Pretty much everybody knows that the airline business is an extremely risky place for investors. Warren Buffett once famously said that if a capitalist had been present at Kitty Hawk, he would have shot down the Wright Brothers, saving future investors a boatload of money they have lost in airline stocks.
On the other hand, the airline industry has been experiencing a big revival in the past few years, delivering huge gains for investors. Fortunately, even if you're not willing to risk your hard-earned money on airline stocks, it's still possible to profit from the airlines' resurgence.
Aircraft leasing firms like AerCap (AER 0.18%), Air Lease (AL 0.18%), and Aircastle (AYR) offer another -- perhaps smarter -- way to invest in the airline industry.
The beauty of the aircraft leasing business
Aircraft leasing firms play an essential role in the global aviation industry. First, they smooth the movement of airplanes across the world in response to demand trends. If an aviation downturn in one country forces airlines there to shrink, aircraft leasing firms can find a home for displaced aircraft at airlines in another region where market conditions are better.
Second, aircraft leasing firms provide access to aircraft for airlines that have weak access to capital and cannot afford to buy planes outright. While this means that aircraft lessors bear some credit risk, this is manageable because their industry contacts put them in good position to sell or release an aircraft that is repossessed from a struggling airline.
Airlines in emerging markets tend to lease many of their airplanes. Photo: The Motley Fool
Thus, fluctuations in oil prices and air travel demand have a limited impact on aircraft leasing firms. Most of an aircraft leasing firm's planes are on multiyear leases to customers across the world, so only a prolonged global aviation downturn would threaten its solvency.
This means that aircraft leasing firms allow investors to benefit from the growth of aviation -- particularly in developing countries -- with less risk than investing directly in airlines.
Solid results across the industry
Aircraft leasing firms have posted solid results across the board recently. Aircastle reported adjusted EPS of $0.33 for Q3, swinging from a loss in Q3 2013 that was caused by aircraft writedowns.
Aircastle's other business metrics are also encouraging. Its net cash interest margin (the gap between its lease revenue and interest expense) rose from 9.6% to 9.9%. Aircastle's fleet quality also improved -- the average fleet age decreased from 10.0 years to 8.6 years and Aircastle reduced its exposure to the weaker freighter market.
Air Lease also had a strong quarter. EPS rose 26% year over year to $0.58 on 21% revenue growth. Air Lease continued to maintain an exceptionally young fleet, with an average fleet age of just 3.5 years. Air Lease also reduced its interest rate risk by issuing more low-cost, fixed-rate debt.
Lastly, AerCap nearly doubled its adjusted EPS to $1.49, as it completed its acquisition of ILFC, making it one of the two biggest aircraft leasing firms in the world. Its net interest margin was very strong at 10.1%. The beginning stages of the ILFC integration have gone smoothly.
Aircraft leasing firms are also benefiting from strong interest in joint venture arrangements. Many investors are looking to invest directly in the aircraft leasing industry by buying airplanes to lease. However, they need to partner with aircraft leasing firms that can find customers and manage those customer relationships. This has created a new, low-risk revenue stream of management fees for aircraft leasing firms.
Investment considerations
There are some important differences between Aircastle, Air Lease, and AerCap that investors should be aware of. AerCap is by far the biggest -- following its acquisition of ILFC, it owns $31.9 billion of aircraft. It also has an unusually high level of debt: $30.8 billion.
Air Lease and Aircastle both have more manageable debt burdens. Air Lease has $6.6 billion of debt and an aircraft portfolio valued at $8.9 billion. Aircastle has about $3.7 billion of debt and an aircraft portfolio valued at about $5.2 billion.
Comparing these two firms, Air Lease focuses on buying brand new airplanes and selling them before they get too old. By contrast, Aircastle buys used aircraft that it thinks are selling below fair value. Air Lease's business is thus more capital-intensive, but on the flip side, it doesn't have to worry about getting stuck with older-model jets that have gone out of favor with airlines.
Among these three top aircraft leasing firms, I prefer Aircastle. Whereas AerCap has no dividend and Air Lease has a paltry dividend yield of 0.4%, Aircastle's solid balance sheet and less capital-intensive business model have allowed it to maintain a dividend yield of more than 4% while continuing to grow. This is a testament to its strong business model.
