Longer term trends for jet values and rates November 2011
Aircraft values have generally managed to regain some of their losses incurred during the recession over the course of the last 18 months but sufficient weakness in the market remains as to dissipate some of the optimism.
To some extent there currently exists an element of disconnect between the strength of the air transport structure and the wider economic climate. The extensive order book, rising production rates, increasing traffic levels, and limited availability of newer aircraft are all serving to indicate that the market recovery is in full swing. Load factors, while variable, are sufficiently strong, to ensure that airlines are able to maintain yields.
While there continues to be speculation that AMR will enter Chapter 11 to address its underlying cost structure, such a move would not likely have any impact on values, contrasting with a decade ago when a number of US airlines entered bankruptcy.
American has already announced that it will cut mainline capacity by 3% in the final quarter of this year. With a fleet of some 700 aircraft, should the 3% be directly translated into a reduction of the fleet this would equate to only some 20 aircraft. The carrier has already announced that it will seek to retire 11 757s during the course of 2012 but has also recently announced significant orders with both Airbus and Boeing for the A320neo and the 737MAX.
Entering Chapter 11 may result in further contraction of the fleet. The carrier operates more than 120 757s and the retirement of a number of them has been expected for some time though withdrawal would be over a number of years. American Airlines also still possesses some 200 MD82s and MD88s, none of which are in service, and these are already set to be replaced with re–engined derivatives.
The 777–200ER fleet is significant and these are ageing as are the 767–300ERs. These may be considered targets for replacement in the coming years though this will take time. Such is the diversity and size of the worlds fleet that the contraction of one of the US majors no longer has such an impact on the level of availability. While wider confidence in the market may be affected by AMR entering Chapter 11 still a possibility rather than a probability values will only be impacted by the disposal of a number of aircraft in a short space of time. The fleet contraction of Japan Airlines only had a temporary effect on 747- 400 values, for example.
In contrast to previous recessionary periods, problems being experienced by a few airlines no longer impinge on the market as a whole. However, the short–term difficulties of the global economy need to be taken into account in terms of the recovery of values. With the expectation of problems over the next few months, values are likely to remain stable rather exhibit any further rise.
The need for financial institutions to be cautious in valuing assets, both for existing equipment and for new deals, has made the acquisition of used aircraft that much more difficult. While sale and leasebacks, transactions between lessors, the acquisition of lease portfolios or investments in newly formed leasing companies are able to secure funding, selling or buying a six–year old aircraft with no attached lease is difficult. Available funding is being channelled to deals involving ECA (Export Credit Agency) backed transactions or Japanese Operating Leases (JOLs) which usually involve new aircraft. Lease rentals have improved slightly but competition among the growing proportion of the fleet owned by leasing companies means that rates remain competitive, thereby limiting opportunities for value improvement. In the case of narrowbodies there is increased awareness that aircraft that may be popular today, will not be in ten years time. This makes it necessary for pricing of used aircraft to be conservative. The limited improvement for new aircraft values translates into a fall for used aircraft, though any fall needs to be placed into the context of a normal five percent decline in value associated with straight line depreciation.
Consistency of cycles
Cycles, in terms of aircraft values, are not consistent in terms of form or duration. As the market is dynamic in nature, with constantly changing variables and relationships, drawing exclusively from historical data is fraught with danger. Cycles do not necessarily exhibit a peak but rather may feature a plateau.
Similarly, a trough may not be represented by the classic V but rather by an elongated period of uninspiring value behaviour. Despite the difficulties of extrapolating the past into the future, the current cycle is showing some consistency with past events though the extent of the recovery will be more constrained due to differing market conditions.
Some data points may have shown that the peak of the previous cycle occurred in 1Q 2008 but such data is usually already out of date by the time it becomes available. While a sale figure may be agreed, documentation can take months to complete. Only then does the data enter the public domain, thereby creating a data lag of approximately three months.
Consequently, the previous peak is considered to have occurred in 4Q 2007. By the time values reach the trough towards the end of this year, three years will have elapsed from the peak. Previous cycles provide a clue rather than certainty to future events. The collapse in oil prices in 1986 saw rapid economic recovery.
The increase in traffic, particularly in the international arena, was compounded by a shortage of capacity as manufacturers struggled to bring new aircraft such as the 747–400 and MD11 into service. The cyclic peak of 1990 saw values of DC10–30s nearly doubling within two years but another eight years were to elapse before the market saw a full recovery although the Asian Crisis caused some further problems. The low point for values was reached in 1995, a cycle notable for sustained production rates during the worst of the crisis. Not until 1996 did delivery rates drop to a low point as manufacturers sought to enforce severe penalty clauses on customers considering order cancellations.
Maintaining pre–downturn production rates during a market decline can delay an upturn.
However, during the early 1990s production rates, expressed as a percentage of the total fleet, was in excess of 6% compared to some 5% today. Production rates should perhaps be more compared with fleet size rather than absolute production levels although utilisation levels have generally increased. Values finally reached a plateau in 1998 rather than a peak during this cycle before starting to decline in the months preceding September 2001.
A three–year period elapsed between September 2001 and the subsequent low point for values, though the actual low was in late 2001 (when placing any value on aircraft was a theoretical exercise in view of the absence of market activity). There were however, already indications that values were starting to erode before September 2001. The subsequent problems associated with SARS and Bird Flu prevented a more rapid recovery during this cycle. Another three years were to elapse from 2004 through to 2007 before the peak in values was next recorded.
Although each cycle and each recovery period is different, a peak or plateau appears between three to five years after the cyclic trough. The current cycle has the potential to be of average duration e.g. six years elapsing between peaks. Recovery is expected to have reached a peak in 2013. Manufacturers are showing their willingness to meet demand for new aircraft despite a rise in storage levels.
Values of older aircraft — the first and second generation Chapter 3 aircraft are therefore the most exposed in this cycle. While newer aircraft are more favoured, market conditions will make it difficult to contemplate a significant increase in value. The development of updated narrowbodies will make the current range of aircraft less attractive even if lease rentals rise to compensate for lesser residual values. The best that can be expected is for values to exhibit a similar plateau as in the late 1990s. The introduction of new widebodies (787 variants and the A350) will make it difficult to justify an increase in values of existing widebodies in view of their imminent replacement. The introduction of new models may cause operators to delay placing new orders thereby leading to shortage but in such an event, there will be a surplus of older equipment available to fill any void on a temporary basis.
Lease rentals were starting to register a rise at the end of 2010 but such increases — apart from some widebodies — has lost momentum more recently in the face of low interest rates. In the four years since the peak of 2007, lease rentals have fallen by more than 20% for those aircraft in production and to an even greater degree for many older examples. The fall in rentals is partly due to the fall in interest rates. The lessors had generally managed to retain their 15- 20% margins during the recession but these margins are now being eroded as new deals at lower rates are secured. Nonetheless, in contrast to previous downturns, the lessors have been faced with fewer calls for renegotiation of existing leases and instead have preferred to take aircraft back and lease to other carriers. This is because the market structure has experienced a significant change -the stranglehold of the major carriers has been broken. There now are a myriad of operators around the world for whom leasing is the only means of acquiring aircraft.
Lessors are no longer dependent on a few operators. Lessees are less able to renegotiate existing agreements because lessors are able to lease elsewhere, even if subsequent rentals to other lessees have had to become more realistic.
A problem for the lessors is that the maintenance of operating revenues has been at the expense of leases agreed before the recession. As these leases continue to expire, there has been little opportunity to place aircraft at the same levels with either existing or new lessees, undermining revenues. If all aircraft currently possessed by the lessors were re–leased at current market rates, the lessors would inevitably report losses rather than profits. Nonetheless, the proportion of premium grade leases will continue to be eroded during the course of the next year. The lease rentals of older aircraft are only likely to experience a sizeable recovery due to shorter terms to the less financially secure operators.
The levels of availability continue to show relatively modest levels which can distort the perceived strength or weakness — of the market. The number of aircraft actively being marketed today would seem to be at lower levels than during the depths of the market in 2002–2003. With a current fleet of some 20,000 jet aircraft, the 650 being advertised at the beginning of this year represents less than 3.5% of the fleet, suggesting a measure of equilibrium between supply and demand.
But owners are simply not advertising aircraft because of the lack of demand, while others are undertaking direct re–marketing. The real level of availability is therefore much higher. The relevance of parked or stored aircraft to used value behaviour has lost its significance as aircraft have reached the end of their service lives rather than be prematurely consigned to the parking lot. While the number of narrowbodies in storage has increased between the end of 2009 and 2010, the widebody total has experienced a significant reduction from just under 400 to approximately 300. The recovery in the fortunes of the widebody fleet is due in no small part to the delay to the service entry of the 787 and the expansion of Asian markets, which require widebody capacity.
MAX and neo
Boeing has finally made a decision on re–engining the 737, which inevitably raises questions as to how far values of the existing A320 and 737 aircraft will be impacted. The 737MAX, a designation that perhaps suggests that the latest iteration maximises the remaining opportunities of the 737 before having to opt for a clean sheet design, ends months, if not years, of speculation regarding the future of the 737. Service entry is scheduled for 2017, two years after the A320neo.
Discussions concerning the next 737 have been ongoing for perhaps a decade or more, only recently taking on a more concrete form as Airbus opted for the A320neo. The re–engining of the 737, like the A320, is a compromise and further development will need an all new structure. The selection of the CFM56 as the sole engine comes as little surprise. CFM previously contributed a sizeable portion of the development cost of the 737NG in return for sole status suggesting that a similar $1 may be in place for the 737MAX.
Inevitably, the re–engining of the 737, as with the A320neo, will result in compromises.
Boeing indicates that the 737MAX will be more efficient than the A320neo but much depends on the assumptions used. As with any operating cost calculation, much depends on the parameters of the individual operators and both manufacturers employ airline analysts to assess actual operating costs on individual routes for prospective customers. Both the A320neo and 737MAX have similar operating efficiency today, consequently, the duopoly that exists will likely persist into the next decade with each manufacturer securing an approximately equal share of the spoils. The 496 commitments announced for the 737MAX suggest healthy interest in the Boeing upgrade. Being second to launch after a period of dithering is not necessarily a disadvantage.
The launch of the 737MAX is expected to cause some anxiety for those with an interest in asset values of the existing A320 and 737NG family members. Historically, values of an existing product line have been adversely affected when a replacement aircraft has been launched though the major part of any decline has been more notable in the period immediately before and after the service entry of the new programme.
The degree to which values of existing products will be impacted depends on the operating cost differential. A double digit improvement in fuel efficiency does not lead to the same reduction in overall operating costs. On shorter sectors the fuel component of direct operating costs is that much less than on long–haul. The capital cost of acquiring new aircraft will partially outweigh the fuel efficiency improvement.
The launch of the A320neo has set the scene for the behaviour of values of existing equipment. While backlogs are long, there will be little appetite for customers to pay more for existing aircraft particularly as the service entry of the new products approaches.
The service entry of the first A320neo is now only four years away. There will likely be an opportunity for values of new aircraft to be delivered this year and next, to register a modest improvement as a result of exceptional demand but thereafter, there will not be any impetus for a rise. The value of a 737NG delivered in 2015 is therefore likely to be the same, if not less, than the value of a 737NG when delivered in 2013.
Once the A320neo and 737MAX enter service, the values of these products will likely remain stable in the short term due to limited availability. An approximate US$3–4 million differential in the capital cost will not be sufficient to prevent deterioration in the value of the existing product. Aircraft being delivered will likely be used just as much as replacement as growth capacity and will therefore displace existing equipment. A higher price of fuel will accelerate this replacement process thereby causing values of existing products to fall that much faster. The expected future decline in values of existing products needs to be seen in the context of prevailing forecasts.
Many future value projections will have already compensated for the introduction of a re–engined aircraft. Consequently, the service entry of the new product has already been compensated. The danger lies if the existing future value forecasts for the existing 737NG is reduced still further simply as a result of investor anxiety. There will however, be some forecasts that have failed to see a reduction in future values in the coming years because of current demand and it is these that may need to be adjusted downwards.
By the end of this decade the product lines of the manufacturers will have undergone a radical change causing long–term market values of current types to experience significant change. The technology offering significant improvements in efficiency in the narrowbody segment may seem distant but ten years ago production of the 737–300 had only just ended, the E–Jets had yet to enter service, the four engined A340–600 was under development and the trijet MD11 was still being produced.