Escalating production rates and changing market dynamics put assumptions on single-aisle depreciation under scrutiny, writes Chris Tarry

A couple of years ago, we considered the issue of the assumptions underlying aircraft depreciation policies and raised questions on the validity of some of the time periods selected, in particular whether 22-25 years for narrowbody aircraft was too long. For various reasons, it is an issue that is worth revisiting against the background of yet another increase in the production of single-aisle aircraft.

From a mechanical perspective, an aircraft can continue in operation for as long as an operator is prepared and able to maintain it. However, the assumptions relating to the economic life of the aircraft are often based on issues related to financing and future value.

The condition that is of fundamental importance is the relationship between the realisable value and the book value of the aircraft in the future. At the simplest level, the difference between the book value and the realisable value will determine whether there is a profit or loss.

But there are a number of other and perhaps more significant issues around residual values and the nature of the depreciation policy adopted - especially if achieving a particular residual value will make the financing economics work and generate the requisite returns from the ownership of the aircraft.

Part of the issue is whether history is an adequate guide to the future. For this to be the case, it would require the replication of the market conditions seen in the past into the future. In this respect, in the so-called 150-seat segment, there are a number of significant differences that have arisen. Outcomes are increasingly determined by supply side effects and the resulting impact on demand, especially the relationship between supply and demand, the dynamics of market correction actions and the consequence for the second-hand market.

Both Airbus and Boeing are producing their single-aisle aircraft at or very close to the bottom of the cost curve, with the consequence that both programmes generate a significant profit and cash. Clearly there are challenges ahead and costs to be incurred with the introduction of new-engine models, which will have an inevitable impact on the residual values of the current models. But how much and when remains an open question at this stage.

There has also been significant change in the adjustment dynamics in the second-hand aircraft market compared with the early and mid-1980s when the A320 family was launched. These will have an increasing effect on elements associated with aircraft ownership and ultimately the rate of new supply.

However, in the near-term, the greatest impacts will be more related to value and financing. The widening gap between the physical life of the aircraft and the assumptions made in respect of life and value in financiers' calculations is a growing concern. The value, and the cash received, is what somebody is prepared to pay for it when the aircraft is sold and this is a reflection of supply and demand across the market.

In the simplest terms, an airline has two main areas of activity. First, the movement of passengers and cargo and second, an asset management business where success is often not only the result of the timely acquisition of aircraft with a "good deal" on price, but increasingly where the disposal of the aircraft may be more important.

Given this, it is clearly important to consider some of the additional factors that may affect realisable value. Unlike many other markets, where a niche or specialised product may attract a premium value, it is not the case for aircraft. If an airline has decided that a lower weight and minimum specification aircraft will reduce the fuel burn, there is likely to be a penalty in terms of value because as it is not a standard aircraft this will restrict the second-hand demand and with it the price on disposal.

Yet against the background where most are questioning the validity of any forecasts, and where an airline chief executive recently told us that for him the "medium-term" is now six months, how much confidence should there be in estimates of future value anyway? And how much, given the change in the supply position and what appear to be conditions of perhaps substantial excess supply in the second-hand market even before production rates are increased. Another key question is how this excess supply will be absorbed and here the issues will relate to price and value, whether for a complete aircraft or one that is parted out.

There are situations where it is cheaper for an airline to continue with its existing aircraft or it holds on to the older equipment as it hopes to get a better price - both of which will have the same effect on the "supply/demand balance" irrespective of a change of ownership. This almost brings us full circle.

Market adjustment is never costless and instant. The outstanding issues are how long will it take and cost and which of the various "actors in the system" will take the financial hit and when. At the moment, there are real signs of instability in this area.

Chris Tarry is head of consultancy CTAIRA.

Source: Airline Business