Investors are already well-aware that an upswing in commercial aviation is underway. Boeing (NYSE:BA) and Airbus are delivering more and more planes, and companies as diverse as General Electric (NYSE:GE), United Technologies (NYSE:UTX) and Alcoa (NYSE:AA) have been talked about for their exposure to the commercial aviation cycle.
While plenty is written on these commercial aerospace plays and commercial airliners, the large airplane leasing companies don't get the same attention. With attractive financing terms, improving lease rates, and strengthening commercial airline trends, now may be the time to consider a name like AerCap (NYSE:AER).

Investopedia Broker Guides: Enhance your trading with the tools from today's top online brokers.

Quarterly Results Were OK, but Don't Often Drive the Stock
There are a few industries where quarter-to-quarter earnings reports are not especially strong drivers, and the lessors would fall into that group. Nevertheless, there were positive developments and comments in the quarter that merit mention.

Revenue fell 2% this quarter as the company saw the impact of some asset sales and the return of six planes from struggling Indian airliner Kingfisher. Lease rates continue to shape up pretty nicely, and it looks like AerCap may be able to reap 20% pre-tax returns on equity from new plane purchases and leases. What's more, rival aircraft lessors like Aircastle (NYSE:AYR) and FLY Leasing (NYSE:FLY) have backed up this view that rates are firming up.

Although management didn't seem all that aggressive about share buybacks, the 3% decline in expenses, driven by solid SG&A control, was an encouraging development.

SEE: A Breakdown Of Stock Buybacks

Leveraging Better Credit For Fun and Profit
So why do aircraft lessors even exist? A lot of the industry's existence is predicated on significant differences in financing.

With the occasional exception like Southwest (NYSE:LUV) or Alaska Air (NYSE:ALK), airlines are lousy businesses with a long history of self-destructive price competition and bankruptcy. Consequently, airlines find their cost of capital is often quite high. By comparison, lessors like AerCap and GE (which, through GE Capital Aviation Services, is the largest lessor in the world) enjoy relatively attractive financing rates.

So, in exchange for taking on the risk of late payments or broken leases, the aircraft lessors capture some of that incremental spread. Companies like AerCap further lessen their risk by leasing to a large number of companies. Moreover, aircraft lease payments are usually one of the last things that an airline will renege on - an airline with no planes is no longer an airline.

A Difficult Industry to Analyze
I expect a lot of fundamentally-inclined investors are going to take one look at AerCap and run away screaming. After all, this company has pretty much never posted positive free cash flow and the balance sheet has loads of debt.

The argument for owning AerCap today revolves around the company's young fleet (below six years), attractive financing terms, and strong leasing rates. In many respects, these companies operate like banks - earning a spread between financing and lease rates, balanced on a thin sliver of equity. Like banks, return on equity is the name of the game and with new lease returns approaching the 20% level, it looks like AerCap has put years of profitable business on the books.

SEE: 5 Must-Have Metrics For Value Investors

The Bottom Line
Investors who need or want a dividend angle on leasing should definitely take a look at FLY Leasing; the company's fleet is about half the size of AerCap's, but the company pays a healthy dividend. With AerCap, I would not expect a significant dividend in the immediate future (if ever).

There are two common ways to evaluate companies like AerCap. Perhaps the most fundamentally sound way is to calculate either the expected value of the company's leases (including some discount for defaults) or the resale value of the company's current airplane fleet. This latter method is a fine approach, but requires the analyst to have good access to information on airplane sales. I do, and that analysis suggests a value somewhere around $18.

A more common, if inexact, approach is tangible book value. On the idea that the company's stock should be worth at least as much as the net value of its aircraft, a 1.0 times multiple to tangible book would suggest a price target of around $16.50 today. That looks like a significant degree of undervaluation for a company leveraged to an ongoing improvement in commercial aerospace.

SEE: Earning Forecasts: A Primer

Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

Related Articles
  1. Stock Analysis

    Analyzing Altria's Return on Equity (ROE) (MO)

    Learn about Altria Group's return on equity (ROE) and analyze net profit margin, asset turnover and financial leverage to determine what is causing its high ROE.
  2. Investing News

    Icahn's Bet on Cheniere Energy: Should You Follow?

    Investing legend Carl Icahn continues to lose money on Cheniere Energy, but he's increasing his stake. Should you follow his lead?
  3. Stock Analysis

    Analyzing Google's Return on Equity (ROE) (GOOGL)

    Learn about Alphabet's return on equity. How has its ROE changed over time, how does it compare to its peers and what factors are driving ROE for the company?
  4. Investing News

    Is Buffett's Bet on Oil Right for You? (XOM, PSX)

    Oil stocks are getting trounced, but Warren Buffett still likes one of them. Should you follow the leader?
  5. Investing News

    Chipotle Served with Criminal Probe

    Chipotle's beat muted expectations and got a clear bill from the CDC, but it now appears that an investigation into its E.coli breakout has expanded.
  6. Stock Analysis

    Analyzing Sprint Corp's Return on Equity (ROE) (S)

    Learn about Sprint's return on equity. Find out why its ROE is negative and how asset turnover and financial leverage impact ROE relative to Sprint's peers.
  7. Stock Analysis

    Why Alphabet is the Best of the 'FANGs' for 2016

    Alphabet just impressed the street, but is it the best FANG stock?
  8. Investing News

    A 2016 Outlook: What January 2009 Can Teach Us

    January 2009 and January 2016 were similar from an investment standpoint, but from a forward-looking perspective, they were very different.
  9. Mutual Funds & ETFs

    3 Vanguard Equity Fund Underperformers

    Discover three funds from Vanguard Group that consistently underperform their indexes. Learn how consistent most Vanguard low-fee funds are at matching their indexes.
  10. Investing News

    Alphabet Earnings Beat Expectations (GOOGL, AAPL)

    Alphabet's earnings crush analysts' expectations; now bigger than Apple?
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>
Trading Center