More and more airlines are setting up leasing companies to manage their own fleets and some are positioning themselves to supply the needs of their competitors – steps that are under increasing scrutiny by the lessor community.
However, airlines acting as operating lessors is nothing new. Many carriers, from time to time, sublease aircraft from their fleets or orderbooks to third parties, particularly in times of excess capacity. This is standard practice among global airlines.
In 1985, the now-defunct airline group Ansett Australia took the practice one step further and established the lessor Ansett Worldwide Aviation Services, which was later sold to an affiliate of Morgan Stanley Dean Witter in 2000 for close to $600 million. In 2004, Ansett Worldwide was rebranded as AWAS.
Singapore Airlines completed a similar move in 1994, jointly setting up Singapore Aircraft Leasing Enterprise (SALE) with Boullioun Aviation Services. SALE was later sold to Bank of China in 2006 for $965 million and is now part of BOC Aviation.
Cargo carrier Atlas Air followed suit and created Titan Aviation in 2008 as a separate leasing entity to handle third-party leases. The Dublin-based lessor focuses on the acquisition, sale, dry leasing, marketing and servicing of mainly freighter aircraft.
AirAsia also has formed an internal management firm to handle leases for its various affiliates.
Following a $500 million investment from Manila-based San Miguel, Philippine Airlines outlined plans last year to form a leasing firm to manage its long-haul fleet requirements.
While these moves have raised a few eyebrows in the leasing community, steps taken by Lion Air and Norwegian to enter the market – not just for their own needs but those of their competitors – have caused lessors to finally stand up and take notice of this developing business model.
No doubt airlines are looking to take advantage of tax and financial privileges afforded to them under a leasing umbrella.
Norwegian indicates that its new leasing subsidiary will help limit currency exposure on the carrier’s balance sheet.
The currency exposure is primarily driven by a mismatch between US dollar-denominated loans and aircraft balance-sheet values denominated in the Norwegian krone, currently managed by “extensive” hedge arrangements, says the airline.
Norwegian will concentrate on new Boeing 737-800 deliveries through its new Irish leasing entity, September Aviation Assets. Its chief executive Bjørn Kjos has confirmed that the entity will assist the carrier’s fleet development by selling or leasing surplus aircraft to third parties.
The carrier has an order backlog for 62 737-800s to be delivered through the end of 2018.
Ian Reid, formerly an aviation banker and operating lessor and now a senior financial advisor at Philippines Airlines, says carriers may start leasing companies for a number of reasons including tax efficiency or because they have a group of affiliated airlines and want to centralise financing and purchasing. Also, carriers that are privately held, he says, may want aircraft’s ownership structures to differ from the airline’s.
What has left some lessors in sour moods about airline lessor business models is the fact that airlines such as Lion Air and Norwegian likely received huge discounts on their mega aircraft orders, which will support their leasing operations.
“I would love for whatever Norwegian and Lion paid for their aircraft to become the most favoured nation pricing that the manufacturers have to provide to leasing companies because that is the important differential here,” Steve Rimmer, chief executive officer of Guggenheim Aviation partners, said at the Ascend Finance Forum in San Francisco in December 2013.
“I think traditionally leasing companies have paid a different price for airplanes than the airlines do, so I think this is creating a false competition.
“If someone walks through the door saying they are going to be an airline and are going to operate those airplanes, and they don’t do that, but they still get the same pricing – I think that is an uneven playing field.”
Another lessor agrees: “I cannot see how the manufacturers and lessors will allow airlines to lease out aircraft they pay airline prices for. It is not fair to the leasing community.”
A major grumble about the business model, according to another lessor, is the fact that manufacturers are selling to both parties, which could stoke a collapse in rental rates and values on aircraft.
“The manufacturers have realised making money via the operating lessor community is like shooting fish in a barrel – sell aircraft to the lessors and sell planes to the airlines at the same time. The car crash takes a few years and comes about in slow motion,” he says.
“High purchase prices, by way of long-term escalation, will force the parties to find homes for their aircraft at any lease rate really and this is not a healthy market.”
Leasing sources fret that while airlines traditionally have been able to secure aircraft at favourable prices, they typically have been unable to raise capital as cheaply or easily as lessors and this could limit their success as third-party lessors.
“There are few airlines that are rated investment grade on a standalone basis. Operating lessors would not exist if airlines could access funding easily,” says Aengus Kelly, president and chief executive officer of lessor AerCap.
Kelly acknowledges that “some” airlines have access to “cheap funding” for aircraft, which they utilise themselves, and those airlines are predominately “household names” around the world.
“To build a leasing platform costs a lot of money, and to run a leasing platform is big bucks,” adds Kelly. “To get out into bank market, on your own credit, is a tough business for an airline.”
He asks: “Is that what airline investors want their airlines to be focused on? Raising $50 million every week? Or do they want them transporting passengers?”
Another lessor questions how airline leasing companies would cope with funding operations during a downturn.
“Good luck to them on getting cheap funding with such little equity and high leverage in the first place,” he says. “But what happens when aviation takes a turn for the worse?
“Will airlines be able to raise financing at sufficiently attractive rates to be a competitive [third party] lessor during a downturn when airlines are handing back aircraft?”
John Willingham – chief executive officer of Macquarie AirFinance and founding managing director and board member of SALE – admits that leasing was a business that, by SIA’s standards, required “a lot” of leverage. Therefore, when the carrier saw a reasonable time to exit the business, “it decided to take it and to use the capital realised in the core business”.
However, to say that airlines cannot access attractive funding is simply not true.
Atlas Air recently refinanced a Boeing 777 Freighter aircraft with a loan – backed by the US Export-Import Bank – for its leasing subsidiary Titan. The $88 million transaction covered a 2009-vintage 777F (MSN 35606) with a 1.839% coupon rate – a very favourable rate for airlines and lessors.
An airline source says the cost of funding largely depends on the credit. “Ryanair can fund itself more cheaply than a lot of lessors, and Cathay Pacific recently raised money using floating rate US Ex-Im Bank bonds, at Libor +28 basis points, or pricing lessors would be extremely happy about,” he says, adding: “True, a lot of airlines don’t have cheap access to cheap funds, but some do.”
Also, more and more global airlines now are able to tap the capital markets, which have traditionally been a US financing tool, in big volumes and at favourable rates.
Last year, Air Canada issued the first non-US enhanced equipment trust certificates (EETC) financing since the 2008 financial crisis.
The $424 million senior “A” tranche carries a coupon of 4.125% and a final distribution of May 2025, while the $182 million subordinate “B” tranche has a 5.375% coupon and a May 2021 distribution. The deal also features a $108 million “C” tranche, which has a 6.625% coupon and a bullet May 2018 maturity.
British Airways also issued its first EETC, a $923 million offering, two months later.
BA’s class “A” bonds have an annual coupon, payable quarterly, of 4.625%, while the class “B” bonds carry an annual coupon, payable quarterly, of 5.625%.
Backed by a strong wave in investor demand for yield in May, Hawaiian Airlines achieved a new milestone in EETC pricing with its $445 million financing. The $328 million, 14-year senior “A” tranche carries a very attractive 3.9% coupon, while the $116 million,10-year subordinate “B” tranche has a 4.95% coupon.
In the previous month, US Airways, hardly a desirable credit, issued an $820 million EETC with attractive pricing. The $620 million senior “A” tranche has a 3.95% interest rate, while the $200 million “B” tranche carries a 5.375% interest rate.
However, it is not just lessors who are critical of airlines moving into leasing.
The leap from operating an airline to running a lessor is likened by Avitas senior vice-president Adam Pilarski to a general doctor branching out into brain surgery.
“My point is that these are two are different jobs,” he says. “Running an airline is quite different than leasing surplus airplanes. You need systems, infrastructure and know-how to run an efficient leasing company.
“Becoming an ‘accidental’ lessor because one bought more planes than one can use does not make good business sense. You do either one or the other, not both at the same time.”
Willingham agrees that the dynamics of running an airline, and the priorities and focus of running an airline, are “very different” from leasing, and the business ultimately increases risk.
“The two businesses are distinct and extremely difficult to mix successfully. Using leasing as a customer helps airlines build fleet flexibility, to optimise the use of scarce capital and reduce their risk in aircraft ownership,” he says, adding: “For an airline itself to become a leasing company does exactly the opposite.”
Willingham says SIA’s thesis at the time it started SALE was to invest the capital that was “over and above” what the carrier needed – “a very unusual position for an airline to be in then, as now”.
Although SIA knew and understood aircraft and the fast-developing Asian market, the carrier also recognised that it had little experience of originating leasing transactions, he says. “It believed therefore that, if it had a capable leasing partner, it could build a successful leasing company.”
However, over time, Willingham says the airline began to acknowledge that it was increasing the investment risk in its business: “It was buying more aircraft, which was not a diversification for the carrier, and it was deepening its involvement in aircraft value risk.”
Knowing which aircraft will maintain their value and how to manage the risks of owning these aircraft are not practices that come naturally to an airline, says another leasing source.
“The tax and currency advantages achieved in these leasing models are obvious incentives but airlines need to really know how to manage these aircraft, how to work a downturn, so not to shoot themselves in the foot,” he says.
John Duffy, president of Transportation Partners (TP), an asset manager for Lion Air Group, believes it is “too early to say” whether the airline lessor model will take hold.
“Both SALE and AWAS began life with airline affiliations,” he says. “It certainly has benefits for carriers who place very large orders, because airlines can exploit their in-the-money purchase prices, and also achieve fleet flexibility if they have the contractual rights to pre-place aircraft with third parties.”
Since TP’s formation in 2011, the lessor’s primary objective has been to act as an asset management for the Lion Group. However, it also plans on leasing to third parties.
Duffy says TP will continue to diversify its funding sources in 2014, in order to conduct “more aircraft trading with other lessors and directly from airlines”. The lessor hopes to have a portfolio exceeding 50 aircraft by the end of 2014, he says.
TP was established under Singapore’s Aircraft Leasing Scheme, a programme run by the country’s Economic Development Board that provides tax benefits for locally based lessors.
The Lion Group has more than $50 billion of aircraft on order. Last year, it ordered 234 Airbus aircraft, following a 2011 order for 230 737s, including 201 updated 737 Max aircraft. It will also receive its initial long-haul jet from Boeing in 2015, the first of five 787 Dreamliners.
Frank Pray, chief executive officer of Intrepid Aviation, who chaired a panel discussion at the Ascend Finance Forum in San Francisco in December, believes that a major hurdle in the airline lessor business model is the airlines themselves.
“Airlines would not want to lease from other carriers as they would have to divulge financial information and operating information to a competitor,” he says.
“I think there are very few examples in history, and SALE being one of them, where this model has actually worked out,” he adds.
AerCap’s Kelly agrees.
“Airline [customers] would ask: ‘Do we really want to get involved in a start-up high growth airline with financing risk?’ The answer, to date, would be a very lukewarm reception to that. Many would prefer to go through the leasing companies.”
Philippine Airlines’ Reid dismisses the possibility of true lessors owned by airlines leasing to third parties. “There has never been, and I don’t think there ever will be, an airline-controlled leasing company doing substantially third-party business with other unrelated airlines and competing with traditional operating lessors on a long-term sustainable basis,” he says. “Airlines generally need all their capital for their own business and there is an inherent conflict of interest.”
Kelly believes that running a third party leasing company will be a “challenge” for airlines.
“Sure, they can lease one or two airplanes, many airlines already do, but would they really be able to go head-to-head and place new airplanes? Also, it that what they really want a CEO of an airline doing?
“Anything is possible, but as an investor in an airline, what are you paying them to do? It may be that they enter the [third-party leasing] business and, if they do, we wish them the best. I just don’t see them becoming a competitive threat.”
A leasing source says he can “hardly blame” the airlines for considering the “affiliated lessor” model.
“Airline operating margins generally remain lower than those of the bankers and lessors who serve them. And come to think of it, so do their salaries, but they are the ones dealing with crashes and bankruptcies.
“If aspiring graduates want to earn well, eat well, and dress well, the leasing, finance and legal industries are still the place to be. The airline industry can be exciting, but it is also highly attritional,” he says.
However, with demand for operating leasing only set to grow, lessors can be sure leasing is not a space that global airlines are willing to abandon, as a lessee or a lessor, anytime soon.