Airline stocks have soared over the past couple years, and there are plenty of reasons to be bullish. Industry consolidation, capacity discipline, and improving demand are boosting profits, yet stock valuations remain low.
However, many investors want to avoid the risks of airline stocks but are still bullish on airlines as a whole. For these investors, there are several alternatives that can capture some of the airline upside while avoiding direct investment in this traditionally challenging industry.
When airlines are strapped for cash, they put off purchases of new aircraft, but the industry turnaround has had the reverse effect. Aircraft orders today are booming with record orders at the two largest commercial aircraft manufacturers, Boeing (NYSE:BA) and Airbus Group (NASDAQOTH:EADSY).
North American airlines are powering much of the growth, as they are among the most profitable airlines in the industry right now, but Boeing and Airbus are also seeing demand from major Asian airlines and growing discount airlines worldwide.
Unlike the airlines themselves, which have gone through the bankruptcy process during tough times, Boeing and Airbus have avoided such reorganizations. While the airlines are exposed directly to consumer demand and the volatile costs of running an airline, aircraft manufacturers are more insulated from this by remaining further back in the supply chain.
In fact, airline bankruptcies don't necessarily cancel aircraft orders. During its 2011 bankruptcy, American Airlines, now part of the new American Airlines Group (NASDAQ:AAL), was allowed to move forward with a record aircraft order.
Airbus and Boeing are further protected from airline industry downturns through their other divisions, which build defense equipment. While commercial aircraft manufacturing is still the big money-maker for these companies, the benefits of having other sources of revenue cannot be ignored by investors looking to reduce risk.
If the airline industry can continue to boom, look for more carriers to direct cash flows toward new aircraft orders, for which Boeing and Airbus are the only games in town for large aircraft.
Not every plane you see painted up in an airline's colors is actually owned by that airline. In fact, there is a multibillion-dollar industry in leasing aircraft to airlines. Leasing aircraft is common for major airlines because it allows them to use the latest equipment without having to raise massive amounts of capital themselves.
Here, AerCap Holdings (NYSE:AER) is the largest player after the aircraft leasing company AerCap successfully acquired International Lease Finance Corporation (ILFC) from American International Group. The cash and stock deal caused AerCap's shares to surge and left AIG with about 46% of the combined company. While there is some integration risk present at AerCap, the shares trade at just over 10 times FY2015 based on data from NASDAQ, which could mean this is already factored into the stock price.
But investors who are looking for a dividend as well may want to take a look at Aircastle (NYSE:AYR), which currently sports a dividend yield of 4.4%. Although smaller than AerCap, Aircastle is still solidly profitable and trades at only 11.1 times projected FY2015 earnings from NASDAQ. With a fleet of aircraft leased to airlines around the world, Aircastle still has the worldwide diversification of AerCap, but with a smaller fleet.
Both AerCap and Aircastle still rely on demand from airlines to lease out their aircraft, however, like Boeing and Airbus, aircraft leasing companies are more insulated from short-term issues. Unlike airlines that rely on current consumer demand, aircraft leasing companies typically sign longer-term contracts where they will receive payments whether the airline is profitable or not.
Of course, there is still a risk of contracts being cancelled if the airline declares bankruptcy, but most recent major airline bankruptcies have seen the airline continue operating during reorganization. While contract renegotiations could force leasing companies to take a hit, their shareholders would probably still come out ahead of those of the bankrupt airline.
Alternatives to airlines
Today, I still remain bullish on airlines, but I recognize airline stocks are more risky than many conservative investors would find suitable for their portfolios. But commercial aircraft manufacturers Boeing and Airbus and aircraft leasing companies AerCap and Aircastle give more conservative investors a way to benefit from a strengthening airline industry while remaining somewhat insulated from airline-related risks.
Alexander MacLennan owns shares of AMERICAN AIRLINES GROUP INC. Alexander MacLennan has the following options: long January 2015 $17 calls on AMERICAN AIRLINES GROUP INC, long January 2015 $32 calls on AMERICAN AIRLINES GROUP INC, long January 2017 $25 calls on AMERICAN AIRLINES GROUP INC, and long January 2016 $60 calls on AMERICAN AIRLINES GROUP INC. This article is not an endorsement to buy or sell any security and does not constitute professional investment advice. Always do your own due diligence before buying or selling any security.
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