Dark clouds loom over fleet financing and why that matters for Indian airlines

Leasing remains the dominant method for airlines to acquire aircraft. This is especially true for Indian airlines.

Up to 80 percent of the current commercial aviation Indian fleet is leased. Compare this to the global average of around 41 percent.

The reasons for this are due to an asset-light model, cash-flow considerations and also the favourable financing climate. Until recently, credit markets were very liquid with low-interest rates, high competition and high demand. This made for an attractive financing environment where airlines were able to have banks, lessors and even manufacturers compete and get extremely good financing offers.

However, this may not be the case for long. Interest rates are rising with LIBOR up 26 percent, geopolitical dynamics are more complex than ever (Brexit, the situation in the Middle East, the slowdown in key Latin American economies and the US-China trade tensions), currency fluctuations are at an all-time high and there is consolidation in the lessor markets as well. All of this combined is making for a tighter financing environment going forward.

The players in the aircraft financing and leasing market continuously evaluate risk and the risk premium for Indian airlines is trending higher. This comprises of default risk, a country’s acceptance of the Cape Town Convention (which provides remedies for default), and also precedence.

Indian airlines in the past witnessed an increase in risk premiums after the collapse of Kingfisher Airlines and it took several years to rebuild confidence. Unfortunately, given the collapse of Jet Airways, several are already drawing equivalence as reflected in wary creditors and lessors. The weak sectoral balance sheets (with one exception) are not helping either. The outcome: an increase in overall lease costs and in collateral requirements.

For Indian aviation, this poses an immediate challenge. Because in a price-driven market each element of the cost structure matters and competitive aircraft financing and lease costs are critical to success. Airlines have to follow the mantra of Steven Udavar Hazy, a legendary aviation CEO who said:

It is not only what you pay for the aircraft, it is also what you pay for the money to pay for the aircraft.

India is forecast to be third largest aviation market globally by 2030. To capitalise on this growth airlines have placed voluminous aircraft orders and there are 1000+ aircraft on order.

This number is significant as it is more than double the existing commercial fleet in India. To absorb these orders, airlines continuously evaluate methods of financing. Traditional sources have included leasing, commercial banks, export credit agencies and at times even the aircraft and engine manufacturers. But increasingly one model is emerging as a cornerstone of fleet financing, namely: the sale and leaseback.

A sale and leaseback model (SLB) is where the airline acquires the aircraft at an attractive price and sells the aircraft to a lessor (usually at a profit) and leases it back for its own use. The SLBs are important as they are cash generative and also help airlines with fleet flexibility.

The flip side is that airlines are left with asset-light balance sheets, over time they end up paying more for the asset and in the case of operating leases lose out on the depreciation cover. And to be sure, not all SLB transactions are profitable.

Indeed if the liquidity on the asset takes a hit, airlines may actually have to engage in SLBs at a loss.  But for now, the SLB markets are holding up well and airlines that have the options are making good on SLB transactions.

The SLB model depends on liquidity on the aircraft type which is usually driven by supply and demand and the ability of a lessor to place these aircraft with a number of airlines during the life of the aircraft. With the Airbus 320 and the Boeing 737 being widely used, these are highly liquid aircraft and thus lessors have had no hesitation in financing these aircraft.

Yet with the 737Max8 grounding an interesting short to medium term trend has emerged where there may possibly be a supply-demand imbalance leading to a lower SLB premium on the fleet type. The consequential impact on liquidity, cash-flows and even profits are significant.

As Indian aviation continues its ascent, the demands for financing by Indian airlines will only grow. For the financing and leasing market to perform well, several factors have to align. This includes strong demand for aircraft, diverse sources of funding, stable EBITDA, an in-depth understanding of the sector and solid airline fundamentals. Other than a strong demand for aircraft, India lags in most of these measures. Significant turbulence is forecast ahead for the fleet financing environment.

Satyendra Pandey is the former head of strategy at a fast-growing airline. Previously, he was with the Centre for Aviation (CAPA) where he led the advisory and research teams. Satyendra has been involved in restructuring, scaling and turnarounds.