The View from the City: Leasing Limits?

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At a recent finance conference in Asia it showed that financiers, investors and lessors are getting increasingly worried about the residual value performance of their current generation of jet aircraft. While new or nearly new aircraft are still very much sought after (especially for sale-and-lease-back transactions) older equipment is falling out of favour. In addition, anything else than a standard Airbus A320-200 or a Boeing 737-800 is already seen as challenging. A319s and 737-700s are now increasingly stigmatized as being types in a capacity range that "the airlines don't want any more". A few days ago, press reports indicated that mega-lessor ILFC had to take an additional $1.5 billion writedown on its portfolio as a result of its annual review of the aircraft fleet. Causes for this downward adjustment reportedly included the high production rates of new aircraft, the lack of market appetite for older equipment and the introduction of the A320neo and 737 Max that would push certain aircraft into early retirement. Apparently, for the affected passenger aircraft in ILFC's fleet, a 25-year depreciation (to a 15% residual value) was too aggressive. The same may hold for the depreciation of freighters over 35 years.

In a way, it is a bit of a shock to realize that ILFC has come to these conclusions. ILFC has been managed for years by what many in our business consider a top-notch management team. ILFC must have benefitted from favorable equipment purchase terms as a result of their - on average - large order size, strategic character and frequent launch customer status. In addition the link to AIG must have ensured ILFC of at least "reasonable" funding costs. If ILFC has to take a substantial additional writedown, what does this mean for other lessors, and maybe more importantly, what is causing this?

In many lessors-panel discussions, the finger is pointed to the manufacturers. Manufacturers are accused of producing too many aircraft and the announced plans for production increases can only be bad news. But such new equipment is exactly what most, if not all, of the lessors are looking for to deploy their capital. The difference in market performance between the A320 and the 737-800 is sometimes cited. The A320 is showing increasingly weaker lease-rates and trading prices vs. its American competitor. A more disciplined production policy in Seattle, together with the 737 production interruption during 2008 is suggested as the cause of this difference in market performance. While this may or may not be true, the manufacturers do have a point when they respond that very few, if any, white-tails have been coming out of their factories over the last decade. Maybe not all deliveries were truly filling 'demand' on the customer side (several airlines seem to have over-ordered) and on top, Export Credit Agencies funding probably prevented many tails from turning white. However, even today, with the neo and Max successor aircraft announced, the backlog for the current generation aircraft is huge. With well over five-thousand A320 Family and 737NG aircraft on order, for many, perhaps, it is difficult to defend the accusation of over-production.

Maybe another kind of oversupply is the real cause of the problem. Maybe - and the jury is still out - it is not so much an oversupply of aircraft, but rather an oversupply of ... money. Now this may sound strange in a period when the main worry of the industry seems to be the lack of funding. While "funding gap", (a term introduced by DVB in 2008) is now old school, in some OEM projections for 2012 a possible $5 billion. "Funding challenge" or even a "funding opportunity" has already been signaled. The problem seems to be that not all dollars are created - or rather deployed - equally. Today's financial and macro-economic uncertainties are an enormous challenge to many fund managers. Private equity funds as well as institutional investors are desperately looking for opportunities to invest funds in a relatively low risk environment but with high single digit or low double digit return expectations. Inspired by a number of successful examples in the recent past, fund managers seem to be attracted by the risk/return opportunities offered by investing in aircraft leasing companies. In addition, some of these investors are under the impression that they would enter the market at a low point today and that lease rates and values are bound to go up significantly in the next few years. The fact that there are real "hard" assets behind these investments and that investments in aircraft are a good hedge against inflation provide additional comfort. So, while it seems there are plenty of equity-dollars around, the funding challenge appears on the side of the commercial bank debt. Here the money market distortions, the resurfacing distrust of banks amongst each other and the scarce US-dollar funding are creating a real bottle-neck. OEM projections for next year indicate a shrinking amount of commercial bank debt but growth for the so-called self-funded part of the lessor financing. Would (unsecured?) commercial bank debt be amply available for the latter or would the capital markets come back? Probably, as in the recent past, the Export Credit Agencies are expected to come to the rescue, but will they have the capacity to take a growing share in a rapidly growing commercial jet market? And who would provide those huge amounts of US$ funding?

So, with the abundant equity made available to a growing group of operating lessors, the competition amongst these lessors is bound to increase. First of all, the absolute share of operating lessor controlled aircraft in the global fleet is increasing. Overall it is close to 35% today. For the more popular types, the shares are higher. Apart from some "odd ball" situations (717, Avroliner), the A320 tops the charts with a lessor managed share of over 50%. Other popular types such as the A319, 737-700 and -800 as well as the A330 twin-aisle have a lessor share still in excess of 40%. Unfortunately, the heritage fleet of 737 Classics is well represented under the lessors as well, with over 50% fleet share. Not many lessors will be too happy with this, for obvious reasons.

What is actually the optimal share of leased aircraft in the global fleet? It seems difficult to answer this question. To look at the share of Avis, Hertz etc. in the global car market doesn't seem to make sense (although I suspect it may be well below 35%). The answer may also depend on one's role in the business. For the airlines, to have ample choice between lessors, (a) for sale-and-lease-back transactions or (b) as suppliers of capacity, seems very attractive. In a simplified world, airlines sell their (nearly) new aircraft for top-dollar to the lessors, who are bidding against each other to buy these assets. All of them have equity-dollars to spend and need to build a sizeable portfolio a.s.a.p.

Next, a few years later, when the initial lease-contracts terminate, again the airlines should be in a comfortable position. They can elect to replace their old equipment by brand new technology aircraft (offered by the speculative lessors) or negotiate a nicely discounted lease-rate should they be willing to hang on to the old aircraft. Both scenarios are detrimental to the values and/or lease-rates of the older aircraft.

So, while the City dearly loves all the operating lessors, shouldn't we ask the question "when is enough enough?" Does it really make sense - most of all for the equity investors behind the lessors - to push for an ever higher share of leased aircraft? What can the market absorb in all reasonableness? At a recent finance conference the example was mentioned of an airline receiving 44 offers from different lessors to their request for proposals for new aircraft.

So, with the availability of many new aircraft from the lessors and/or the willingness of lessors to enter into airline-friendly sale and leaseback deals, it's not that strange that airlines are increasingly less interested in older equipment. If, on top of this, the commercial banks are becoming less interested in providing funds for older equipment, values of older aircraft are bound to come down even further. The consequence would be that more lessors will need to adjust their depreciation policy if they want to prevent additional writedowns. A fundamental solution to this problem would be a structural increase in lease-rates, but if that's achievable? Would you put your money on it?

Article contributed by Bert van Leeuwen, DVB Bank SE Research managing director