The failure of two airlines at the start of February hints that 2012 could be a shakeout year for air carriers.
Malev, Hungary's national airline, and SpanAir Spain's fourth largest airline, both grounded their fleets due to financial trouble. But, despite the failures, orders for new aircraft are soaring.
Boeing (NYSE:BA - News) reported more than $100 billion in new orders for 2011, a record backlog of $356 billion and said its 2012 production was "sold out.
The company also forecast its aircraft leasing portfolio would continue to dwindle this year, as it finances fewer planes and lessees pay off long-term agreements.
This is the climate in which Los Angeles-based Air Lease (NYSE:AL - News) came public last April. Chief Executive Steven Udvar-Hazy, who founded the company in 2010, has placed Air Lease's emphasis squarely on operating leases, generally three- to five-year agreements, mainly to emerging market airlines.
But the largest and most rapidly expanding among such airlines, in China and the Middle East, are well capitalized. They tend to buy their equipment outright, or opt for the less-costly, long-term financing arrangements.
That leaves a fracturing market of smaller air carriers, many of which are candidates either for bankruptcy, a la Malev and SpanAir, or for takeover by larger operators.
"The industry worldwide is in the process of consolidating," said George Hamlin, president of Fairfax, Va.-based Hamlin Transportation Consulting.
"As the industry matures and consolidates, it would seem that there is going to be less need for operating leasing," Hamlin said.
In this environment, Hamlin says Air Lease's greatest strength is Udvar-Hazy, who effectively created the aircraft operating lease industry in the 1960s, founding International Lease Finance Corp. and building it into the world's largest lease fleet.
Hazy sold ILFC to AIG (NYSE:AIG - News) in 1990. He remained as chief executive of the unit until 2010.
"You have, in Steven Udvar-Hazy, someone who invented this genre," Hamlin said. "He's very knowledgeable, he's made a lot of money in the past and it's tough to bet against him.
After its April initial offering, Air Lease fell 35% to an October low. Shares have since recovered 47%, aiding the Commercial Services-Leasing industry group's rise to a No. 5 rank Friday, up from a No. 139 ranking Nov. 1. That's out of 197 industry groups that IBD ranks based on six-month stock price performance.
Overall, the industry group includes 22 companies whose activities range from leasing aircraft to renting out trucks and storage space. The group's rise also stems from powerful gains by construction equipment rental leaders United Rental (NYSE:URI - News) and RSC Holdings (NYSE:RRR - News), as well as to railcar leasing firm GATX (NYSE:GMT - News).
1. Business All of these companies operate on the same principle: Buy equipment, often through favorable long-term lease agreements, then lease or rent the equipment on pricier, shorter-term contracts.
Unlike long-term leases in which the lessee assumes ownership at the end of the term, rental companies and operating lessors maintain ownership. This means their operations include sales of off-lease units on the secondary, or used, equipment market.
In the rail business, leasing companies generally aim to lease equipment for 200 to 300 basis points above their cost of capital, says Zahid Siddique, an associate portfolio manager and head of industrial research with GAMCO Investors. If a company borrows capital at 6%, its goal is to try to book leases for an 8% or 9% return.
"That's what these leasing companies reach for," Siddique said. "Depending upon equipment prices and leasing rates, they may or may not get there.
• Name of the game: Scale, relationships and timing are crucial. Buy equipment in bulk to negotiate low prices. Use cash or secure long-term financing to help keep costs low. Lease back to customers, often under three- to five-year operating agreements. Sell off-lease equipment into the secondary market at the right time and price, to keep your portfolio trimmed to the most profitable fleet.
2. Market There are roughly 1.6 million railcars in the U.S. About 900,000 of those are leased, most of those by the largest rail carriers. Railroads actually own another 400,000. Shipping companies own the rest.
The U.S. airline trade is essentially the opposite. Large air carriers, particularly legacy carriers like Delta and American Airlines, can get favorable pricing from manufacturers and thus rarely use operating leases, Hamlin says.
That leaves the bulk of the aircraft leasing market overseas, primarily in emerging markets led by Asia and Latin America.
In the construction equipment rental market, United Rental tied up with RSC Holdings in a $1.9 billion deal announced Dec. 16. The deal put a 58% premium on RSC, which gained 91% since the announcement. United Rental has since gained 54%.
The marriage gives the companies a 15% share and few competitors in the highly fragmented market for short-term rentals, Siddique estimates.
Rentals have gained as building and construction markets stage a choppy recovery and builders of all sizes take on new business. More construction, combined with an uncertain economic outlook, is giving the rental trade a boost.
Under the circumstances, many small- and mid-sized builders are opting to rent, rather than buy or lease all types of equipment.
"Given the volatility in the construction market, they don't want to take on too much capital risk," Siddique said, "so they tend to rent as needed.
3. Climate The latest data show uneven improvement in the U.S. economy, but equipment manufacturers in many sectors are running flat out.
Backlogs among aircraft manufacturers are large right now, Hamlin says. That means buyers interested in some of the more popular models have to look out several years. Railcar buyers are in the same situation.
In both markets, leasing companies, led by operations like CIT Group (NYSE:CIT - News), GE Capital and AIG's ILFC, are some of the biggest buyers.
And while the outlook for rail demand and railcar leases appears healthy, the long-term circumstances for smaller aircraft lessors may be more difficult.
On the international front, Hamlin says, "It's likely we're going to see more carrier failures.
In the near term, Africa and Asia are most prone to airline failures.
"The market in Asia is growing and expanding," he said, "but economies will be cyclical and it's likely that there's too much capacity in these market now.
But Udvar-Hazy's industry savvy casts Air Lease as a wild card. The chief executive, known for putting his money and name to a massive National Air and Space Museum annex, has said he intends to expand the company's current, 79-aircraft fleet to between 300 and 500 units within five years.
News reports have also detailed Udvar-Hazy's intent to reacquire his original company, ILFC, from current owner AIG. ILFC operates a fleet of nearly 1,000 jets, many of them on long-term leases to major airlines. That fleet could significantly alter Air Lease's prospects, as well as the industry landscape.
4. Technology Leasing companies increasingly have taken advantage of new technology to keep track of their fleets.
One good example of that comes from Ryder Systems (NYSE:R), the largest company in IBD's leasing group by both revenue and market cap.
Ryder, which rents, leases and manages trucks and truck fleets, in January upgraded its onboard telematics system that allows fleet managers to track and monitor vehicles.
The new, cloud-based system replaces clunky GPS devices that offered only rudimentary mapping. The new devices serve up detailed maps and permit drivers to check traffic densities on specific routes, helping to bypass congested areas.
The units also record location, mileage, speed and direction of all the fleet vehicles. They store a 48-hour record of idle time, fuel consumption, average speed, miles logged and hard-braking events.
The system, currently installed on 22,000 leased vehicles, saves lessees the cost of investing in their own monitoring systems.
"Companies leasing from Ryder will not have to worry about investing in the equipment, maintaining it, or learning how to use it," said John Gleason, a Ryder sales and marketing executive, in a company statement.
5. Outlook Leasing and rental companies are cyclical, Siddique says, behaving as an early or midcycle plays. Ed Yardeni, president and chief investment strategist with Yardeni Research, says the economy is in the midst of a staged recovery. Some economic sectors, like energy and agriculture, are beyond the early stages. Others, like housing and autos, are just starting to fire up.
"Now companies seem to be at the point in the profit cycle where they are hiring again: initial (jobless) claims are down, which suggests that firing is down," Yardeni said. "More jobs should lead to more car sales and more home sales.
For the leasing sector, more car sales mean higher rail demand. Home sales mean rising construction rentals.
• Upside: Upticking global economies and expanding middle classes in emerging economies point to rising demand for transportation of all types. Maxed out backlogs from manufacturers mean many railroads and airlines must turn to leasing operators in order to expand capacity. The outlook for low interest rates will helps lessors keep rates low for the foreseeable future. In the equipment-rental trade, mending construction markets surrounded by a still-uncertain economy increase demand for rented vs. purchased equipment.
• Risks: Air: global consolidation in the airline industry could ultimately reduce demand for operating leases. Rail: a revival of paused regulations vs. utilities could dim demand for rail coal transport. Equipment rental: a firming of confidence in construction markets could spur contractors to buy or lease, rather than rent, more equipment.
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