Aircraft lessors face tough times with aircraft values plummeting. And as leasing companies prepare to weather the storm, there are questions over when and how the sector will eventually re-emerge

Aircraft lessors are hardly alone in suffering in the wake of 11 September. But few sectors have had to endure the level of pain that has followed for the leasing community, with aircraft harder to place and a massive devaluation in fleet values. Now the world's lessors find themselves wondering when the sun will once again emerge and what their sector will look like when it does.

There is little disguising the sudden slump in demand for airliners after 11 September. The market "went strongly into reverse" in the words of John Willingham, chief operating officer for Boullioun Aviation Services. Leasing companies have already begun to see aircraft returned early and are finding it more difficult to place their fleets. The result is that rental rates are at new lows while aircraft values have fallen dramatically. Mark Hemmann, analyst at Pegasus Aviation, is far from alone in going through "the most challenging time in our company's history".

Value collapse

The extent of the collapse in aircraft values shows through in latest estimates from the Airclaims consultancy, which again provides data for this year's Leasing Survey 2002 (see pages 50-52). Airclaims says that rental rates for narrowbody aircraft have dropped 10-17%, while rates are down further at 15-20% for widebodies. Figures from the database also suggest that the value of the world leasing fleet has fallen by more than 17% since 11 September. The consultancy calculates that the fleet of 4,535 aircraft which were in the hands of the world's leading lessors at the start of 2002, would have been valued at close to $90 billion at their pre-crisis levels. An estimate based on today's values wipes some $15.5 billion off that total (see table opposite). Not all fleets have been affected equally. The declines range from over a third fall in value for the oldest Boeing 737s and around 25%for McDonnell Douglas DC-10s, through to 15% for the latest 737s and Airbus A320 family.

While the events of 11 September may have triggered the industry's crisis, some point out that the problems they exposed were not new. Philip Scruggs, vice-president with International Lease Finance Corporation (ILFC), believes that the root cause of the current turmoil has less to do with the after-effects of the terrorism attacks and more with fundamental flaws in the structure of the aircraft business.

"The industry's structural problems began well before last September," he says, pointing out that airline profits peaked in 1997, whereas aircraft production continued to climb through to 2000. "So just as airline profits were beginning to slide, production was reaching its all-time high,"he says, charting the familiar industry cycle. "Therefore, while 11 September certainly deepened and advanced the situation - and sped up the decline of airlines - lease rates were already dropping significantly."

The question of when the crisis will end remains open. Nobody feels recovery has truly begun - or that it will soon - although Willingham says he sees "a light at the end of the tunnel". Another head of a leasing company says that he does not expect to see a return to the days of 5% annual growth in aircraft demand until 2007, or even 2008.

For his part, Scruggs says that ILFC is "bearish" on the market and does not anticipate the industry getting healthy until after 2003. He does, however, anticipate noticeable improvement by the end of this year as the major airlines carry out their announced fleet retirements and Boeing's output cuts begin to reduce the oversupply of aircraft.

When the tide does eventually start to rise, most agree that it will not lift all ships equally; for some players, a return to better times will be insufficient to maintain their position in the business.

Much as the crisis in the airline industry brought to light deep-seated weaknesses in several carriers, it seems the leasing sector's crisis will reveal which companies are fit to succeed in the post-11 September world.

Boullioun's Willingham holds that the basic ingredients for success remain: "People, planes and funding". That includes a good spread of modern aircraft and a reliable source of funding - vital to give the company both a lower cost of capital and protection in dangerous times. To this list, Airclaims consultant Eddy Pieniazek also adds the need for a strong base of sound airline clients which are unlikely to default or return aircraft early.

Modernity and diversity are indeed king when examining a lessor's stable of aircraft, but today's market favours narrowbodies. In addition to heightened airline demand for smaller aircraft are several maxims that have renewed importance under current conditions. Willingham explains that widebodies are currently less desirable because the number of eligible lessees with which they might be placed is that much smaller and also because the high cost of reconfiguring them becomes especially painful during periods when revenues are low.

As this year's Leasing Survey demonstrates, not all leasing companies have seen the same fall in values. While the two giants ILFC and GE Capital Aviation Services (GECAS) have been close to the average, others, including those with less diversified or older fleets, have fared worse, with falls of 20-25% or more.

Financial fortunes

Future prospects also rest heavily on the state of a leasing company's finances. Industry leaders ILFC and GECAS are subsidiaries of parents with massive financial muscle: respectively the American International Group insurance group and General Electric. Boullioun too is owned by German investment bank WestLB.

The importance of deep pockets has long been accepted, but the current situation could help to reinforce the advantage of strong parentage. Scruggs acknowleges that ILFC has not been immune to the industry's malaise - it counted such as Swissair, Sabena, Air Afrique and Canada 3000 as "important clients". However, he argues that such high-profile failures, and his company's ability to take them in its stride, could actually help airlines to appreciate the importance of doing business with a financially solid lessor, such as ILFC with its AA credit rating. He notes that the prospect of a weak or bankrupt lessor putting its lessees' deposits at risk is something for which carriers will have little appetite.

Extensive financial resources also allow a company to take advantage of opportunities to buy for the future at a time when manufacturer prices are low and carrier liquidity tight. Willingham explains that WestLB's enthusiastic backing has enabled Boullioun to undertake post-11 September sale/lease-back transactions with Finnair and Air Berlin.

Solid funding

A good balance sheet also gives a company the weight to sail relatively unscathed through rougher economic water. A high-ranking industry insider says that firms with solid balance sheets and remarketing skills should never lose money. In bad times, he says, they should be able to place their aircraft at low rental rates with short contract terms, making them available for longer, more lucrative contracts when the market turns and rates rise.

Conversely, companies without this reliable source of funding find themselves even more prey to economic factors. Hemmann at Pegasus explains that his company, which is wholly owned by equity investors but exploring other ownership options, has seen its manoeuvrability curtailed by the current situation, especially with regard to the drop in aircraft values. Because these companies' only sources of funding are securitisation transactions, bank lines and other forms of direct lending, when the value of their assets drop, so too does their ability to raise funds for new initiatives.

Many in the industry believe that problems such as these may promote a round of consolidation, as the smaller lessors see that they are ill-equipped to survive the more severe business cycles, never mind compete for airline customers with the larger outfits.

So, as lessors wait for the downturn to reverse itself, they do so in the knowledge that their industry may be fundamentally changed the next time conditions take a dive.

Source: Airline Business