As investors sought diversity, aircraft emerged towards delivering consistent returns and grew to be a very attractive asset class. With strong fundamentals including 4.9 billion air trips in 2019, forecast growth in emerging markets and the mobility of aircraft, sky was the limit. The number of aircraft leasing companies grew exponentially. As of 2019, the top 30 aircraft lessors owned approximately 12,200 aircraft and the lessor portfolio totaled $336 billion. A variety of factors ranging from production rate to demographics to capital flows, aligned towards generating strong investment returns. The pre-tax margins ranged from 18 percent to as high as 35 percent. Profits flowed in, until a 120 nano-meter particle that is everywhere now spelled doom and changed everything all at once.
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The stability of cash-flows now replaced with "rearrangement" requests
Stable cash-flows are attractive to all investors. And aircraft leasing provides just this. Aircraft lessors lease out airplanes for use to airlines and the cash-flow is secured via monthly payments. Not only for the use of the aircraft but also via monthly payments for the maintenance costs. Add to this deposits and final dues and it sums up to a very attractive proposition. In exchange for monthly payments airlines are granted use of the aircraft which in turn is deployed towards earning revenue for the airline. And since the asset is the core to the airline, this translates to the stability of cash-flows.
The cost of the asset (read aircraft) is usually recovered during the first lease term which ranges from eight to ten years. At this stage the asset still has more than half of its life remaining. Future leases thus became extremely attractive and accretive. Finally, at the end, the aircraft is sent to be torn down where parts that can be salvaged are removed. This too is cash accretive.
As long as airlines were operating a stable schedule and clocking in revenue, the aircraft continued to be serviced with monthly lease payments and supplementary rent payments. This made for excellent stable cash-flows. In better times leasing firms in addition to placing aircraft with airlines around the world, also engaged in aircraft trading towards rebalancing their fleet portfolio. There was no looking back.
But the last nine months have changed the very foundations. Airlines are now sitting on large fleets with limited deployment possibilities. Forex fluctuations are leading to increasing outflows. With fuel price forecasts, the capital costs of new assets are being constantly weighed against the utility of older assets. Renegotiation, restructuring and repricing are what the airlines are pushing for. The stability of cash-flows has been replaced with “rearrangement” requests,
Supply demand mismatch leading to declining aircraft values
Two years ago, airlines were clamouring for new aircraft but the OEMs (mostly Airbus and Boeing) slots were booked solid. To get a new aircraft – you essentially had to wait in line. Airlines that required aircraft had no option but approach the leasing market. Even airlines that had placed large orders counted on leasing firms to help finance them with the sale-and-leaseback mechanism.
But with restrictions on flights, quarantine measures and extremely weak demand, the demand for aircraft has seen significant imbalances. This now has a direct impact on aircraft values.
Aircraft values have declined across the board. Most impacted are widebody airplanes such as the Boeing 747, Airbus 380 and the Boeing 777ER. Newer orders for airplane types like the Boeing 777X and A330 NEO are few and far between. Even the most popular aircraft types namely the Boeing 737 and the Airbus 320 are facing pressure on value retention and witnessing value erosion.
For India’s airlines that are collectively sitting on 900 aircraft orders, this is of particular significance. Because declining values directly impact cash-flow and other covenants. Add to this the fact that several airlines were using financing income as a means of working capital and it does not bode well for investor confidence.
Ample liquidity but airlines’ ability to pay in question
With aircraft being multi-million dollar assets, financing of these assets is critical. In better times, this is no challenge since the aircraft is a very mobile asset and serves as collateral. But as Steven Hazy the CEO of Air Lease Corporation and a pioneer in the aircraft leasing business states, "It’s not only what you pay for the asset, it’s also what you pay for the money to pay for the asset."
With the money secured by underlying asset coupled the debt servicing via the stability of cash-flows, lessors were able to raise money at very competitive rates. The spread between rates offered to a lessor versus that obtained by an airline could range between 7% - 9% depending on the credit quality. Complex structures further helped mitigate risk. And because of this, several airlines continued to fly with inadequate equity. Shareholder guarantees, charge on assets and intangibles were used as collateral – all of which have lost value.
But now the viability of these structures is in question, due to the inability of airlines to furnish rent payments. Without this the entire structure falls apart.
Also read: Diminished cash-flow and exhausted credit: India’s airlines are on the edge of a precipice
Ironically, investors are looking for avenues to deploy cash and there is ample liquidity. But when assessed against default risk of airlines, the risk-return profile simply doesn’t hold. Not only that, the secondary market – that is a sizeable base of airlines that are comfortable with using older assets – has also seen significant challenges. Traditionally the market was very strong and demand for aircraft came from diverse regions. With the pandemic, both primary and secondary markets are impacted.
This leaves airlines with outstanding orders and inadequate investor confidence in a precarious position. It is not only the ability to induct the orders but also the ability to finance these orders and subsequently fly profitably. And if that wasn’t bad enough, the price escalation can lead to non-competitive capital costs. Further, several airlines are rethinking contractual commitments given that the need of the day is to shrink the fleet and conserve cash. Together these elements are making for the perfect storm.
The flight path ahead is turbulent
As far as India’s airlines are concerned, until the volumes return which then impacts the airline’s ability to pay or a semblance thereof, the ride ahead promises to be very turbulent. Credit quality stands eroded and asset light balance sheets have led to a situation where there is simply no collateral. Asset financing solutions are few and far between.
For India's airlines, local solutions for asset financing continue to be overlooked due to the sheer complexity of the issue. Yet mitigating measures are available and deliberate decisive measures can help structure solutions. That though remains a project in itself.
In the last decade investors came to appreciate aircraft as an asset class, and capital flowed into the sector. But as Walter Wriston the former Chairman of Citicorp famously stated, "Capital goes where it is welcome and stays where it is well treated." With diminishing returns, uncertainty on cash-flows and consequential impacts across the value chain, when it comes to aircraft as an asset class, investors are found wanting for solutions.