. ban on travel from six countries translate into an identifiable traffic trend, said Alexandre de Juniac, IATA's CEO, in an April 6 release.

The industry's biggest, ongoing concern: an oversupply of aircraft.

"When oil prices go down, jet fuel prices go down, and if jet fuel prices are lower, older planes have a longer economic life," Nolan said.

Longer service lives for aircraft mean an increase in the size of the global fleet. Oil prices have stabilized in recent months after the Organization of the Petroleum Exporting Countries members and top non-OPEC producers agreed to a six-month production cut. Some analysts expect the deal will be extended to the end of the year. But despite that - and the U.S. military's airstrikes on Syria and protests briefly interrupting several fields in Libya - oil prices are struggling to hold near $50 a barrel.

Another potential factor: Trump's policies could alter the competitive landscape for U.S. vs. foreign-based players in the industry.

In an FBR note dated Nov 22, Nolan wrote that "Air Lease would benefit from Trump's proposal to lower the corporate tax rate from 35% to 20%."

The Trump administration this week said it targets a 15%, rather than 20%, corporate tax rate. But tax reform is just one of several items Trump is trying to pass, and the bill could face an uphill battle with Democrats in Congress.

At the same time, the U.S. may be losing the advantage of historically low interest rates, which have helped leasing companies grow their customer base.

"With interest rates set to rise in the U.S., that puts a little crimp on zero-interest-rate financing," Mann said, which makes capital raising difficult.

Nolan is still very bullish on aircraft leasing firms as he believes they currently trade at a discount.

"Despite really good earning performance, you still have names like AerCap trading at a discount to its book value. We think the equity market is discounting the value of the aircraft on the balance sheet as well as those on order."

Ahead of their earnings reports on Thursday, both Air Lease and Aircastle are basing, and fighting to retake support at their 10-week moving averages. Air Lease shares are just starting up the right side of a nine-week flat base with a 40.34 buy point. Aircastle is also in a flat base, showing a buy point of 26.08.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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