Market Outlook: Feeling under depreciated

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Chris Tarry looks at the consequences of moving to faster-track aircraft depreciation. Analysis by Flightglobal Insight

the recent announcement that China is going to acquire 218 aircraft in 2010 might be taken by some as "business as usual". We beg to differ.

To understand what underpins the shifting market dynamics, look no further than Qantas' recent earnings release, which talks about the impact of lower second-hand aircraft demand on residual values and depreciation. Beyond this, at the release of its fourth quarter results, lessor AerCap made reference to "significant drops of market values observed during 2009 by the appraisers".

Taking it back to basics, aircraft demand has two elements: growth and replacements. There are also two sources of supply: new and second hand. And, unless an aircraft is going to be kept by the original buyer for its full economic and operational life, residual values must be considered at the time of the order.

A number of factors impact future values, including the net price achieved versus the market value, as well as the availability and cost of finance. But, perhaps most importantly, you need confidence that there will be sufficient demand at the time of the planned disposal, along with finance. And, right now, evidence suggests it is difficult - if not impossible - to finance/refinance 10-year-old aircraft.

One thing which stood out from the Qantas results was an additional A$48 million ($44 million) depreciation charge for this year, and a further A$92 million for FY2011. This is because Qantas has switched its policy from depreciating aircraft to 12.5-20% of their value after 20 years, to a new policy where they are depreciated to 10% at 20 years.

The first reason for this is the prospect of new generation aircraft which threaten to impact current generation residual values. Secondly, regulatory changes in Brazil, China, India and Russia mean they will not take "older" aircraft. Coupled with weaker travel demand, this has impacted used market demand and put pressure on residual values.

Depreciation policies vary widely, and periods range from 15-30 years to values of 5-10%. ILFC and AerCap both depreciate over 25 years to 15% for passenger aircraft and, for freighters, ILFC uses a 0-30 year period.

Companies must ensure that aircraft balance sheet valuations are realistic. Recent developments are likely to result in, at least, a review of current values and an appraisal of whether accelerated, longer-term depreciation is necessary.

From this, we may see owners keep their aircraft for longer, cutting down second-hand turnover. The cost of aircraft ownership and leases may also rise, as depreciation charges increase. And, unless prices fall, new aircraft demand will also drop. These changes may also have significant implications for residual value guarantee providers, if aircraft owners choose to "cash in".

In the extreme case, where an aircraft's economic and operational life is shortened, there could be some dramatic effects. If, for example, instead of operating for 25 years, narrowbodies are broken up and parted out at, say, 16 years, the value of the parts may be greater than the sum of the parts.

Indeed, to create demand and retire older aircraft, a funded scrappage scheme - similar to the those seen in the shipping and automobile industries - might emerge. However, given the cost and other issues, this must be considered unlikely.

Returning to nearer-term issues, although depreciation is not a cash item, any need to increase the charge will have an impact on stated profitability and asset values in the balance sheet.

The cash consequences come later, when the aircraft is disposed of. This is because the lower realisable value translates into less cash at that time. For airlines and lessors, dependent on asset sales for cash, the near-term - let alone the longer-term - effects, will be damaging.

The ILFC US filing describes this issue succinctly: "We are balancing the need for funds with the long-term value of holding aircraft and the long-term prospects for us."

This is a clear summary of the current situation, where the outlook is challenging for many. But it is, perhaps not quite equally, a time of opportunity for others. The supply and demand of aircraft is even more out of balance than usual. The process of adjustment will largely determine who the winners and losers will be.