Are early indications of an approaching boom in aircraft markets premature?

Kevin O'Toole/LONDON

Recession is barely over, yet many are already beginning to dust off the bunting ready to welcome back another boom in aircraft markets. Whether the reality of the coming year lives up to this early optimism remains to be seen.

There are certainly signs that investors are again starting to flow back to a market they all but deserted three years ago, buoyed by the promise of healthier airline profits and rising aircraft values.

Among the committed optimists in the leasing industry, there is even talk of a pending shortage of aircraft as the cycle of supply and demand comes full circle some time in 1996.

On the experience of past economic cycles, the industry is about due for an upturn and most of the traditional indicators appear to bode well for recovery.

Passenger-traffic growth appears to have settled down to a steady upward path after an erratic recovery from the collapse in 1991. Early 1994 figures from the International Civil Aviation Organisation suggest that world traffic climbed by 5% and, better still, that capacity growth lagged comfortably.

Most forecasters now seem to agree that the outlook over the next decade is for annual growth of at least 5% overall, with international services continuing to outperform the market.

Getting capacity under control has also helped to improve the look of airline finances. Despite some notable exceptions, the industry is already close to break-even and should be back in the black this year, barring any disasters.

Output of new aircraft is also running at a more manageable level, thanks to dramatic production-rate cuts by the manufacturers. Since the peak in 1991, when jet-airliner production climbed above 800 aircraft, output has dwindled to fewer than 500 in 1994 and is expected to stay there for at least another two or three years. New orders remain scarce and have been all but offset by the wave of cancellations.



A good sign that supply and demand are gradually easing back into balance comes from a gradual whittling away of the numbers of parked aircraft awaiting a return to the market.

The number of stored jet-airliners more than doubled in 1991 as the industry went into free-fall and that figure continued to climb. By the start of 1994, the figure stood at almost 1,100 aircraft, according to Airclaims, the UK-based consultancy.

The encouragement comes from what has happened since then. Over the last year, the number has edged down steadily, to little above 900.

Even at this level, the volume of idle aircraft is huge - in all, it represents more than 7% of the entire Western-built jet-powered fleet. As Airclaims points out, however, at least one-third of the idle aircraft are over 25 years old and many have been languishing in the desert since the recession began, with no real hope of returning to active service.

Of the remaining fleet, only the 300 or so Stage 3 aircraft and the more modern Stage 2 types are genuinely expected to return to the skies.

Despite an overall fall in storage levels, the outlook is far from uniform across the types. The number of older widebodies sitting in the desert, such as the McDonnell Douglas DC-10 and Airbus A300, has continued to grow.

Depending on which of the complex and, occasionally, mysterious measures are used, the market value for such widebodies has fallen by between one-third and one-half over the past two years.

The whole market for used widebodies is expected to stay under pressure as a steady supply of new aircraft continues to enter the market.

At the same time, the market for cheaper and more versatile narrowbodies has been showing signs of life. Movement among old favourites such as the Boeing 727 and McDonnell Douglas DC-9 types have accounted for the bulk of the reduction in the desert fleet over the past year, benefiting from what appears to be the first hints at stability throughout the narrowbody sector.

"The market for modern narrowbodies is improving quite fast and it will begin to show in sales figures and lease rates over the next 18 months, but perhaps not in the next six months," says Jack Cunningham, chief executive at UK aircraft-trading group Fortis Aviation.

He sees potential for 15-20% in lease rates for newer Stage 3 narrowbodies, but concedes that such a rise will still leave the rates at 10-15% below those of the boom in the late 1980s.

Cunningham also damps some of the enthusiasm surrounding the older narrowbodies, warning that prices are still at rock-bottom, even if the aircraft are easier to shift. "People are getting quite excited, but all we're seeing is that the deals are taking place more easily. They're still at depressed prices," he says.

Although the evidence from secondhand markets may not be conclusive, as the Avitas consultancy comments, signs that "...order is beginning to return to the market" is welcome enough after the roller-coaster ride of the past three years.



Despite the still-fragile state of the market, the US leasing community has already begun to talk up the prospects of reaching another industry peak over the next three to four years.

Any further growth in demand will lead to a capacity shortfall and a steep increase in leasing rates, argues Glenn Hickerson, of GATX Air. "There's going to be a scarcity again," he says, pointing to the lack of new-aircraft orders now pencilled in for 1996 and beyond. Lease rates for a typical narrowbody aircraft could rise fivefold, he believes.

Hickerson is not alone in his optimism. John Pluegner, vice-president at International Lease Financing, agrees that the better indicators coming through at the end of 1994 may prove to be a turning point on the way to a "real renaissance" in aircraft demand.

"If you believe in ten-year cycles in this industry, then that would tend to indicate that the peak should be in 1988/9," he says. "I think we're going to see the whole demand equation turning around again as we approach the peak. It will move from a buyer's to a seller's market."

Pluegner admits that the market is not there yet. So far, lease-rate increases have been patchy and done little more than pass on the cost of interest-rate rises.

Investors also appear to have scented an upturn. Best of all, the Japanese lenders have re-appeared. Before the market collapse in 1991, Japan's banks had underwritten over half of aircraft financing. Their unceremonious departure left an undoubted hole.

Their recent re-entry has been just as dramatic. Reports suggest that billions of dollars in Japanese tax-backed financing has been channelled into the market over the past year.

Aggressive competition has ensued, at least for the better airline credits, driving down lending margins - a fact not entirely welcomed by Western banking rivals.

"The Japanese banks are coming back in a big way, but only for the right type of credit. Margins are as fine as ever they were," says Ed Hanson, who manages the treasury at GPA. The Irish leasing group has more cause than most to remember when banks took a very different attitude to airliner financing.

The competition is still highly selective, with queues only forming for the best credit notes. Cash should eventually filter down to other airlines if the competition stays as strong, but no-one is yet forecasting a return to the funding free-for-all of the late 1980s.

The same rules seem to apply for stock-market investors. While markets have begun to regain a little more confidence in the airline industry now that it is crawling back into profits, the enthusiasm is firmly focused on the perennial profit-makers.

The recovery is still an unsteady and nervous affair. A year ago, Northwest Airlines sprang back from its near-fatal debt problems with a highly successful share flotation, helping to fuel speculation of renewed Wall Street interest in the airline sector. Since then, US equity markets have blown hot and cold, with each new indicator.

Europe has shown a little more interest, pepped up by the prospect of privatisations. Lufthansa's share flotation was a success and others could follow. Share issues by KLM and, more recently, Finnair, have also been well received. The Finnish carrier found its offering twice oversubscribed. Again the emphasis has been on quality rather than quantity.



Although all of these auguries may be favourable, signs of an upturn remain tentative. Even the most ardent optimists concede that it would only take the collapse of one of the US airline majors to destroy the good work so far. Cancellations by Continental Airlines have been enough to provoke further production cuts by Boeing.

Some within the industry still have lingering doubts as to whether the industry will experience a sustained surge in aircraft demand .

"This time the cycle could be different," warns Chris Tarry, leading aerospace analyst with UK securities house Kleinwort Benson. He points out that the present lack of new-aircraft ordering could be a sign of fundamental and long-term change in the airline market, rather than a short-term expedient which will result in a future burst of orders. "It begs the question of whether there will be an ordering upturn at all in this cycle," he says.

Unlike in previous recessions, the airline industry has not been swept back to profitability on a wave of economic expansion. Instead, carriers have been forced to face up to a radical review of their cost bases - in some cases for the first time.

Having started to win the cost battle, Tarry argues that they will have little appetite to indulge in a new bout of capacity expansion. Rather the emphasis may be on pushing up utilisation, productivity and efficiency, with existing aircraft and personnel.

If the result is to round off the next market peak into a more gradual undulation, then the industry may find little to complain about. Missing the boom could be a price worth paying for avoiding the bust to follow.


Questions of cash

Signs of recovery in the airline market may be encouraging talk of a future boom in aircraft ordering, but the industry still has to tackle the ticklish question of where the cash will come from.

Even on conservative estimates of aircraft deliveries, the sums involved will be vast. Assuming that output recovers to a relatively modest annual total of 600 aircraft, the market would have to find funding of nearly $40 billion a year. That is roughly twice the volume being swallowed up before the boom of the late 1980s.

Some of the slack is likely to be taken up by operating-leasing companies, whose share of the world market is expected to carry on growing to around 30%.

"We can now demonstrate that in good times and bad, leasing has grown," says John Pluengner of International Lease Finance, adding that leasing is no longer restricted to the traditional clutch of small carriers. Airlines such as Cathay Pacific, KLM and Swissair have all now dipped into the lease market, helping to shield balance sheets and lessen their exposure to tumbling residual values.



During recession, airlines have also looked to the traditional haven of manufacturer support. Accordingly, the exposure of Airbus Industrie, Boeing and McDonnell Douglas (MDC) to customer financing has roughly doubled, to above the $10 billion mark. Credit-rating agency Moody's estimates that it could double again by the end of the decade.

Airbus reveals that volumes of financing are running at 5-10% of sales, a figure which MDC admits is not far off the mark. Regional-aircraft manufacturers have fared no better, as the near-ruinous level of liabilities racked up by British Aerospace testify.

Although none of the manufacturers is keen to expand its exposure, all are now treating the prospect as a serious possibility.

Airbus financial director Ian Masseypoints out that, even if the percentage of support remains relatively constant, the growth in aircraft sales will ensure that the dollar value carries on multiplying.

That is a key reason behind the consortium's decision to borrow from the experience of its UK partner and launch Airbus Finance (AFC) towards the end of 1994. That is a necessary step to put the consortium's jumbled finances in order, says Massey.

Fokker has launched a similar financing operation through its parent Daimler-Benz, while the Saab and MDC civil-aircraft divisions are strengthening links with their existing group-finance arms.

Manufacturers have been able to count on their governments to take some of the strain of customer funding, through the provision of export credit guarantees. The volumes of US aircraft and engine financing being put through the powerful EXIM bank peaked at nearly $3.5 billion in 1993, with a further $3 billion in the 1994 fiscal year.

Airbus says that the European export credit agencies have been underwriting as much as 30% of its annual sales during the recession, giving a value of around $2.5 billion.



In the past, export credits and customer financing have been little more than stop-gap solutions and, although this time round they look likely to linger longer, they fail to provide a fundamental answer to the funding problem.

New horizons are opening up, however, in the form of asset-back securitisation. For years, credit-card companies and others have been bundling up their assets and using them to raise vast volumes of financing. In 1994, the US market for such securities was sized at around $250 billion.

GPA pioneered the market for aviation two years ago with the launch of its first ALPS securitisation. Essentially, the leasing company parcelled up a hand-picked portfolio of 14 leased aircraft and raised more than $500 million against it from investors.

Provided that sufficient aircraft are put into the portfolio as security, such a deal is more or less assured of high A-credit rating. That allows companies to tap into investment markets which they may not have dreamed of reaching with their own credit rating. It also makes the borrowing significantly cheaper.

Airlines, too, have begun to test the market with their own variations on the theme. In 1994, Northwest Airlines applied securitisation techniques in raising over $400 million in two transactions. These included the use of ten of its aircraft, pooled into an equipment trust.

What made the Northwest transaction different from more conventional asset-backed deals is that the airline was able to divide it into separate tranches, explains Jackie Naturman, at the Lehman Brothers merchant bank. The top tranche was heavily securitised by the aircraft and so won an A-credit rating, quite independently from the airline's own B-rating. "The savings can be dramatic," she says, adding that there is no reason why other rated airlines should not now follow suit.

In a similar transaction, Boeing was involved in setting up the Jet Equipment Trust, based on five 737-300s and two 747-400s on lease to United Airlines. Again, the top portion of the issue has won an A-rating.

"The rating gets you in the door," says GPA treasurer Ed Hanson. Once through, the potential is enormous. Hanson cites the example of the US commercial property market. The first securitisation of commercial mortgages took place in the late 1980s with a $1 billion issue. The market has now blossomed to $20 billion.

With GPA's second ALPS launch and the Northwest deals, he points out that aviation will have raised close to $1.5 billion in the securitisation market over the past 12 months. If commercial mortgages are an example, then more could follow.

Manufacturers have been taking note of the potential. Massey says that once the new Airbus financing arm has had time to secure itself a suitably high credit rating over the next four to six years, the aim will then be to move some of the liabilities off its books. He suggests a deal of between $2.5-4 billion based on a portfolio of 40-80 aircraft.

Securitisation is not a universal panacea. As Hanson says, you have to be big enough to create a good risk-free spread of assets. It is also more than a tool for those wishing to free themselves from existing liabilities than for new-aircraft acquisitions. If it achieves no more than this, then manufacturers and airlines alike will have good cause to celebrate.


Source: Flight International