The View from the City: Have the tables turned?

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Dow Jones Newswire recently quoted the chief executive of Cebu Pacific saying the airline had no plans to buy Airbus A330 aircraft and rather wait for newer generation jets: "We are willing to pay high-lease costs and would wait for new aircraft rather than have end-of-life aircraft on our balance sheet".

While a number of the major airlines - such as Singapore Airlines - for many years already have been very good in offloading residual value risks to investors and lessors, it seems now also the small and medium sized airlines have become a lot smarter with respect to managing their residual value risks. Indeed, commercial aviation may be starting to resemble the shipping business, where operating the vessels is just a way to pay the running cost, while the ship-owners are mostly interested in the "asset-play".

In the "good old days" airlines focused mainly on the operational characteristics of their fleets. Can this aircraft safely fly my passengers from A to B in acceptable comfort and against the lowest possible operating cost? Aircraft were production tools and an airline bought what the manufacturers offered without too much eye for the residual value of the asset. In the early 80s things started to change. A new breed of entrepreneurs discovered the hidden value in used aircraft, a value not yet recognized by most airlines. For a number of smart traders and lessors, this was an opportunity to make easy money. Airlines were happy to sell their aircraft at price-levels well below market values, although most of them didn't realize this, as there was little information about where aircraft values actually were at the time. It wasn't unheard of that a trader or a lessor would acquire an aircraft from a major flag carrier and flip the plane the same day to a smaller operator in another part of the world, realizing a profit of a few million in between. The transaction where a trader bought a fleet of ex-KLM aircraft and sold these to airlines such as Evergreen and Midway the same day - making a million or more in between - made a lasting impression.

Today, the situation seems much different. Airlines have become a lot smarter and leasing aircraft is not just a way to finance equipment. More and more it's a way of off-loading residual value risk. Airlines no longer seem to see aircraft as just a tool to transport passengers (or cargo) from A to B. Timing the investment right and - maybe more importantly - timing the sale of the aircraft right can add a lot to the bottom-line of the airline. Trading aircraft becomes similar to trading paper securities, and criteria for selecting aircraft have changed accordingly. Effectively, the process has become a lot more complicated and, in some cases, it seems the distinction between airlines and lessors or traders has become blurred. Based on an analysis of lessors' shares in the global fleet and lessors ordering pattern, it can be concluded that over the past few years, the majority of their fleet expansion has generally not come from speculative ordering, but by a growing volume of sale and leaseback transactions.

Airlines with mega-orders for narrowbodies as well as the more popular widebodies, notably the A330 and Boeing 777 have found a lessor community ready and actually eager to enter sale and leaseback deals. It is probably this experience that has given some airlines the confidence to place mega-orders for next generation aircraft.

One could argue that some of these airline mega-orders are actually "speculative", similar to what lessors used to do on a large scale in the past. Aggressive low-cost airlines have apparently seen an opportunity to benefit from the launch of a new generation narrowbodies, in particular the Airbus A320neo and the Boeing 737 Max. The latter has now won order for more than 450 aircraft from only three airlines! The benefit may come in several ways. First of all, the carrier ensures itself of access to the latest technology and consequently to a very competitive, fuel efficient fleet. By taking a large position in the manufacturers' orderbook, maybe even one exceeding a realistic in-house need for replacement and expansion, the airline get most likely a very attractive price-level on the date the contract is signed. Furthermore, claiming early production slots for new technology aircraft may be attractive as these slots may start to have an increasing value. This value may be realized via sale and leaseback deals or - if the contract allows - transfer of the slots or aircraft to other carriers. If one were to take a cynical position, it could be argued that if the airline can't take delivery of all of the aircraft on order, it's not so much their problem. If you can't finance one aircraft, it's your problem. If you can't do hundred aircraft, it's the other guy's problem, right?

More realistically, there are still a few risks in this ordering strategy. First, will the new aircraft meet or exceed the performance promised by the manufacturer? Second and maybe more importantly, will the (hugely escalated) delivery price be attractive enough to find financiers willing to finance at high loan-to-value levels or lessors eager to enter in sale and leaseback deals that are profitable for the airline? Third, with orders exceeding - say - a hundred aircraft, won't lessors and banks run up against exposure limits on individual lessee clients? While one may speculate the market will find a solution for all problems, there are no guarantees. Although the word "funding gap" is so passé, it looks like finance will not be plentiful - to put it mildly - for used equipment transactions in the coming years. Will new equipment be sufficiently appealing to attract the estimated $95-100 billion in 2012 as a start? What are the risks that could actually reduce the expected contributions from the different funding sources? Based on the widely used Boeing estimates, the Export Credit Agencies should chip in a total of around $32 billion this year. This implicitly assumes also the US Ex-Im Bank will get green light from Congress to increase its cap to $140 billion. Nobody in the industry doubts that in the end a solution will be found, but what if the unthinkable happens? The second source, again based on the Boeing estimate, will be airline cash. Airlines are expected to contribute $24 billion. For the time being, it looks like airline results from last year were robust enough for the airlines to indeed contribute a significant amount. However not all airline's results were positive and in the first few weeks of 2012, Jade Cargo, World Airways, Malév, Spanair and CargoItalia have got into trouble with undoubtedly others to follow.

Commercial banks still are expected to contribute $20 billion to this year's financing requirements. It is very difficult to assess the reality of this number. Much will depend on the general banking climate in Europe and how banks will set their priorities. Probably the strong aviation credits won't have too much problems accessing bank loans, but weaker credits where loans would be more asset-based may struggle. Banks from emerging countries or Japanese banks celebrating a comeback may help, but will this help more challenging credits? Probably the most upside potential is offered by the capital markets. If and when structures are found that appeal to the non-US markets this may be a big step forward. Finally lessors are expected to self-fund $7 billion. Will they find the necessary leverage to reach their return on equity target? Based on the outcome of the RBS Aviation Capital sale, there must be another $10-15 billion floating over the market from the runners-up that is earmarked for investment in commercial aircraft. The big question will be if timing is right for them? Does it make sense to invest billions in a generation of aircraft that is slowly approaching the end of its technology life ("last-of-the-line" discussion), with significantly more efficient aircraft on the horizon? Cebu Pacific (and many others) seems not to be convinced this makes sense. Will the investor see this differently?

So, will it this time be the smart airlines that are benefitting from the game of asset play, or will they fall into a deep funding gap? Alternatively, will lessors allow airlines to off-load significant residual value risks and will lease-rate levels allow investors to depreciate book-values to realistic residual value levels? While pioneer lessors and traders clearly benefitted from some ignorance on the side of the airlines during the 1980s, have the tables turned now and will the new generation of airlines be the winners? Time will tell. Fortunately we will probably only start to see the outcome five years from now, so sleep well, at least tonight.

Article contibuted by Bert van Leeuwen, managing director - Aviation Research, DVB Bank SE