As the New Year gets under way, it’s time to reflect on the year just gone, give some thought to what the next 12 months may have in store and make a few New Year Resolutions.
2011 was another of those sporting clichés, a year of two halves. It started promisingly, with strong traffic growth in most regions coupled with good capacity discipline and a sense that economic recovery was under way. In fact, a good deal of that early growth was the tail end of a rebound from the steep declines that followed the 2008/09 financial crisis. Consequently, the pace of recovery slowed as the year advanced. The reversal was especially swift in the air cargo market, a leading indicator of the fortunes of the wider industry and by mid-year, as passenger growth was slowing capacity was also starting to increase more rapidly, outpacing demand. This shift, compounded by weakening premium traffic performance, put pressure on yields, which were also being eroded by oil prices that remained stubbornly high and above 2010 levels throughout the year. Further pressure came from the market disruption that followed the events of the Arab Spring and, later in the year, the widening ripples of economic turmoil stemming from the Eurozone.
Nevertheless, 2011 will have been kinder to the airline industry than the recent narrative would suggest and, whilst IATA’s latest forecast of a $6.9bn collective net profit may yet prove optimistic, a positive outcome remains likely. This is just as well, since the rate at which capital is invested in new aircraft deliveries continued to increase, with Airbus and Boeing together delivering over 1,000 aircraft during the year, both slightly ahead of their 2010 totals. With net orders well over double the numbers booked in 2010 (thanks principally to Neo and Max), production backlogs have remained close to their record highs, although an increasing proportion of orders is scheduled for delivery a decade or more in the future. In the deteriorating economic environment, fleet replacement trumped network growth in respect of where the majority of deliveries have been deployed, but average load factor has nevertheless fallen back from its peak, underlining concerns that production is already too high.
The financing of these deliveries was once again split broadly three ways between commercial lenders, lessors and the ECAs, with the latter again supporting record deliveries. A welcome resurgence in commercial bank participation at the start of 2011, when a number of new as well as some familiar names (re-)entered the aviation space, has since been overtaken by events in the wider financial markets, with funding liquidity levels and costs moving in divergent and unwelcome directions in the closing months of the year and several lenders exiting the sector.
This, along with the wider economic environment, is a key focus of the industry as we head into 2012. Reduced liquidity, lenders’ flight to quality, more restrictive debt terms and the return of liquidity premiums are already evident, putting those airlines and lessors with large-scale near term financing requirements under considerable pressure. It appears highly unlikely that there will be any swift resolution to the Eurozone debt crisis and, by extension, the deep-rooted problems faced by the mainly French and German banks that have long been a mainstay of aviation financing. There’s little point in debating what may or may not develop in the coming months in respect of the sovereign debt challenges faced by Greece, Italy and others, or of the future of the Euro itself – the answers are simply not knowable at this point. What is very clear, though, is that 2012 will see fewer “old dependable” lenders able to conduct business as usual, due to a combination of Eurozone exposures, Basel III and US dollar funding pressures. New entrants from various backgrounds will emerge, in North America, the Middle East and Asia, where, for example, Japanese aviation financiers are awakening from decade-long quietude to again become important sources of liquidity alongside other increasingly active banks and lessors in the region. Nevertheless, the risk of a funding gap is real, even allowing for the ECAs, which are prepared to underwrite further record levels of lending for the industry, since the question of whether the bank market will have the depth to write all of the business that the ECAs can support will only be answered with time. For the ECAs, 2012 represents a final surge before returning to their former role as lenders of last resort when the new ASU comes into force in 2013. For the coming year, they will not only be directly supporting airlines but also much of the lessor community, which is expected to increase its contribution to market liquidity in 2012, taking up around 35% of the forecast $90bn total required to finance new deliveries.
The airlines will have as great a need for external financing as ever, given that they are most unlikely to see anything other than a deterioration of their financial performance in 2012. For the first time, IATA has presented two industry forecasts for the year, one as a baseline, the other showing a downside “banking crisis” scenario. Their net profit forecasts range from +$3.5bn to -$8.3bn and it is not hard right now to imagine a scenario where the lower figure prevails, since the most optimistic resolution of the Eurozone crisis will not avoid another recessionary period in Europe. Even at the higher end of the range, the net margin of 0.6% is woefully short of the level required to sustain independent re-investment and growth. Faced with this embedded weakness and exposure to economic and market volatility, it is likely that 2012 will see some airline failures, with an acceleration of consolidation and M&A activity, especially in Europe, providing an alternative fate for some and growth opportunities for others. As always, it will remain much harder to exit the airline business than to enter it.
The manufacturers will need to maintain their vigilant watch on near-term delivery skylines as, although the overall number of aircraft deliveries in 2012 is likely to be close to the levels already announced, slot deferrals and accelerations will be prevalent. In the event that financial and economic issues remains unresolved, or deteriorate further, the OEMs will also have to revisit their plans for further increases in aircraft production. Last year’s net orders conceal the cancellation of more than 250 firm aircraft commitments and, as financial pressures mount, more cancellations and deferrals will be sought for future years, leaving gaps in the skyline sufficient to negate one of the core arguments for higher output. White-tails still remain a distant and low level threat, but could become a reality in such circumstances unless the manufacturers reconsider their production plans. Beyond 2012, the reduction in ECA support could also exacerbate the situation if the commercial bank market has not spooled back up by that time.
Aircraft market values took a step back during the course of 2011 after a period of recovery and convergence towards base values. Until the broader markets show signs of improvement, it is likely that market values will remain lower than they would have been had the cycle not been interrupted. Whilst this will lower the near-term returns for sellers of aircraft, it also extends the investor window of opportunity for well-priced acquisitions, which is further enhanced by the expedience for airlines to conserve cash thereby driving them to greater reliance on lessors to provide liquidity. It remains the case that investing in aircraft generates reliable and less volatile returns than most other asset classes through the cycle.
The point has frequently been made that uncertainty and volatility create opportunities to those who are positioned to exploit them. This definitively remains the case heading into 2012, both for airlines and lessors – the former will be rewarded if they have the lowest costs and a strong balance sheet, the latter will benefit from having “through the cycle” shareholders and identified sources of financing to meet existing commitments and support further acquisitions.
So to the New Year Resolutions, which are written from an operating lessor’s perspective.
Maintain close and open relationships with existing lenders and constantly seek to widen the circle through frequent interaction with the financial markets.
Raise the level of intimacy with existing customers, from both marketing and credit risk standpoints. All airlines are facing into a headwind and the industry has become riskier; make sure that credit risk is properly assessed and mitigated. Be mindful of new opportunities or new ways to provide support.
Make sure that the market is paying an appropriate price for the risks being taken. In the current environment it’s not reasonable or prudent to take open risk on interest rates or liquidity costs
Continue to impress on the OEMs the importance of production discipline in maintaining aircraft values and work creatively with them and the airlines to facilitate deliveries.
Be hungry, but not greedy. Embrace opportunities confidently and maintain a long-term view of the investment horizon.
Stay focussed – don’t let near-term pressures divert business from longer term objectives