The current down cycle has exposed the need for carriers to find a new level of flexibility in managing fleets. Lessors and global alliances could both hold parts of the solution
The present downturn has highlighted, like no other before it, the need to build flexibility into airline fleets. With a string of global crises still fresh in airline minds and the red ink still wet on their accounts, not to mention a record fleet still sitting idle in the desert, the industry has been left looking at how better to weather the jolts and shocks of the cycle. Lessors and global alliances have been keen to take up the challenge.
Previous cycles too have raised the question of asset management, but this downturn has been different in at least two ways. First it has been more severe. The outright collapse of US traffic that followed the terrorist attacks of 11 September 2001 dealt a sharper, swifter blow even than that which followed the first Gulf war in 1991. So too did the SARS epidemic which devastated traffic in Asia. Second, the affects have been more global, with shock waves rolling across all the major world markets.
While carriers may be astute at moving aircraft around their own network to offset weak demand on key markets, the global nature of the current crises simply left many with too much capacity and no place to fly it. There was little alternative but to park aircraft or fly them less, which, in the words of Philip Baggaley, credit analyst at ratings agency Standard & Poors', hardly represents an "efficient" use of expensive assets.
"In the past, downturns were short-termed or regional, like the Asian crisis, and people could shift equipment around," adds Tony Simpson, Boeing Capital Corporation's managing director financial services in Europe. But even with some traffic recovery showing through in Asia and Europe, the industry has been able to shift less than 10% of the 2,000 aircraft that remain parked, he estimates.
Besides the operational risks that over-capacity has brought in key markets, most notably for the hard-pressed US majors, there is also the issue of the asset risk that airlines take on their idle aluminium. Lessors are swift to point out that they may form part of the solution.
Reflecting on the past two years, Henry Hubschman, chief executive of leasing giant GECAS, notes a regret by some carriers that they had been left holding too much risk. "Airlines are saying in hindsight, 'I wish I had removed some of the ownership risk to someone else'," he says.
"Airlines have realised, as a result of the trials of the last two years, that liquidity gives control and, at the expense of short-term costs, can protect you from risk. Aircraft are the biggest capital strain." Leasing can help to balance that risk, he adds.
Market reach
Debis AirFinance chief executive Klaus Heinemann argues that the major lessors are, in any case, better positioned to shift aircraft around world markets during the downturn. He adds that they have the technical "know how" to move aircraft from one national aircraft registry to another, meeting local civil aviation authority requirements.
For such reasons, the operating lease has already gained much ground over the past couple of decades. John Willingham, chief operating officer of USA-based lessor Boullioun Aviation Services, estimates that in the 1980s only 3% of the world's fleet was on lease. Today that figure has climbed to more than 25%.
Lessors remain bullish that the trend will continue. "I wouldn't be surprised if 50% is on operating lease by the end of this decade. You are moving into a corridor going past the 25% mark," says Heinemann, adding that the rise is likely to be fuelled in Europe and North America by the growth of the low-cost sector, which has tended to favour operating leases more than traditional mainline counterparts.
In the early days, the leasing market may have been dominated by carriers too small or too new to pay the full cost of aircraft ownership, but that profile has been changing. Major carriers, especially in Europe, have been fuelling the trend to free up balance sheets and gain a little more fleet flexibility.
Among the majors, Air France has as much as a third of its fleet on operating lease and in the recent downturn chose not to renew some contracts as part of its capacity cuts. It postponed deliveries shortly after the events of 11 September and made early retirements of its older aircraft, but also chose not to renew some of its medium-haul fleet. For example, shortly after the terrorist attacks, Air France chose not to renew leases on three Airbus A321s after the winter 2001/2 season.
Leasing growth
Other of the region's national carriers also have plans to play the leasing game. The Austrian Airlines Group, which includes Lauda Air and Austrian Arrows (formerly Tyrolean Airways), had relatively few operating leases going into the current downturn, but chief executive Vagn Sørensen outlines a target of having some 30% of the portfolio on lease.
"We will in future have more operating leases to increase our flexibility and become more resistant to the swings in the market," says Sørensen, adding that such flexibility would have been a distinct advantage during the crises of the past couple of years.
The US majors, by contrast, have relied little on the operating lease, instead freeing up their balance sheets through the relatively cheap aircraft financing deals that had been available in the capital markets. Prior to the 11 September attacks, the US majors had virtually no operating leases, while their medium-sized counterparts have typically leased a quarter of their fleet, estimates Baggaley. Conditions have since changed, he adds, with the cash-strapped carriers having much less access to cheap debt.
Mindful of the Chapter 11 bankruptcy filings taking place in the US market, investors are less receptive to airline deals, raising the prospect that even the US majors, squeezed out of the capital markets, may have to plug into more operating leases. "Low-cost, long-term financing is no longer available. Airlines will have to rely on more operating leasing then they had in the past," says Baggaley. "There were a number of airlines that have said ruefully, we didn't give it value before but we do now."
The pace of change in world markets may also put pressure on carriers to seek the inherent flexibility of leasing rather than acquiring new aircraft. Even over the shorter term, carriers cannot be certain of their fleet requirements, argues Heinemann. "In a fast-changing environment, no airline can say for certain that this aircraft is my aircraft for the next 15 years," he says. "Some airlines will find it difficult to know what they will need in two to three years' time. The market is changing so fast."
But, as airline finance departments know only too well, flexibility comes at a price. The tax benefits associated with owning aircraft leave some large carriers as yet unconvinced about the value of raising the number of leases in their fleet, when they can offset earnings against the depreciation of the asset.
British Airways general manager fleet and network planning Robert Boyle explains: "We clearly value flexibility in the fleet. In a perfect world we would have complete flexibility. But flexibility costs money and generally in the end you go for flexibility when the cost for buying that is reasonable. And you buy it for part of the fleet for the downside." BA's off-balance sheet financing strategy has been to achieve "the best deal at the time", he says, sourcing a range of structured finance options of which the operating lease is just one.
Boyle notes that there are good lease deals out there but it depends on the aircraft type. For example, the level of activity in the narrowbody market - long the high-volume darling of the leasing industry - means that there is more likelihood that rental deals will be competitive with other forms of financing.
BA has taken on more operating leases in the downturn as it looks to add more liquidity to its balance sheet. Boyle says the airline has completed a number of sale and leaseback deals in the past two years. But he argues that even though operating leases provide the airline with the flexibility to "exit the asset" and hand back the aircraft at the end of the contract, "it doesn't give you the flexibility in between".
Lufthansa, which holds only one aircraft on operating lease out of its 250-strong fleet, remains equally wary of the potential cost implications of leasing and its apparent flexibility. Incoming group chairman Wolfgang Mayrhuber has argued that aircraft ownership has given Lufthansa the ultimate flexibility, allowing the group to park aircraft as and when the conditions require, without having to factor in the cost of paying rentals on an idle asset.
However, for others with less robust balance sheets, the ownership option may look less attractive. Even Mayrhuber's predecessor, Jurgen Weber, comments in a parting shot that the airline industry in future may have to start making hard choices about the size of the asset risk it carries. The airline of the future may be "lighter on assets" and heavier on the service side of the business, he predicts.
Mobile partnerships
But leasing companies may not be alone in providing a vehicle capable of moving assets more efficiently around the world. Partners within the global airline groupings too have been exploring the opportunities to move aircraft to where they are most needed.
Oneworld partners British Airways and American Airlines were both able to provide aircraft on temporary sub-lease to alliance member Qantas Airways. The bankruptcy of Ansett Australia in September 2001 left a vacuum which Qantas stepped in to fill. As a result, it needed temporary capacity just as its partners were faced with dramatic declines in the US domestic market and on the North Atlantic.
Qantas took American Boeing 737s and at the same time took one of BA's Boeing 747-400s on a two-year lease, which it charged to their joint venture. BA's extensive commercial co-operation with Qantas also meant it could use some of its excess capacity to take over one of the frequencies on the London- Australia joint service for one season. Elsewhere, Star Alliance member Austrian sub-leased two of its Boeing 767s to Lufthansa during the crisis.
But even when deals can be struck with partners, the lack of aircraft standardisation can hamper the smooth flow of assets. As one airline executive points out, the wrong type of galley can make or break a deal. At the same time, carriers have been reluctant to sign up for standard aircraft at the expense of their jealously guarded product differentiation, even if the reward is a measure of fleet flexibility. However, hard times have concentrated minds.
The Star Alliance is evaluating a group order for regional jets and SkyTeam members have discussed the issue, although they play down talk of going further. Star airlines are currently working towards a standard order of up to 200 regional jets between 70-120 seats that they will take from one or two manufacturers. Although pricing is the main motivation for the deal, the four carriers seeking new regional jets - Air Canada, Austrian, Lufthansa and SAS - believe the ability to swap aircraft between airlines will be a side benefit.
Sørensen, who leads the Star Alliance fleet coordination working group says: "There is a range of opportunities for technical co-operation and co-operation with product, but also to really utilise operating flexibility and optimise our different seasonal patterns."
Thus far, alliance partners have "infrequently" leased out aircraft to each other. But the new regional jet order could signal an opportunity for partners to swap aircraft between each other even "overnight" says Sørensen. If the aircraft had the same configuration, such as galleys, that too would cut crew re-training costs and make inter-alliance leasing smoother.
While airlines may be reluctant to drop the flourishes that make them unique, the airframe manufacturers appear to support more standardisation. "It makes the aircraft cheaper for them and cheaper for us to build," says Simpson at Boeing Capital. "It is better for lessors and airlines in the long run for residual values because these aircraft can be swapped around better."
Standard aircraft
Chris Buckley, Airbus senior vice-president Europe, agrees. "There will be economics for us to build a large number of aircraft to a set specification," he says. A further benefit for alliance partners could be the ability to swap delivery slots with each other, he says, adding that this could be done at short notice if the only difference is the aircraft's livery.
So, will airlines be able to turn such theory into practice? S&P's Baggaley argues that it is "an interesting possibility" but remains doubtful. "Airline marketing people may have overestimated the value of the livery and other parts, but it is very much the mindset of the airline industry," he says, pointing out that there are costs attached to adding in the branding features that few retail businesses would be happy to live without. "It's the role of the operating lessor and manufacturer to shift capacity from one market to another. When an airline can't take a plane they can place it in another region."
REPORT BY MARIA WAGLAND IN LONDON AND DRESDEN
Source: Airline Business
