The View from the City: Time Warps

This story is sourced from

Time Warps*

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

During a recent meeting with one of the major engine manufacturers, DVB had discussions about the increasingly complex world of aircraft design, production, operation and financing. It is interesting to realize that in the world of commercial aviation sometimes extreme differences in time horizons exist.

OEM are at one extreme. Airframers and engine manufacturers have a planning horizon of many years, or even decades. Take the Boeing 787 as an example. Essentially Boeing already had to start thinking seriously about a more advanced successor to the 767 in 1995, when Airbus announced the A330-200. Seattle's initial response, the stretched 767-400ER was more or less rejected by the market and less than 40 were built. It became clear that it would be difficult to develop anything superior to the A330 without a fairly radical change in technology. Consequently, in 2001 the Sonic Cruiser was presented, an "almost supersonic" jet of a radical design. With the 2001 global crisis, the market environment changed dramatically, trees no longer grew into heaven and the Sonic Cruiser plans were shelved shortly thereafter. What next? "Efficiency" became the name of the game in the post-9/11 environment. Consequently Boeing came up with the 7E7 in 2003. With the initial outline of the 7E7, the Americans cleverly avoided a trap that years later Airbus fell in when it presented its initial version of the A350. The initial A350 was condemned as just a "warmed over" A330. Rather than showing a 767- or 777-like aircraft design, the initial artist's impression of the 7E7 showed a sexy, streamlined machine with a pointy nose and a shark-fin stabilizer. This, in combination with the claimed efficiency of the new engines, the composite fuselage, interchangeable engines, damage sensors in the skin, etc., eventually won over dozens of airlines. In 2004 the 7E7, later renamed 787 was launched. Roll-out took place, as planned, in 2007 and the - delayed - first flight in 2009. Assuming that entry into service indeed will take place in 2011, one can conclude that it took Boeing almost 16 years (!) between the first attempts to launch an A330 competitor and the moment the company can start to recover its investments in this plane. The 787 case may be extreme but vividly illustrates how much time can elapse between a "market challenge" and the availability of a solution. Between 1995 and 2011 Boeing was forced to continue investing in Research & Development and the total amount of "sunk cost" must be in the many billions of dollars by now. For the engine manufacturers, the situation will not be much better. Unfortunately they may even be in a more difficult position as they have to anticipate what future requirements the airframers will have in terms of power-plant performance and airframe-engine interface.

Airlines, traditionally the main target market for the airframe and engine manufacturers have a shorter, but still fairly long time horizon. Depending on the exact business model, they will have to recoup their investment in a new aircraft over a period of five to 15 years. There are some extremes here as well. At one end of the spectrum take LCC's like easyJet and Ryanair, who will sell their aircraft at the end of the maintenance honeymoon period. On the other extreme, take a carrier like Northwest (now Delta) that is still operating DC9's produced during the early and mid-seventies. The common element is that both the manufacturers and the airlines look at aircraft from a "technical/operational" point of view. Aircraft with better performance characteristics, so more payload, and longer range of lower operating cost are always welcomed by the airlines.

Over the past two to three decades, another group of customers for the OEM's has emerged: the aircraft lessors. It seems the time horizon for the lessors - or at least the investors behind the lessors - is shortening. While initially lessors and the investors behind them had a fairly long-term view on the market, this may be changing as well. Early lessors like ILFC and GPA built significant fleets over time. By buying aircraft cheap (volume discounts) and finding low-cost funding, they tried to generate a profit based on the financial returns a "fundamental leasing" model has to offer. In recent years this has changed. The investors in the new generation of leasing companies have a business concept that can be described as a "trading model". Last year saw a number of new aircraft leasing companies entering the market, all blessed with significant amounts of equity. Well within a period of two to three years, these new lessors started launching plans to find new equity sources, and maybe via an initial public offer, release the original equity, including a potentially handsome profit.

With aircraft lessors now managing over one third of the global commercial jet fleet and the expectation that this percentage will go up 40% or even 50% over the next couple of years, it is becoming increasingly difficult to keep all parties happy when launching a new aircraft. Airframers generally want to sell as many new aircraft as possible. If aircraft economic (or financeable) lives are indeed shortening, this should be good news for them. Engine manufacturers on the other hand sell new engines at substantial discounts and generally make their money in the parts (after-) market. Increased engine reliability in combination with shorter aircraft lives may be a fundamental threat for their business model. Something may need to change there. Airlines are generally looking for "production tools" with the lowest overall cost. New aircraft with lower operating cost will generally be welcomed, especially if the value loss in the old equipment can be off-loaded to a third party investor.

Finally the leasing companies. As such the lessors are focused on aircraft value and liquidity and not on operational characteristics (only to the extend these influence value and liquidity). As Airbus has experienced before the launch of the A320neo, while airlines were generally positive about the new improved A320 version, almost all lessors were initially negative. Interestingly enough, objections also came from new lessors that did not yet have a fleet of A320's or 737NG's that they needed to protect against the potential residual value pressure caused by the new engine option. The reason for this may be that the time horizon of the new lessors does not allow them to wait for the A320neo. Actually, any market turbulence the "neo" would cause could potentially be negative for their exit scenarios.

So, in an equipment market that is increasingly depending on leasing companies as direct buyers from the aircraft manufacturers it will be a real challenge to develop a product strategy that keeps all parties happy. Satisfying the airline's need for more efficient aircraft and at the same time making sure that innovations do not undermine the existing fleet values of the lessors too much is and will remain a delicate balancing act. Unfortunately for the time being, the high safety standards in commercial aviation do not allow the OEM's to develop cheaper but less durable "12-year life" aircraft. Now if they could, that would really change the "View from the City".

*: Theory that time bends, folds or warps from the observer's point of view