The depreciation debate
Happy New Year. The industry is slowly digesting the news of the new Aircraft Sector Understanding (ASU) rules, is struggling to analyse the longer term implication of the NEO launch, and tries to conveniently forget the 500lbs. Gorilla in the room - the rising fuel prices. On the backstage, we are seeing that slowly some of the more experienced and specialised players, are starting to question the conventional wisdom regarding aircraft depreciation policy that most of us follow.
Let's recall this widely shared common wisdom, endorsed by most of the ''prestigious'' audit firms for the last decades: passenger aircraft have a useful life of 30+ years, and are depreciated over 25 years, straight line, with a residual of 15 %.
While no one is contesting that this rule has provided for a robust and compliant reflection of reality for the last 25 years, there are some signs today that this may need to be revisited.
We will leave aside the fatigue problems that are impacting some of the ageing Boeing 737s and 757s. We are indeed not disputing that the technical and even the economic life of a properly maintained aircraft is still around the 30+ years but what we observe today is that the capacity of older aircraft to maintain their value - or, put it another way, to generate meaningful cash flows - is certainly going south. Surely, depreciation policies are not designed to report on the capacity of an aircraft to fly, but rather to make money for its owners...
There are a few signs which may be puzzling for some of us. While scrapping a 12-year old Bombardier CRJ or a five-year old Airbus A318, or even converting a 13-year old 747 into a freighter does hardly provide for valid data points for the potential shortening of aircraft "finance" lives. The number of rather 'new' aircraft - i.e. less then 15 years old aircraft - that are now sitting somewhere is Arizona remains high, and not only oddballs and outdated technology of which production continued too long. Unfortunately, retirement and storage statistics fail to capture the fact that an increasing number of aircraft can only be sold for "peanuts" or leased out for token amounts. Many experienced (re-)marketing agents having to sell - or lease - an excellent 13-year old 777-200ER, a 747-400 or even a 10-year old A320, seem to be really struggling these days with only very few "serious" takers. Let's put it this way, serious takers are those that are prepared to pay a purchase price or a lease rate that validates the depreciation policy that was applied to the aircraft originally. As usual, the sanitized statement coming from the optimists in the industry is that the phenomenon of Market Value < Book Value is just 'temporary' and things will restore themselves when the market will 'recover'. This statement is weak and proves that some are still travelling light in a world that is changing dramatically. On the contrary, we believe that the forces behind shortening the economic life of aircraft are strong and here to stay:
- The end of the stable "equal technology" duopoly and the war between manufacturers to 'stay ahead' in terms of technology is driving them to introduce quicker 'new' technology aircraft, even when large parts of the industry lack any enthusiasm for such a development. The NEO is one beautiful example and precipitates the negative outlook on 'Classic' A320s. No doubt that the NEO will be sold (we even anticipate some spectacular orders, as clearly the credibility of Airbus' commercial team is at stake here), but the question is at what price? By the same token, the 787 and A350, in their various versions, will eventually hit hard on the residuals of the 777 and especially A330 - request for proposals for sale and leasebacks on those two models are counted by the dozen as smart airline-managers anticipate what will happen once new technology aircraft enter service...
- The restrictions on flying older aircraft are gaining ground and most significantly, they are coming from countries that have a significant growth potential (China, India, Mexico, de facto or de jure, all have a 10-15 year-old restrictions). Boeing has calculated that Import Restrictions now cover 28% of the world's fleet potential and this number is growing.
- Migrating larger aircraft from one operator to another, especially when changing registration, is becoming a nightmare, and all the more so for older aircraft. Bridge maintenance checks, new interior parts etc... are very expensive and often take long lead times.
- Changing airline business models may drive operators to new aircraft as well. The ever spreading LCC model in many cases implies using new aircraft as much as possible for a few years and sell them before the first heavy maintenance check is due, to avoid rising maintenance expenses and increasing downtime. In addition airline consolidation may result in a shift to new equipment. As an example, the fragmented Latin American market used to be a "dumping ground" for older aircraft. Nowadays with a handful of powerful operators this has completely changed.
- Last, the availability of ECA funding that is covering now 30% of the value of deliveries, makes it easier for operators to look at brand new aircraft while in 'normal' circumstances, airlines would have turned to used equipment. Adding to this, many financiers are reluctant to finance older aircraft and DVB knows about many potential trades that did not happen because of the lack of financing. One of the most dramatic consequences of this is a risk that prices for older aircraft continue to go south, reinforcing the financiers conviction that it is better to avoid older aircraft.
In all fairness, the jury is still out on this delicate issue and the timing to address it a little sensitive when new equity is coming massively to the party. However, if there is a trend here, the industry will be better off debating this now, before intrusive auditors start to impose restrictions that are likely to be more onerous...
Article contributed by Bertrand Grabowski, Board Member for Aviation and Rail, DVB Bank SE.