The view from the City: Funding NEO

This story is sourced from

Funding NEO

contributed by Bert van Leeuwen, DVB Bank SE's managing director Aviation research

It looks increasingly likely that soon there may be an end to the comfortable Airbus A320 - Boeing 737NG market equilibrium in the narrow-body segment. When Pratt & Whitney decided to throw a rock in the pond in the form of their ultra-efficient GTF, they - at the same time - ended an almost unique era of equilibrium between the only two remaining 150-seat jet manufacturers.

While way back in the 1960s and '70s the DC-9 and 737-200 were initially equally matched, in the early 1980s the stretched and re-engined DC-9 Super 80 gained the upper hand. Boeing reacted with the CFM56 powered 737-300, which gave it in its turn a superior weapon. When newcomer Airbus entered the market with the A320, Boeing again was forced to react and launched the 737NG, which brought its technology to approximately the same level as the A320. The golden era of air finance had commenced.

It looks like the next chapter in this saga is about to be written. At the time of writing, the market was still awaiting a decision from Toulouse whether to go ahead with the A320NEO (New Engine Option) or kill the initiative and restore peace in the market (at least short term), but industry observers are increasingly betting that the NEO-marketeers within Airbus will gain the upper hand.

Apart from Pratt (CFMI has little to gain), who will be happy with the re-engining of either the A320 and/or (less likely ) the 737NG?

On the positive side, the Green Movement and society in general should be happy as both Pratt's GTF and CFMI's competing LEAP-X are claimed to feature significantly lower fuel burn and less pollution. Some airlines may welcome it, at least those that get a head-start over the competition with early deliveries of the re-engined aircraft, assuming reliability is as good as the current generation of powerplants.

Now, who will not be so happy? Well, most of the leasing companies, even the ones that have not yet built a big fleet of "conventional" 737s and A320s have already indicated that this re-engining was "the dumbest idea ever". The reasons are obvious; for those lessors that follow a "fundamental leasing" business model, the launch of a superior technology aircraft eventually will cause value loss of the old technology to accelerate downward (albeit only after a few years) disrupting all of the residual values projections. For those lessors that follow the "trading" model, the launch of a new generation will make it much harder to convince new investors of the stellar IRR's of their portfolios. Maybe in an attempt to take away some stress for the lessors, Airbus announced the A320NEO will be priced at a premium over the current A320. Is the indicated $7-8 million. (of "list" or "net flyaway"?) the optimal level? Set it too high and sales volume will be too low, set it too low and the current A320 clients will be frustrated. In addition, if GTF is selected, Pratt will most likely want to build market volume as quickly as possible, which is not consistent with a premium pricing policy.

Where are the banks? While specialized banks generally thrive on uncertainty in the market (which keeps the fair weather players out), the launch of a re-engined A320NEO will bring some challenges for them as well. While it is fairly obvious how (and when) the impact of the NEO will start to affect values of the older generation aircraft, it is more challenging to answer the question of whether NEO will get sufficient market mass to make it itself an asset suitable for asset-based finance.

While Boeing has thus far indicated that a 737RE won't work, things could change rapidly under pressure of the market. Initially the NEO may be attacked with additional discounts for the 737NG (+). This may quickly erode away the assumed $7-8 million premium for the NEO. To take it one step further, if one assumes a purely hypothetical case where a major European low cost carrier would order 300 A320NEO's and a US Major finds the A321NEO to be an excellent replacement for its 100+ 757 fleet, a stronger response from Seattle is inevitable. A newly designed successor to the 737NG might prematurely kill the A320NEO, in turn forcing Airbus to go one better, maybe in the form of open rotor technology.

Winners in this game are unlikely although, such events would probably also kill both the C919 and MS21. Will it bring the "Big Two" and their shareholders any gains? While in the short term, one of the two may gain an advantage, the launch of NEO may undermine the all-important orderbooks for the current narrowbodies. Is killing the cash-cows, stressing engineering resources and adding billions to the research & development budget the best way of creating shareholder value ?

So, will NEO be the post-modern Messiah from the Matrix-trilogy for commercial aviation, or will it leave the City "Sleepless in Seattle" as the beginning of a decade of value instability. Time will tell. Let's hope the wise men in Toulouse and Seattle will make the right decisions.