Industry review and outlook

Transcription

1 Industry review and outlook Despite several destabilising developments in the global political environment, the first half of 214 has generally been favourable for commercial aviation, discusses Bert van Leeuwen, Head of DVB s Aviation Research. The global economy has resumed its growth-path, and the International Monetary Fund now projects 3.7% economic growth for 214, rising to 3.9% in 215. However, the inconsistency in the performance from country to country is still a concern. GLOBAL AIRLINE TRAFFIC increased strongly in the final months of 213, resulting in a 5.2% growth in airline passenger kilometres for the full year. Global spend on air transport exceeded US$7bn in 213 and a 5% increase is projected for 214. The start of 214 was promising as well with a 5.9% growth in passenger traffic during the first six Bert van Leeuwen months. In terms of airline profitability, the past few years have been relatively strong, albeit the average returns generated on industry level are still relatively low. During 213, system-wide global airlines earned a total of US$12.9bn net profits, more than double the result from the year before. Apparently the industry has successfully adapted to cope with continuing high, but relatively stable oil price levels. For 214 IATA projects a US$18.bn net profit. While these amounts are certainly impressive, the EBIT margin in 213 was only 3.%. Preliminary figures for the first quarter of 214 indicate an improving financial performance, albeit not evenly spread across the regions either. A combination of strong transport market circumstances, abundant availability of liquidity and the introduction of a broad range of technologically advanced and fuel efficient new aircraft types pushed order-levels for new commercial jets to record levels. During 213 (civil) operators placed a total of 3,671 1 new orders for western built commercial jets. This number includes 151 type swaps but excludes 88 orders for eastern MC-21s and Sukhoi Superjets as well as 13 orders for western built turboprops. After a few weaker years, the used equipment market recovered during 213, at least for modern (single-aisle) types. In contrast, significant numbers of older single aisles, including A32s went into storage or were retired. The weakness of the cargo market also saw many B747s grounded or retired as cargo conversion seemed no longer an option and even factory built nose-loader B747s had difficulty finding new homes. From the finance side, it is clear that the funding gap that kept the industry busy only a few years ago is no longer an issue. In early 214 there was plenty of liquidity available to the industry, from a range of debt and equity providers, which, together with prevailing low interest rates, drove down the finance cost for the acquisition of additional aircraft. Air transport market Air transport remains an essential element of society and is expected to continue to grow in the foreseeable future. The effect of increasing GDP and world trade volumes, together with the decreasing real cost of airline tickets make air travel affordable for a larger part of the global population. Global spend on air transport is estimated to be 1% of GDP with the average airline fare, according to the International Air Transport Association (IATA), reaching US$231 (excluding surcharges and tax) in 214, down 3.5% vs. the year 213. Overall, airlines connect over 16, unique city-pairs worldwide and smaller long-haul aircraft may expand this number even further. A total of 3.32 billion passenger departures are projected for 214, about 5.7% more than 213. A significant number of these passengers are tourists, who on an aggregate level are estimated to spend over US$6bn in 214, assuming no unexpected disruption of the global economy. Airfinance Annual 1

2 Table 1: IATA monthly international traffic data 214.H1 Passenger traffic (in RPK): International 6.4%; Domestic 5.1%; Total 5.9% 214.H1 Freight traffic (in FTK): International 4.4%; Total 4.1% 4% 8% 3% 7% y-o-y RPK & FTK growth (%) 2% 1% % 1% 2% Jan-5 Jul-5 Jan-6 Jul-6 Jan-7 Jul-7 Jan-8 Jul-8 Jan-9 Jul-9 Jan-1 Jul-1 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 International RPK growth (LHS) International FTK growth (LHS) International pax.load factor (RHS) 6% 5% 4% 3% 2% 1% Pax load factor (%) 3% % In mid-214 the world is facing a number of challenges that may influence passenger traffic during the second half of the year. The unrest in the Middle East, the conflict in Ukraine and the response of Russia to western economic sanctions following the sad events around flight MH17, as well as the Ebola outbreak in Africa are just a few of the potentially destabilising developments that need to be monitored carefully. Fear of an armed conflict or a disease may prevent people from travelling, with negative consequences for the global airline business. As of mid-august 214, there are however no signs that this is happening on a larger scale. While passenger traffic prospered in 213, air cargo remained in the doldrums during most of the past year, despite decreasing freight rates. On average the freight rate per tonne is estimated to be only US$2.18 in 214, down 4% compared to the previous year. Research by Seabury Group and IATA indicate that the modal shift away from air cargo to ocean freight has cost the sector almost two percentage points of annual growth since 2. Air freight s share of total global containerised maritime cargo declined from 3.1% in 2 to 1.7% in 213. Seabury s research indicated that the shipment of raw materials and perishables had been affected the most by modal shift, but fashion, high-tech and machinery parts shipments had also experienced significant shifts from air to ocean freight. The main factors driving modal shift included the cost difference between air cargo and container freight rates, increased reliability of ocean freight, and environmental factors. Despite the fact that not all airlines are profitable, the industry as a whole is generating close to record profits. 214 is expected to be the fifth year in a row where the airlines will show positive results. 214 is actually expected to be an absolute record-year. Are we as some say now living in a golden age of aviation? The industry is doing relatively well, but is also still vulnerable to any outside shocks. In the recent past, widely diverging events have pushed global aviation in regional or even global crises. As indicated above, whether natural disasters or the outbreak of diseases, political unrest or acts of terrorism, economic problems or a financial crisis, the significant negative impact of these events was not and could not be predicted. Very little has to go wrong before the airline industry plunges into the red again as profit margins are still very thin. According to IATA data, the return of capital during 213 was a meagre 4.5%, well below the Weighted Average Cost of Capital for the industry. The relatively strong performance of the global airlines are the result of favourable circumstances beyond the control of airline management but also a more disciplined and bottom-line focused airline policy. Of tremendous help to the bottomline was the relatively stable fuel price that prevailed since ca With oil price levels between US$11 and US$14 per barrel, the absolute price level of jet kerosene remained high but apparently the market could absorb this level. It is remarkable to notice that despite political unrest and even military conflicts in some oil producing countries, the oil price remains relatively stable. The availability of large reserves of shale oil in the US as well as the production fine tun- 2 Airfinance Annual

3 Table 2: Air freight market growth (in %) by IATA region FTK growth 213 vs. 212 FTK growth 214.H1 vs. 213.H % Africa Asia/Pacific Europe Latin America Middle East North America Table 3: Air passenger market growth (in %) by IATA region RKP growth 213 vs. 212 RKP growth 214.H1 vs. 213.H % Africa Asia/Pacific Europe Latin America Middle East North America ing by some of the other OPEC countries, especially Saudi Arabia, may be responsible for this stability. The first half of 214 has shown strong overall growth in the air travel markets. Total transport volume, expressed in Revenue Passenger Kilometers, increased by 5.9% (YoY), according to IATA (the trade association of airlines whose 24 members comprise 84% of the total air traffic), which is an increase over the 5.2% achieved over the full-year 213. International travel showed the strongest growth with 6.4%, while domestic transport increased only 5.1%. Domestic markets Airfinance Annual 3

4 Table 4: Crude oil and jet fuel price development 25 2 Cushing, OK WTI spot price FOB (US$ per barrel) US Gulf Coast kerosene-type jet fuel spot price FOB (US$ per barrel) US$ per barrel Jan- Jan-2 Jan-4 Jan-6 Jan-8 Jan-1 Jan-12 Jan-14 Table 5: Airline net profit (post tax, in US$bn) by IATA region 1 8 Net profit 212 Net profit 213(E) Net profit 214(P) 6 US$bn 4 2 Africa Asia/Pacific Middle East Latin America North America Europe 2 are obviously only relevant for larger countries such as Brazil, China, India, Russia and the US. As in previous years, the Middle East region (airlines based in the Middle East), showed the strongest growth with 13.9% increase of total traffic. Asia/Pacific and Latin America followed at a distance with 6.9% each, closely followed by Europe, which achieved a relatively favourable 6.1% over the first six months, an improvement over the 3.8% over the full-year 213. North America showed a modest 2.6% improve- 4 Airfinance Annual

5 Table 6: Financial forecast IATA/ICAO Net results in US$bn ment overall and Africa once more carried the red lantern with.6% negative growth. Just looking at market growth in the domestic markets, Russia leads the way with an 11.6% increase, closely followed by China s 1.8%. Despite disappointing passenger numbers during the football World Championship, Brazil s domestic traffic increased by 7.3% The US was relatively stagnant for the domestic part of its market as well, with only a 2.1% increase. Looking at the relationship between traffic growth and capacity expansion, clearly an increase in fleet capacity, resulting in more destinations or higher frequencies, stimulates demand. The Middle East airlines added a significant 1.3% more seat capacity to their fleet, but as the 13.4% traffic increase demonstrated they were capable of filling all these extra seats. This strategy stands in sharp contrast to that of the North American carriers, who added a meagre 2.1% capacity. They also could easily sell the extra seats given the 2.6% traffic increase. While the likes of Emirates, Etihad and Qatar are aiming at expanding their networks to increase their global market shares, the North American Majors seem now much more bottom-line focused than ever before. In a relatively stagnant North American market, airline profitability has shot up, thanks to the lower competitive pressure resulting from the most recent round of airline consolidation. With the market largely carved up amongst the remaining Majors, pricing power is pretty strong and in an environment of relatively stable operating cost this results in strong financial results. The preliminary financial results actually confirm the success of the strategy as the North American airlines reported the best Net post tax result in US$bn (LHS) June Operating margin % (RHS) E 214F 3% 6% 9% result of all regions. The preliminary net post-tax profit over 213 is estimated to be US$7.bn, over three times the result of the year before and over two-thirds of the US$1.6bn total 213 net profit of all IATA airlines. The Asian-Pacific carriers reported a positive result over 213 as well; net US$2.bn. The Middle East chipped in US$1.bn, with the other continents between US$.1bn (Africa) and +US$.5bn (Europe). As per mid 214, the projections for the year have been slightly adjusted downwards, but overall still a record net profit is anticipated of US$18.bn for 214. North America is now starting to reap the fruits of consolidation with a projected US$9.2bn net profit. Asia (US$3.2bn) and surprisingly Europe (US$2.8bn) are the runners-up and the Middle East is fourth with US$1.6bn. Latin America is expected to show a decent result with US$1.1bn, while Africa is anticipated to escape the sea of red ink with a US$.1bn positive result. While as a whole these results look impressive, it should be taken into account that the net profit per passenger in most cases could barely buy a fast-food lunch. Per passenger the result vary between US$1.64 (Africa) and US$11.9 (North America), and this is in what is expected to be the best year in recent history in the airline business. With respect to the above figures, it has to be considered that not all airlines are IATA member and they may not contain all the data for some of the (most profitable) low-cost carriers. Commercial jet market Against a background of relative prosperity in the airline business as well as a sea of liquidity in the financial markets, triggered by 9% 6% 3% % Operating margin as % of sales Airfinance Annual 5

6 Table 7: Annual volume of orders placed (Western commercial jets civil operations) 4, 3,5 Full-year orders Orders Jan July 3,671 No. of orders 3, 2,5 2, 1,958 2,78 2,543 2,751 2,54 2,162 1,992 1,5 1, ,482 1,45 1,32 1, ,244 1, DVB analysis Source: Ascend Table 8: Annual delivery volume 1,6 1,4 Full-year deliveries (Western commercial jets civil operations) Deliveries Jan July 1,312 1,41 No. of deliveries 1,2 1, 8 6 1,178 1,171 1,125 1,119 1,118 1, DVB analysis Source: Ascend 6 Airfinance Annual

7 Table 9: New commercial jet orders (Western built, all civil operations) No. of orders 1, Jan July Inc. type swaps A32Fam NEO B737Max B737NG A32Fam CEO A E-Jets B E-Jets E A33 B777X B777-2/3 A38 CRJ Cseries B747-8F ERJ B767 MRJ DVB analysis Source: Ascend the various rounds of Quantitative Easing, it is no wonder that new aircraft ordering is at peak levels. The year 213 marked an absolute high in terms of new commercial jet orders. During the calendar year 213, a total of 3,94 commercial aircraft for all civil operations were ordered (excluding business jets). 1 The vast majority (3,671) being western built commercial jets. Apart from 26 Tupolovs, Antonovs and Ilyushins, 88 eastern built jets potentially aimed at the global market were ordered. From the orders for eastern built jets, 62 were for the Irkut MC- 21 and 26 for the Sukhoi Superjet 1. In the turboprop category, 13 new western built aircraft were ordered plus 25 eastern designs. Focusing on the main category of western built jets, the 3,671 new orders included 151 so-called type-swaps, effectively aircraft that had been ordered before but where the customer decided for a different type or version. With or without type swaps, 213 was a record year by any standard and it is unlikely that 214 will break that record, although the order total may not be that far away from 213. During the first seven months of 214, including orders placed around the Farnborough Air Show, a total of 1,992 western built jets were ordered for all type of civil operations, compared to 2,162 the year before over the same months. Extrapolating the orders received in the first half of 214, it looks like the full year 214 may still see around 3, new western built jet orders. Generally, new aircraft announcements trigger a flurry of new orders. Compared to 213, 214 will see less new aircraft types announced by the manufacturers. At the 213 Paris Airshow, Embraer announced its new E-Jets E2 second generation, while Boeing launched its new B787-1X as well as the new B777-8X and 9X at the same event. Apart from the re-engined Airbus A33-2 and -3 dubbed respectively A33-8neo and -9neo, no significant new aircraft designs were announced during the Farnborough Airshow in 214 and no other major announcements of new types or major variants are expected during the remainder of 214 as all manufacturers already have their hands full. The single aisle 15 2-seat category remains the focal point of the industry. After 211, the year of the (A32) Neo and 212, the year of the (B737) Max, 213 was another Neo-year with 864 orders for the Airbus product and 699 for the jet from Seattle. It looks like 214 will be another Neo year. After the Farnborough Airshow, the Airbus A32 family had scored 947 orders in 214. Over half were for the A32neo, but still over 1 for the outgoing A32ceo. Second-most popular member of the A32-family was obviously the A321 with 15 orders for the A321neo but no less than 181 for the A321ceo, Airfinance Annual 7

8 Table 1: Number commercial jet deliveries (Western built, all civil operations) Jan Jul No. of deliveries A32Fam B737NG A33 B777 E-Jets B CRJ A38 ERJ B747 B767 DVB analysis Source: Ascend indicating the strong short term demand for this stretched version. The A319 has clearly fallen out of favour with only four A319neo sales and 1 A319ceo. While Airbus originally at the launch of the product stated it would not allow conversion of Ceo-orders into Neo-orders, this position seems to have changed. In mid-214, Airbus stated that it wanted to quickly shift to building only A32neo jets, so it is cancelling orders with carriers that do not want their planes immediately rather than letting them defer deliveries. Many of the well over 1 cancelled A32ceo deals, including those from Tiger, Qantas, AirAsia, LATAM and Azul, would re-emerge as orders for the A32neo. The Boeing B737 remained the second most popular aircraft family during the first months of 214 with 588 orders, the majority (396) for the B737Max but still a respectable number of orders (192) for the outgoing B737NG. The B737Max-8 was most popular with 27 orders, not far ahead of the 184 orders scored by the B Many other orders for the Max remain undecided with respect to which version will be selected. For the B737NG, six orders went to the stretched -9ER and two to the -7. With the shift to higher capacity aircraft in the single-aisle segment, both manufacturers are proposing higher capacity versions of their best-selling jets. Airbus proposes to launch a 189- seat A32neo version, matching the capacity of the Boeing B737Max-8. Not to be outdone, Boeing subsequently launched a 2-seat version of the Max-8 by adding the option of a mid cabin exit door, clearly aimed at the likes of Ryanair. Despite the introduction of the new A33-8 and -9, the honour of the fastest selling twin-aisle still went to Boeing for the first months of 214. The Boeing B777 booked 245 orders, the vast majority of 21 aircraft for the new B777-8x and -9X but still 2 for the -3ER and despite the cargo slump four for the -2 Freighter and one BBJ. At the other end of the spectrum, in the turboprop category there was a surprise as ATR scored no less than 144 new orders, 119 for the ATR72-6 and 25 for the shorter ATR42-6. Together with the 23 orders for the Bombardier Q4, this reconfirms the revival of the turboprop category. In the regional jet category, 66 Embraer E-Jets were ordered, 6 for the second generation E19/195-E2. The stars at the 214 Farnborough Airshow, the Airbus A35XWB and the Boeing B787 were less successful during 214 from a commercial perspective with 12 and 27 orders respectively. The good old A33 booked 34 orders of which 21 were for the -3 version. The number of A33 orders will prob- 8 Airfinance Annual

9 Table 11: Order backlog commercial jets increasing 12, 1, 8, 6, 4, Order Storage Order % total fleet 1.% 9.% 8.% 7.% 6.% 5.8% 5.% 4.% 3.% 2, 2.% 1.% % DVB analysis Source: Ascend Table 12: Backlog as percentage of fleet per region 14% DVB analysis Source: Ascend 12% 1% 8% 6% 4% 2% Africa Asia Pacific Europe Latin America and Caribbean Middle East North America Middle East Asia Pacific Europe Latin America North America Africa Airfinance Annual 9

10 Table 13: Backlog as percentage of current fleet 9.% (Western built commercial jets civil operation) 8.% Backlog as % of in service plus store 7.% 6.% 5.% 4.% 3.% 2.% 1.%.% 21.Q1 21.Q3 22.Q1 22.Q3 23.Q1 23.Q3 24.Q1 24.Q3 25.Q1 25.Q3 26.Q1 26.Q3 27.Q1 27.Q3 28.Q1 28.Q3 29.Q1 29.Q3 21.Q1 21.Q3 211.Q1 211.Q3 212.Q1 212.Q3 213.Q1 Regional jets Single-aisle jets Twin-aisle jets Factory built jet freighters Total Western built commercial jets (all civil operators) 213.Q3 214.Q1 DVB analysis Source: Ascend ably increase significantly in the coming months, but most will be for the -8 and -9. Commitments for 121 A33neo have been announced to date, amongst others from ALC, AirAsiaX, Avolon, CIT and Transaero. With the A33-8 and -9 now launched, Airbus is likely going to cancel the smallest member of the A35 family, the -8XWB. Due to an uncontained engine failure on one of the test aircraft, the Bombardier CSeries did not make it to Farnborough, but still booked 23 orders in 214 YtD. Finally, the large twin-aisle jumbo category did not do too well in 214 with only 2 orders for the A38 and one for the B While the discussion about a possible order bubble continues without an industry-wide consensus, the first months of 214 saw a number of rather high profile cancellations. Of the 333 reported cancellations, the vast majority were for Airbus products. Probably the highest profile cancellation came from Emirates as they decided to open up their order for 7 A35s to a new competition between Airbus and Boeing. 1 Japan s Skymark cancellation of six A38s was widely reported. Another 122 single-aisles were deleted from the order book of the A32 family. Air Asia, Tigerair, LAN and American were amongst those giving up their slots. Boeing had to report 55 cancellations of B737 orders, mainly from Jet Airways and Virgin Australia. Several airlines kept their orders in place but announced that a part of their fleet would be moved to an in house leasing company. Lion Air, Norwegian and Qatar were amongst the operators announcing such initiatives. As the ordering of new aircraft continued at a high pace, the backlog has reached record levels. As per the end of July 214, the backlog for western built commercial jets (all civil operations) stood at 12,332, or 56% of the 21,895 strong in service fleet or 51% of the total fleet. If one were to include all reported aircraft options and LoIs, the total commitments would be about 88% of the in service fleet. With 1,41 commercial jets delivered during the year 213, the current backlog would be sufficient to keep the production lines busy (at 213 production levels) for well over eight years. The jet storage level is at a relatively low 9.8% of the total fleet and includes many outdated previous generation types. The backlog is not evenly distributed over the regions. As to be expected, the Middle East carriers are expanding fastest and their backlog in terms of aircraft count is just under 8% of their current fleet. Asia/Pacific has a backlog equal to about 5% of 1 Airfinance Annual

11 Table 14: Current market values new commercial jets (Index 26=1) 125% 12% 115% 11% 15% 1% 95% B777-3ER E-19 A33-3HGW B777-2ER B737-8 A32-2 9% 85% 8% B767-3ER 75% Source: Ascend. their fleet. For Europe and the America s the backlog is around 4% of their current fleet, while for Africa this percentage is under 2%. In terms of backlog over the various aircraft categories, this is currently highest for twin aisles. Probably due to high backlog numbers for the new generation wide-bodies e.g. the (delayed) B787 and A35, this category has been in the lead since around 25. With the introduction of the B737Max and A32neo, the backlog percentage for the single-aisle category has been climbing fast since 21 and is now reaching twin-aisle levels. Regional jets are making a come-back after 212, probably as a result of the launch of new types such as the E2s and the MRJ. Finally the air cargo crisis has pushed the factory freighter backlog well under 1% of the fleet size. Impact of generation change The industry is going through an almost unprecedented generation change in terms of equipment designs. In the regional jet segment, the Embraer E2 family, the CSeries as well as the Mitsubishi MRJ, will aim to replace the current E-Jets and CRJs. In the single-aisle segment the A32neo family and the B737Max will replace the A32ceo and B737NG. In the smallto-medium twin-aisle segment the A33neo, A35-9 and B787 will replace the A33ceo/A34 (CFM) family as well as the B767-3ER and B777-2ER. In the large twin-aisle segment the B777-3ER and A34 (RR) will be replaced by the B777X and A35-1. In the jumbo segment, the B747-8I and A38 have already taken the place of the B For investors and financiers it is important to analyse what the impact of this generation change is or will be on aircraft values. If a new aircraft design offers better fuel burn and/or maintenance cost levels, the only way the older technology planes can remain competitive is by lower capital costs, i.e. lower purchase prices or lower lease rates, none of which is good news for an investor with a position in the older design. The lack of real price transparency in the commercial jet market is a limiting factor. Factors, such as the strategic importance of an aircraft order, the order size and the order timing often result in significant differences in net-net delivery prices of aircraft of similar specifications delivered within the same time period. Based on value data for newly delivered aircraft (source: Ascend) price developments over the past years have been significantly different for various aircraft types. While these values are not necessarily equal to the actual prices charged by the manufacturers, they may serve as an indication about possible price trends. OEM s pricing power vs. its airline and lessor customers is influenced by many factors including competition from other suppliers, existing production backlog, cost structure and technology. Boeing has clearly benefitted from Airfinance Annual 11

12 Table 15: Changes in aircraft value Jan. 214 vs. Jan. 213 (constant ages) 5% % 5% 1% 15% Source: Ascend. 2% 25% B Yr B Yr B Yr B Yr B Yr B Yr B Yr B Yr B Yr B767-3ER-5 Yr B767-3ER-1 Yr B777-3ER-1 Yr A321-2ER-15 Yr B777-2ER-15 Yr B767-3ER-15 Yr A33-3HGW-1 Yr B767-3ER-2 Yr B777-2ER-1 Yr Embraer 19-5 Yr A Yr B Yr A33-3HGW-5 Yr A Yr B777-2ER-5 Yr A Yr A Yr B777-3ER-5 Yr B Yr A Yr A Yr A Yr A Yr A Yr the almost monopoly-like position of the B777-3ER after the demise of the four-engine A34-6. Embraer apparently also has been able to maintain good pricing power for its E-19. After a period of weakness, in reaction to the launch of the Boeing B787, the A33-3 has regained strength in recent years. For the B777-2ER it seems the game is almost over and pricing weakness manifested itself. For the B767-3ER the game was over years ago and production is maintained at low levels to bridge the gap to the start of the KC-767 (KC-46A) military tanker/transport for the USAF. It is interesting to note that the mainstream single aisles, the B737-8 and A32 enjoyed recovering values despite the fact that replacement types are around the corner. The strong short-term demand, a huge backlog and the impact of escalation clauses seem to have a positive impact on values of new built single aisles. What can be expected for the future? The top-three aircraft types in this overview B777-3ER, E-19 and A33-3 all have direct successor types arriving in the coming years (B777X, E-19E2, A33-9) but still a lot of open production slots left for the current version. This is a big difference with the A32ceo and B737NG, where there are very limited if any open production slots left. For the coming years, will Airbus, Boeing and Embraer be able to maintain pricing power for the A33ceo, B777-3ER and E- 19, or will increasing price concession be required to fill the remaining production slots? Airbus has already indicated its reengined A33neo would be unbeatable because of its substantially lower capital costs, compared with the B787. The relatively modest incremental development cost of the reengined aircraft probably will allow Airbus to undercut prices of the all new B787 where the full development cost of a new type will still have to be amortised. If this scenario becomes reality, this may put pricing pressure on both the current A33ceo as well as on new B787 orders. Used equipment market With continuing peak action in the new equipment market, how did the used equipment segment fare? Here we can differentiate between largely financial transactions where aircraft change hands from one owner/manager to the other without any change in operator and transactions where there is a real operator change. While it is difficult to compile any statistics, the impression is that there is significant activity in the financial part of the used equipment market with large-scale buying, selling and swapping aircraft by investors. With abundant liquidity we have seen a significant number of aircraft managers setting up a portfolio of aircraft for new or expanding investors that are looking for tangible hard assets and yields above the ultra-low interest rates on bank accounts. Often these investors are acquiring these aircraft in the form of 12 Airfinance Annual

13 Table 16: Early and late production models Age at which first aircraft of the type/production phase went under 5% value-when-new aircraft produced during high inflation era Age DC-9-3 early B747-2B early DC-1-3 early B757-2 early B737-3 early MD-82 early B767-3ER early B737-8 early A32-2 early A321-2 early B747-4 early A33-3 early B777-2ER early B737-8 late A33-3HGW early A34-6 early A318-1 early A321-2 late A32-2 (5A/A1) late A32-2 late B777-2ER late A319-1 late MD-82 late MD-88 late A3-6R late A34-3 late A34-5 late A34-6 late B737-3 late B747-4 late B757-2 late MD-83 late small portfolios from established leasing companies, who are looking to re-balance their portfolios. While hard data is difficult to find, the general impression of one of the leading lessors is that today more aircraft are offered for sale than at any other time in history. In terms of used aircraft values, between early 213 and early 214 Ascend reported a bit of strengthening in the value of A32s and young A321s. At the other end of the spectrum, the older B747-4s, B737-3s and B737-7s suffered not insignificant value losses. The debate about aircraft economic life continued and the jury is still out. Based on historic data, one can conclude that as aircraft designs age (and new, more efficient types are introduced) aircraft value loss seems to accelerate. The so-called last off the line effect is not a phenomenon that suddenly kicks in towards the end of production of an aircraft type but rather is a gradual process caused by the creeping obsolescence of any aircraft design. The shape and angle of a value curve can only be determined at the end on an aircraft life and many types are still too young to perform such an analysis. However, if one measures how long it takes for a new aircraft to drop to say 5% of its original value, a broad range of aircraft types can be investigated. Because of a relatively high inflation environment some older jet types (early DC-9s, DC-1, B747-2B, B757-2) performed very well and it took well over 2 years to drop to 5% of the original purchase price. Under less inflationary market circumstances, early built B767-3ERs, A32s, B737-8s, A33-3s and even B747-4s took 1 to 15 years to drop in value by 5%. The vast majority of aircraft that lost value faster were late production planes, almost regardless of the type. Some late built MD-8s, A34s and even B737-3 and B747-4 aircraft lost half of their value within four to five years! While the above may seem a rather theoretical exercise, for investors and financiers that enter the market today floating in on the sea of liquidity, many of the aircraft that are delivered today and over the coming two to three years can probably be characterised as late production aircraft. Could it be that we are seeing some of the smart money selling their positions in these aircraft in the form of portfolio sales or even by selling their equity positions in some leasing companies? As indicated before, the A32 lease rates saw a noticeable (cyclical) recovery during the period January Based on appraisers data, A319s also benefited, despite this short version becoming less popular. Lease rates may have been positively impacted by the increasing popularity of the higher capacity A319 version with double overwing exit (mainly ex-easyjet aircraft). At the other end of the spectrum, B737-7s, mid age and Airfinance Annual 13

14 Table 17: Changes in current market lease rates Jan. 214 vs. Jan. 213 (constant ages) 4% 3% 2% 1% % 1% DVB Analysis Source: Ascend. 2% B Yr B Yr B Yr B777-2ER-15 Yr B777-2ER-5 Yr B777-2ER-1 Yr A Yr A33-3HGW-1 Yr A Yr B767-3ER-2 Yr B767-3ER-15 Yr B767-3ER-1 Yr A33-3HGW-5 Yr A Yr A Yr A Yr B Yr B Yr B767-3ER-5 Yr A Yr A Yr B Yr A33-3HGW- Yr B767-3ER- Yr A33-2- Yr B Yr A32-2- Yr B Yr A Yr A Yr A Yr A Yr A Yr A Yr A Yr A Yr older B777-2ERs and A33-2s saw lease rates decline. It should be taken into account that especially for older aircraft small absolute movements in lease rates result in relatively high changes in percentage. Leasing and finance markets Several changes took place in the structure of the leasing market over the past year or so. On the one hand we see some consolidation, e.g. by AerCap taking control over ILFC to create the second largest megalessor just behind GECAS in terms of the number of aircraft under management. On the other hand we see new lessors being created by a combination of experienced industry players and new equity investors. Behind GECAS and AerCap there is now a group of about 15 lessors with fleet sizes ranging from 1 to 5 aircraft. Here we find names like BBAM, SMBC Aviation Capital, AWAS, CIT, ACG, BOC Aviation, ALC, ICBC Leasing, Aircastle, Avolon, Macquarie, ORIX, CDB and Standard Chartered. While the changes in lessor names have been limited, behind the scenes a lot of changes in equity investors have taken place and more are to be expected. Avolon, owned by Cinven, CVC, Oak Hill and GIC, may change hands with China s AVIC Capital seen as a front runner (in August 214). Also AWAS main shareholder, Terra Firma, is expected to sell a part of its younger portfolio to an Asian party. Hong Kong s Cheung Kong conglomerate, controlled by reportedly Hong Kong s wealthiest man, Li Kashing, seems to be in pole position to acquire this fleet. In general it seems that the role of Asia, particularly Japan and, even more so, China, in aircraft leasing will increase. Already the market share of the Chinese lessors, such as CDB Leasing, ICBC Leasing, Minsheng, CASC and Bocomm, in the domestic Chinese market is growing rapidly. Similar to BOC Aviation, more Chinese lessors are to set up offshore subsidiaries to expand their activities to compete against western lessors in the global aircraft leasing market. While for new aircraft generating a significant lease volume may be relatively straightforward for lessors with deep pockets and ambitious growth targets, in the future the remarketing of 1 15-year old aircraft may be more challenging. A global remarketing team as well as technical skills are essential to successfully placing these older planes on second or third leases. Will the newcomers all possess these skills? While a few years ago lessors had difficulty finding debt for older aircraft transactions, that situation is changing rapidly. Similar to what has been seen in previous market recoveries, it is déjà vu all over again. Initially investors and financiers reluctantly return to the market, focusing on quality transactions, essentially new(ish) aircraft for top tier airlines. As more and more money 14 Airfinance Annual

15 Table 18: Positive finance outlook for aircraft deliveries Increasing demand and deliveries driving financing requirements US$14 25% US$112 23% US$125 US$129 US$135 US$139 14% 22% 5% 28% 9% 25% 23% 18% Cash Capital markets Lessor self fund Bank debt Export credit Tax equity RJ export credit Manufacturer Source: Boeing follows the same strategy, investment returns and debt pricing comes under pressure with alternative market segments being explored that offer better returns. The focus shifts and used aircraft and second tier operators become more acceptable as a means to reach volume targets. As the recent Castlelake securitisation has demonstrated, there is already an increasing appetite amongst investors and financiers for older aircraft. One step further on this path takes the form of a growing interest in parting out older aircraft. Increasing numbers of relatively small investors are buying older aircraft under the assumption that positive returns can be achieved by cashing the maintenance reserves and part-out proceeds of the aircraft in as-is/where-is condition after they have been returned by their last operator. Other market niches that seem to have become more attractive as alternative to the mainstream first-tier commercial jet market include the turboprop segment as well as potentially the rotary wing (helicopter) segment. As mentioned before there is no shortage of funding sources in the commercial aircraft market. Boeing estimates the market for new commercial jet financing at around US$112bn for 214, up from US$14bn estimated for 213. Further growth to a funding need of US$139bn by 218 is projected. Commercial bank funding is expected to cover 25% of the US$112bn needed in 214, followed by cash from the increasingly profitable airlines themselves (23%). Capital markets are expected to cover 22% of the finance need, but indications are that because of the highly competitive pricing of bank debt this percentage may drop a little. The same goes for export credit, which is expected to cover 18% 2%. Export credit has become more expensive as a result of the changes in the ASU rules and again bank debt has become more competitive. The current political debate in the US about the pending five-year re-authorisation of the US Export-Import Bank by Congress is interesting. This re-authorisation decision is scheduled for the end of September 214, but it is hotly debated at the moment and a stop-gap solution seems more likely than a straightforward extension. While only a few years ago any interruption of Ex-Im financing would have had a major impact on the industry, under the current circumstances this may be less likely. Several lessors have indicated that they do not expect any major negative consequences should Ex-Im not be re-authorised. Maybe there is a bit of self-interest in this and the position probably will change rapidly in case of another financial crisis. Lessors are responsible for about 9% of the US$112bn market for new aircraft financing, about US$1bn. This is the amount self-funded by the lessors. On top of this US$1bn, lessors use bank debt, capital markets, etc. to fund their purchases. In terms of regional shares, where is the money actually coming from? The increasing importance of Asia China in particular is not only noticeable amongst leasing companies. Chinese banks are expected to be the biggest aircraft financiers in 214, providing 23% of all bank debt. While initially focused on their own domestic carriers, Chinese banks are rapidly turning into global players. Japan takes second place with 2%. The market Airfinance Annual 15

16 shares of German and French banks are under pressure and now only provide 17% and 16%, respectively. In 211, German and French banks still had a market share of 58%! It is remarkable how fast the financing landscape has changed. However, will all the newcomers still be there when the going gets tough again? Outlook It is always difficult to point to the peak in any business cycle. Short term it seems all indicators for the commercial aviation business are still green. It seems however as of August 214 our industry is an oasis of relative stability and prosperity amidst a world where many destabilising factors can be identified. The conflict in the Middle East between the Islamic State and the Kurdish and Iraqi troops has the potential to drag western countries into another war or to trigger an increase in global terrorism. The increasingly dangerous situation around Ukraine has the potential to get out of hand and, in Africa, Ebola seems to spread more rapidly than initially anticipated with some countries already closing their borders. Any of these situations may turn out to be either irrelevant by the time this article is printed or could develop into a global crisis. Limiting ourselves to the aviation business itself, the first half of 214 has seen a continuing robust growth in the passenger markets. Global demand increased by 5.9%, exceeding the capacity increase of 5.6% and resulting in higher passenger load factors. There are no reasons to assume this situation will turn around short term as global economic growth continues. Even the black sheep of the aviation family, air freight, has experienced a modest growth of 4.1% in the first half of 214, outstripping the 3.6% capacity growth over the same period in 213. With the expected launch of several new products in the consumer electronics market in the second half of the year, air freight should continue to recover, at least volume wise. Air cargo yields probably will continue to be under pressure as a result of the surplus main-deck freighter capacity and the growing bellyfreight capacity of the new generation of twin-aisle passenger jets. While on the macro-scale the industry is doing well, not everybody is benefiting. Some major airlines have already been rescued by their governments by a (partial) take-over. The big Middle East carriers are continuing their double-digit expansion and are putting even more pressure on the established flag carriers in Europe and Asia-Pacific, who are struggling to stay in the black. With strong Middle East competitors in part of the long-haul network and aggressive low-cost carriers (LCCs) attacking the short-haul routes, many European flag carriers have to re-invent themselves to survive. 214 has already seen some new initiatives including the launch of LCC-subsidiaries by the established flag carriers. The need for action is all the more urgent as another round of LCC initiatives have been announced, but now on the long-haul network. In the growing Asian market, the local LCCs are expanding rapidly as well, but in that region it seems some of the entrepreneurs behind these airlines have been a little too optimistic regarding the pace of expansion. Overcapacity seems unavoidable and it remains to be seen if the idea of establishing an airline controlled aircraft leasing company to cope with this problem has any long-term viability. Despite continuing strong growth Asia-Pacific no longer is the epitome of stability it once was. Ironically enough, this role now seems to have been taken over by North America. Maybe for the first time since deregulation and with thanks to Chapter 11 there seems to be a kind of equilibrium in that market. After the wave of consolidation, now only a handful of larger carriers control the market and it seems none of them are planning to rock the boat. Only a few years ago, who would have thought that with oil prices around US$1/BBL and market growth of just 2% 3%, the North American airlines would be able to show record profits? So, given the relatively strong condition of the global airlines, what can we expect in the aviation equipment market for the rest of 214? With a record backlog for commercial jets and a strong order intake for the first half of 214, it seems not much can go wrong here either. Aircraft manufacturers cannot build the current designs fast enough and almost any new design launched into the market is met with great enthusiasm by airlines and lessors alike. In 213, the Embraer E2 series, the Boeing B787-1, B777X and in 214 even a simply re-engined A33neo immediately found enthusiastic buyers, leasing companies as well as airlines. Obviously there are many reasons for this bullish market environment. First of all, the new aircraft designs promise between 1% and 15% better fuel burn, which with oil around US$1/BBL should make a significant difference in operating cost levels. While most of the new designs are more expensive to purchase vs. their predecessors, the low interest environment as well as the ultra-competitive finance market ensure that operators still can afford these new toys. From a financial perspective, with abundant liquidity in the world economy, investors are looking for yield everywhere. Commercial aircraft have done relatively well during the past crisis and now form an attractive asset-class for investors. While saleand-lease-back transactions are attractive short-term solutions for a liquidity surplus, within the range of existing aircraft types not too many opportunities are left to take a longer term position without becoming a me too player. A new aircraft type often is a good opportunity to establish a position in a not yet too crowded market segment and offer an attractive growth perspective to established or new equity investors. Is the industry over-ordering because of the above? As it is difficult to predict the demand side of the business, this question is difficult to answer. None of the major manufacturers are building any white-tails and actually most claim they are overbooking orders, assuming some orders will be deferred or cancelled anyhow. Given the favourable characteristics of the new technology aircraft (including OEM cost-guarantees with respect to fuel burn and maintenance) it looks like none of these hi-tech planes will end up in the desert. Where we do see some potential clouds on the horizon is for 16 Airfinance Annual

17 the current generation equipment. Unless we indeed are now experiencing what has been called a supercycle in the past, it is hard to imagine a continuous demand growth for the coming decade. History has shown that the availability of superior new technology aircraft with stagnant demand can be a lethal combination for aircraft values. The resulting capacity surplus will result in the retirement of the aircraft with the highest operating cost, meaning the older generation. The historic value curves of late production B737-3 perfectly illustrate this. So summarising the above, our market outlook from the point of view of the business cycle is still positive, albeit external factors such as Ebola and the Ukraine or I.S./Iraq conflicts have the potential of spinning out of control. Within our industry, the ultra-competitive LCC market in Asia as well as the competitive pressure from the expanding Middle East carriers could eventually cause some airlines to default. While under favourable market circumstances the market probably will be able to absorb the huge number of new aircraft that are ordered today, any normal cyclical downturn could upset this comfortable equilibrium and result in overcapacity. Our main concern is the potential impact of the significant technological change that is taking place. A large fleet of relatively new (in years) aircraft of the current generation often referred to as the last of the line aircraft may soon be outdated by a 1%-15% more efficient new generation. While late production aircraft traditionally have experienced significantly steeper value curves, any market shock resulting in lower or negative traffic growth could trigger a large-scale value correction. Yes, the skies are blue but exposure to too much sunshine is a dangerous thing. Note: 1 Data source: Ascend. This article was written by G. (Bert) van Leeuwen, Managing Director, Aviation Research, DVB Bank SE, WTC Schiphol Tower F 6th Floor, Schiphol Boulevard 255, 1118 BH Schiphol, The Netherlands. Tel: Fax: Bert.van.Leeuwen@dvbbank.com. Website: DUBLIN BELFAST LONDON NEW YORK SILICON VALLEY We bring a wealth of experience to support our clients in developing unique solutions. Excellence means securing your success with arthur cox you can expect sound judgment and advice. You can expect in-depth sectoral expertise that will find new solutions to secure your success. You can expect a total commitment to your business a genuine partnership that gives you the confidence to move forward and embrace new opportunities. With Arthur Cox you can always expect excellence. To find out how we can assist your organisation please contact Caroline Devlin, Partner, Head of Aviation Group, on: Expect Excellence. Airfinance Annual 17