Stockwatch: One for the risk-takers

Can low oil prices further boost aircraft leasing company Avation? From the latest prelims, management asserts: "Avation has substantially increased lease revenue, cash operating margin, fleet assets and now has significant cash resources which can be deployed to fund additional growth." I suggest the recent drop in oil prices should benefit demand for aviation, and if oil analysts are correct this scenario will persist for about two years. So Avation has an interesting blend of micro/macro factors with the general economic growth trend perhaps most critical.

Very low PE multiple

The non-index stock has risen from 122p to test 135p, albeit the chart suggests traders are wary of Avation - in a volatile trend, the price reached 162p mid-summer then turned down amid global jitters. Company REFS shows the annual average PE has been 10 times or lower in recent years; moreover if estimates by house broker WH Ireland are fair, the PE falls to as low as 4 regarding the year to end-June 2017.

Such a rating reflects caution towards the inherent risks of an asset and debt-heavy business model: a lessor will hit trouble if over-extended versus a downturn, when it cannot then easily sell down its fleet to cut debt. Moreover, Avation's results show it prone to a few surprises also. There is no prop from a dividend yield of just 1%, the very high earnings cover reflecting their risk also debt service costs.

Yet the latest balance sheet shows net tangible assets up 33% to 149p a share, worth noting. Last June, the chairman's investment company bought 30,000 shares at 137.5p and 50,000 shares at 140p, and while some might say that was propping up his 18.5% stake, the finance director also bought 10,000 shares at 137.5p. So at that time they considered the company well-poised. It will be interesting to see if any insiders add to their holdings now the stock is lower and the company out of its closed period (on dealings). Since June, worries have obviously increased about the global economy.

Leasing companies are often hairy beasts

As an international business Avation reports in US dollars: the latest results show $51.6 million (£33.6 million) short-term debt and $376.5 million longer-term debt, in context of $128.2 million net assets, meaning a net interest charge of $18,088 versus $33,608 operating profit. Who knows if there will be a China-led slowdown in the next two years, but mind how 76% of Avation's 2013/14 revenues related to "Australia and Oceania" - making this company exposed to Asia-Pacific economic activity. That is a Company REFS figure, I have tried to obtain a latest but it is not in the prelims and the company's website is not available at the time of writing.

Leasing companies are, therefore, only suited to enterprising investors who appreciate the need to stay alert and potentially trade; they are not stocks to tuck away. Avation's "margin of safety" by way of discount to net tangible assets is notional because assets would be only be liquidated in a downturn, in which case they might fetch low prices or not get sold at all. So you are very much guessing the medium-term trajectory of the business, which looks good but needs regularly weighing versus the macro context.

Financial profile is growing riskier

Latest results show a 7% fall in net profit due to variability in aircraft trading gains and losses, a subsidiary ceasing trading, and a new depreciation policy in context of a larger fleet which meant a 22% higher depreciation charge. More positively administration charges as a percentage of leasing revenue have reduced from 14.3% to 12.6% despite an overall 3% rise in the charge. A 12% rise in finance expenses compares with a 17% rise in lease revenues, and the cash operating margin has improved from 53.7% to 57.5%. Gearing like this works well for so long as demand holds up, but traders will be on the look-out for when it turns down. In fairness Avation's five-year record shows good progress, although net financial gearing has expanded from about 90% to near 250% - i.e. the overall financial profile has become riskier.

Further fleet growth may require yet more debt and management states: "access to funding does remain a risk, which is common to all capital intensive business models." Avation seeks to diversify its airline customer base to reduce client credit risk and asset impairment/residual value risks, although sizing up brings its own risks, too. Not to get hung up on risks when the results' tenor and broker forecasts imply underlying momentum, but you should be aware.

Mind the company broker's track record

WH Ireland is seemingly the only broker publishing forecasts. It rose in profile during the commodities boom around 2008 when it floated a large number of small resources firms and had close relations with the RAB Capital special situations fund - which boomed only to nearly go bust. I distinctly recall how this broker had high hopes for Max Petroleum which soared to several pounds per share then collapsed to penny status, currently 0.16p (brokers changed in June 2014). Its private client side has recently been criticised, too.

Not to tar WH Ireland, as capitalism could be said to work less efficiently without high risk-takers, just appreciate the kind of firms it engages and promotes.

China and its influence, is likely the crux

The chief medium-term factor looks to be how China plays out, with stockmarkets gaining on hope of further stimulus while a veteran economist at Citigroup warns of "a 55% chance of a global recession made in China".

In July 2012 however, he also warned of a 90% chance of Greece leaving the euro. You have to consider what extent of risk suits you, and diversify appropriately; China will affect many stocks anyway. As counter-balance, aviation-oriented firms should benefit from lower oil prices for the medium term.

The stock is therefore more a gamble than investment, but prices in much of the risk - hence can still be an intelligent bet.

For more information see: avation.net.