Airfinance Annual 2011 – Industry Review and Outlook
By Dick Forsberg, Head of Strategy
2010 saw strong recovery in both passenger (+8%) and cargo markets (+21%), with passenger numbers continuing in the same vein through the first half of 2011, although cargo growth has slowed. Now capacity has started to rise again, in some markets already out-pacing demand and putting pressure on yields, which should be moving in the other direction to compensate for oil prices that are unwilling to stay below $115 (Brent crude). Following their best financial performance in a decade in 2010, the airlines are on course to make a meagre $4bn this year, according to IATA, whose Director General’s view of 2010 was “a pathetic margin of 3.2%”. During the course of 2011 we have experienced oil price spikes, natural disasters in Japan, unrest in the Middle East and another volcano, this time in Chile. We have also seen record ordering of the Airbus A320neo, Boeing’s eventual response and escalating production rate targets for both single and twin aisle types. Impending changes in aircraft fleets extend beyond the single aisle sector to include next generation wide bodies and an up-scaling in the large regional jet sector. With new rules for export credit support and several lessor platforms on the market, change is also afoot in the financial markets, which will be asked to support more than $250bn of new deliveries over the next three years. Yet constancy of capital is still not guaranteed, with several aerospace banks exiting the market again even as others come back in. Wider global uncertainty in both economic and financial markets adds to the confusion, with developed market sovereign default concerns at the forefront of ongoing volatility.
According to ACI, global passenger numbers exceeded 5 billion for the first time in 2010. Whilst traffic volume does not automatically confer profitability, by the end of 2010 the airlines were looking in pretty good shape, although their aggregate numbers hid considerable regional variation. Overall, the industry (represented by the IATA membership) earned a record net profit of $18bn in 2010, on revenues of $550bn. Total revenue increased by 15%, off an 8% increase in passenger numbers and 5% higher yield, with freight volumes up 12% and yield strengthening by 22%. However, as IATA’s outgoing DG pointed out, these results continue to represent the slimmest of margins and fall well short of the levels required to support future growth. Much of the industry’s strength remains concentrated in emerging markets, with developed regions turning in lower levels of growth and profitability (Chart 1).
IATI Airlines 2010 Profitability by Region
European legacy carriers earned combined profits of just $1.9bn and an EBIT margin of 2%, held back by a weak economic environment which led to a modest 5% traffic growth. North American airlines fared better, maintaining good capacity discipline and, despite a challenging economic environment, achieving traffic growth of almost 10%, which produced earnings in excess of $4bn and a 4.7% margin. However, it was left to the Asia-Pacific airlines to generate the majority of the profits (55%) and the highest net margins (10.9%) in the industry last year, maintaining the inexorable eastward shift in the balance of regional market power.
Sustained recovery can be seen in both premium and economy market segments, with premium traffic volumes just reaching their pre-crisis level again but economy passengers advancing more strongly (Chart 2).
IATI International Traffic Index
Moving into 2011, fuel prices continue to exert pressure and weaken bottom line performance, whilst capacity discipline is showing signs of slippage in many markets. Disruption in markets from North Africa to Japan and from Chile to Australasia has also hit traffic and revenue streams, but strong growth in the low cost sector has been maintained, assisted by the weakness of developed economies and the massive potential of middle class consumers in emerging markets. This has resulted in a shift in the patterns of traffic growth, with Latin America overtaking Asia (affected by the events in Japan) with 18% passenger growth in the first half of 2011 and Europe recording an 11% increase, reflecting a rebound from last year’s ash cloud impact (Chart 3).
Passenger Growth by Region
The US major airlines had a disappointing Q1, with aggregate losses of close to $1bn driven up by the fuel price spike. There is growing evidence that passenger demand has topped out, as fuel-related fare hikes drive travellers to make alternative plans – with direct benefits for the LCCs. Nevertheless, stronger Q2 performance suggests that the legacy sector is capturing the benefits of managing returns rather than market share, with only American amongst the majors failing to turn in a net profit. Barring further disruption, the US industry should manage to at least break even in 2011 as a whole.
American Airlines and US Airways are most exposed to competitive challenges in a market where consolidation has now run its course, following the merger between United and Continental last October. US Airways has the weakest balance sheet and liquidity of the legacy carriers and a high cost base; American has set out its stall to reduce operating costs through a record-breaking re-fleeting order with Airbus and Boeing. This marks the start of a series of events that have long been predicted, but deferred – namely, replacement of the ageing fleets that grace many of North America’s largest airlines.
At the low cost end of the spectrum, Spirit completed a successful IPO during May and continues to perform strongly in an increasingly competitive market segment, helped by the absorption of AirTran by Southwest. Spirit represents the leading edge of the next wave of ultra-low cost carriers that are re-inventing the low cost model in the US and targeting true discretionary travellers.
Further south on the continent, consolidation has been accelerating, with mergers between LAN and Tam, Avianca and TACA and, most recently, Gol and Webjet all surfacing to further strengthen the largest players in Latin America.
In Europe, consolidation is also under way, with BA’s merger with Iberia creating a clear #3 player in the region and the newly-formed IAG has eyes on additional acquisitions in Europe and beyond. It is increasingly likely that a larger portion of Alitalia will eventually end up in the AF/KLM fold, although progress to build the Italian airline back to profitability is taking longer than the new owners had hoped. Air France also plans to launch low cost services on a sub-set of its short-haul A320 fleet, but is likely to face strong opposition from labour unions which could swiftly end this attempt to get its European services back into profitability.
As always, having the lowest unit costs provides maximum protection against competition and there remains clear water between Ryanair, Wizz and most of the other European LCCs in this respect, with hybrid models, in particular, struggling to lock in appropriate returns for shareholders. Legacy carriers and LCCs in Spain and Italy are watching their backs as Ryanair ramps up its level of activity in both markets, building on a strategy of allocating increasingly scarce capacity to the most potentially lucrative operations. With no additional new order pipeline forthcoming from Boeing, Ryanair has started to build bridges into other manufacturers to secure its future growth, with a MoU for cooperation with China’s Comac presenting some interesting opportunities for speculation around the industry.
Within the next few months, the European Emissions Trading Scheme (“ETS”) will be up and running, adding another cost burden for airlines – one estimate puts the additional cost for the industry at around €1.4bn in 2012 alone. The scheme is still attracting huge controversy and opposition, however. Many countries outside the EU are arguing strongly that imposing the ETS on non-EU airlines is illegal, with several, including the US, heading for the courts for a resolution. US Congress has been considering passing a law to make it illegal for US airlines to participate in the ETS, which would create an interesting impasse and put the airlines firmly in the political crossfire. Elsewhere, China, Russia and Latin America have all denounced the proposed scheme and may be expected to retaliate with measures directed at EU airlines.
Chinese airlines continue to benefit from consolidation, with the “Big Three” reporting record profits in 2010, totalling more than $3.5bn and representing an increase of 325%. However, even China is not immune to wider global influences, with Q1 airline profitability down by 10% despite 27% more revenue.
The Chinese government has identified the aerospace sector as having strategic priority over the next five years and will also invest heavily in regional airports and infrastructure. This is likely to enhance demand for regional jets and turboprops, especially those of indigenous manufacture. Investment of over $230bn is expected from the government over the next five years, with more than 45 new airports being opened and a larger number being refurbished and expanded. There are also plans for further airline consolidation, with tax breaks and other incentives being proposed to improve the competitiveness of China’s airlines on the world stage.
Indian airlines continue to grow and transition their domestic activities towards low cost operations, with Kingfisher admitting that their (full service) business model is flawed. Domestic travel increased by 20% in 2010, to an annual total of 52 million passengers, and expanded by a further 18% in the first half of 2011. However, intense price competition, led by a struggling Air India, has had a severe adverse effect on yields, negating much of the traffic gain. The Indian airlines’ other perennial problem is the price of fuel, with punitive taxes continuing to be levied despite protracted lobbying, and the proceeds helping to prop up Air India, which is seeking government equity support having lost an estimated US$1.5bn in FY2010/11. The Indian DGCA is also doing its bit to protect the weak, recently prohibiting airlines from charging for extra legroom and seat selection and banning the separate charging for food on board. Despite the challenges in the market, Indigo Airlines, one of India’s leading LCCs, announced a record order for 180 new A320 family aircraft at the Paris Air Show, including 150 new generation Neo variants.
In Japan, the emergence of JAL from bankruptcy, combined with very strong results for their FY2010/11 (a $2.3bn operating profit) demonstrates the efficacy of strong medicine, but may leave their competitors wondering what they now have to do to bring their own cost structures into line. Although they have ceded large parts of their international market, JAL remains a significant longhaul, as well as domestic, operator and is likely to maintain its strong performance over the medium term. This may well create some challenges for Skymark, the domestic LCC with longhaul aspirations and an A380 order, although a recent IPO significantly bolstered their financial resources.
The low cost phenomenon continues to expand around the region, with Singapore Airlines the latest to announce the launch of an in-house longhaul LCC and initiatives under way in Japan, Korea, Thailand, Vietnam and the Philippines to create local low cost JVs with existing successful players in the space. Heading in the other direction, Virgin Australia – newly rebranded – is repositioning itself in the domestic market with a view to picking up a larger share of premium business travel. Together with Qantas/Jetstar, they have benefited from the suspension of Tiger Australia’s operations on safety grounds, which, whilst vigorously contested by the airline, will inevitably have knock-on effects amongst the travelling public well beyond the period of their suspension.
Having fallen off a cliff in 2009, net orders picked up again in 2010 for all of the manufacturers, with a total of 1,528 firm orders booked compared to just 480 in 2009. This number included more than 160 orders for new emerging market products – the C919, Sukhoi SSJ and Mitsubishi MRJ. Airbus and Boeing each accounted for around 40% of total sales, with Embraer and Bombardier at close to 5% each and the remaining 10% going to the “new entrants”. Total deliveries, however, declined by 5% due to significant slowdowns at the regional producers – Embraer delivered 20% fewer commercial jets whilst Bombardier’s CRJ output declined by 43%. Airbus and Boeing together dominated the market with 88% of deliveries, with Airbus ahead of Boeing by 46% to 42%.Having fallen back slightly, the total backlog of firm orders increased again in 2010, by 5% to 8,100 (Chart 4).
Western Jet Orders & Deliveries
The first six months of 2011 saw all of these trends continue. Orders totalling almost 1,100 comprehensively overtook the 400 booked in H1-10 and deliveries increased, albeit modestly, from 536 to 552. At the end of this period came the biannual Paris Air Show, where commitments (including MoUs) for almost 1,000 aircraft were announced, a 50% increase over the Farnborough 2010 tally.
Airbus took full advantage of the Paris Air Show to stage manage an exemplary display of salesmanship around the A320neo, announcing over 600 new commitments for the type and taking the gross order book total to well over 1000. The icing on the cake would have been the announcement of an American Airlines order for Neos, but, even though most insiders were aware that there was a deal in the making, the timing was just too far off and this coup de grace had to be held over for another month.
By the end of the air show, Boeing was under siege, although their own 737NG backlog had been advanced by 87 units, and facing extreme pressure to offer American something that would allow them to include Boeing in their fleet decision. Even at that point, Boeing appears not to have crystallised a clear view on the way forward, continuing to believe that there was a prospect that the laws of physics could be bent far enough to deliver an all new single aisle aircraft before the end of the decade without putting supply chains at risk. In the end, however, pragmatism won out and they made the only decision which could be delivered to customers with any certainty – although at the time of writing Boeing has still not firmed up the detailed definition of what it will deliver to American and has yet to secure its own Board’s approval and authority to offer. The unseemly scramble across the finish line in Dallas underscores the extent to which Boeing has been wrong-footed since the formal launch of the Neo last November.
Ultimately, Boeing has made the best decision from an investor standpoint. With broadly matched technology, the two product offerings (Neo and 737RE) are likely to result in a continuation of the status quo between the two manufacturers for at least another decade, giving technology the time required to develop and mature around a real next generation engine configuration. The focus is already shifting to the rate at which the two airframers can deliver their products, both current and new, to meet the burgeoning customer demand for aircraft for fleet replacement as well as for growth. Whilst most commentary continues to focus on the potential fuel savings of the re-engined models, it is capacity growth rather than replacement of ageing equipment that will sustain the order books over the long term. Nevertheless, there are more than 3,000 older generation narrowbodies that will be priorities for airlines to retire as their new orders start to deliver, with a bulge of retirals anticipated starting around the middle of the decade reflecting the order peak of the late ‘80s. This supply of predominantly 737 Classics, early A320s, 757s and MD80s will ensure that the installed fleet of in-production types will not be quickly eroded by the newer, more efficient variants.
With current single aisle backlogs still representing 6-7 years’ of production, both Airbus and Boeing are striving to find ways to raise production rates and give customers access to product in an acceptable timeframe. This has been a recurring issue for customers and suppliers alike, but raising output is no longer a straightforward matter, as supply chains have globalised and are close to their limits of reliability. The cost of over-reaching can be significant, as the airframers know from experience, hence the cautious approach that is been taken to committing to further increases. However, there are now signs that this is changing, with both manufacturers seemingly prepared to talk up future single aisle output levels from the current 40-ish to 50 or 60 units a month. At these levels, production processes will likely need to be radically redesigned with much greater focus placed on suppliers at every tier of the chain.
Until Airbus and Boeing can figure out how to raise output without jeopardising product quality and delivery schedules, lessors will benefit from the resulting lack of supply, either through their own order books or in the remarketing of used aircraft. This will be a key driver in strengthening lease rates and values, starting almost immediately as the American Airlines order starts to absorb capacity. Both manufacturers will be increasingly tapping lessor direct orders to provide bridge deliveries of current generation aircraft in the 2012 – 2017 timeframe, with the American order at the leading edge.
Boeing’s decision to go with a re-engined 737 will support residual values of the current NG fleet, although they were not under any immediate threat from either decision. Once Boeing has approval to offer the 737RE, and the performance data to support a sales campaign, they will be on the road in force working to recover their lost ground. They may have a steeper hill to climb than Airbus in getting the new product established as they will not have the competitive engine dynamic that exists on the Neo – as a 737 derivative, the 737RE will remain locked into the single source agreement with CFMI.
The pricing required to get American’s attention, and ultimately their order, will have been spectacular – but arguably no more so than other launch customers of new products would have seen in the past. Given the size of the order, however, it is likely that the deal was better even than that secured by Indigo and AirAsia, previously suspected to have been unprecedented. Neo pricing for all of the launch customers will almost certainly have been sharpened further by the engine OEMs, who have been competing for the business on the strength of the performance guarantees that they are prepared to give on what is, in both cases, unproven technology. Their role has certainly been pivotal in securing the overall level of interest shown in the Neo, but cannot be expected to be sustained into the future, either on price concessions or on performance guarantees. Now that both P&W and CFM have secured serious orders (CFM in particular has pulled its market share up from zero to over 60%) and the all-important associated aftermarket business, they will be focussed on building back the value in their technologies and, outside of “strategic” campaigns (and there will doubtless be a number of these), pricing of both the Neo and the 737RE can be expected to return to more rational levels.
Amidst all the noise around the Neo, Bombardier has been working hard to create a market for its C Series, with some recent successes but well short of what had been anticipated. With little more than a year to go before first flight, Bombardier’s sales team remains sanguine about the prospects for the aircraft and should be helped by the clear endorsement of the engine by customers ordering the Neo – which itself is a large part of the problem. Bombardier has also entered into a JV arrangement with Comac, which has the potential to fundamentally change the dynamic for both those organisations. Bombardier has extensive rail business in China which must be included in the overall equation, but closer links with China Inc, which increasingly require transfer of intellectual property and not just increased market access, could ultimately be transformational for both surface and air transportation businesses.
Comac was present in strength at the Paris Air Show, although no new orders for the C919 were announced, or indeed have been since the launch orders for up to 100 aircraft at the Zhuhai Air Show in November 2010. Nevertheless, programme development continues to move ahead and the project will benefit significantly from the priority placed on aerospace in the government’s current five year plan. For the moment, the programme will have single source Leap-X engines from CFM; in time a second western power-plant may come on board but emphasis is additionally being placed on the importance of developing a home-grown engine capability.
Now that Boeing has made up its mind on the future of the 737, Embraer can firm up its own plans for their next generation of aircraft. Several options remain on the drawing board, any one of which would introduce an exciting new competitive dynamic to what is already a crowded stage and complementing their existing E-Jets family, which notched up its 1,000th order during the year. Having deliberated long and hard, the company must now make up its mind what its 2020 product line will look like. Given their capabilities and ambition, the single aisle market is likely to become a little more crowded.
The turboprop market has been enjoying a resurgence, boosted by the high fuel prices, although the good news is not evenly distributed. Both ATR and Bombardier saw net orders increase in 2010, the former increasing almost fourfold, from 21 to 74, and Q400 sales up from 16 to 26. ATR continued to surge ahead in 2011, adding 88 firm orders plus 42 options in H1-11, including their best ever Paris Air Show result, and is looking at raising production rates to satisfy a backlog of more than 200 aircraft. On the other hand, Q400 orders have been sparse during the first half of 2011, with no additional orders taken in Paris, and Bombardier is planning to cut production to reflect the declining backlog.
The financial markets funded the delivery of around $62bn of new commercial jets in 2010, a similar level to 2009. Around 30% of the total was financed through commercial bank debt, another third by operating lessors (a combination of direct orders and sale and leasebacks) and close to 30% was again supported by the export credit agencies, which also provided support to several lessors as has now become the norm. Once again, the manufacturers largely managed to avoid taking additional customer financing exposure onto their balance sheets (Chart 5).
2010 Delivery Financing
The markets continue to be buffeted by uncertainty, principally arising from the Eurozone crisis and the inability of US politicians to agree a way forward on raising the borrowing ceiling to avoid a debt default. Nevertheless, the breadth of availability of aerospace financing has increased considerably over the past 12 months, with commensurate improvements in terms and pricing. Existing aviation sector banks increased their levels of exposure and a number of new lenders have entered the market, including several based in North America and Asia. This broadening of the regional sourcing of finance is not limited to local relationship lending, but represents a significant ramp-up in interest from entities that have historically not looked far from home for business.
Signals remain mixed, however, with several banks reducing their activity this year or exiting aviation completely – recent examples being Lloyds and HSH. The lack of capital constancy from some quarters is likely to remain a risk for airlines and lessors alike for some time to come.
With so much global focus now on China, it is no surprise that the number of supplicants beating a path to the doors of China’s financial institutions has increased dramatically, although the level of funding flowing out of the Middle Kingdom has not yet grown to the same extent, with most liquidity still going to domestic customers. However, this is expected to change, as many of their institutions, which include three of the world’s 10 largest banks measured by regulatory capital, have reiterated their strong interest in financing and investing in aircraft globally. This is being manifested both in direct loans to Chinese airlines to finance aircraft deliveries and in the emergence of Chinese aircraft leasing platforms, with varying levels of expertise and global reach. Chinese banks still suffer from constraints on dollar lending and face tougher Tier 1 capital requirements, put in place in part to cut excess liquidity and avert the feared property bubble. Tougher and more counter-cyclical lending guidelines are also being implemented, with margins likely to rise as a result. However, China’s financial appetite for the aviation sector remains very strong, linked to a desire to be top tier global participants in the aviation finance space. As with the wider banking sector, expect to see Chinese entities listing amongst the highest echelons of aircraft leasing by the end of the decade.
The lessors are also returning to business as usual, with most of their problems now behind them and a bright future ahead. Amongst the rehabilitated, ILFC stands out with a new management team, re-invigorated balance sheet, renewed appetite for growth and, most recently, indications that an IPO may be forthcoming. GECAS is firing on all cylinders again and most of the other established names are also increasingly active. Amongst the new entrants, ALC and Avolon have been the most active and creative capital raisers, the former successfully closing an IPO in April and the latter extending both its equity base and leverage over the course of the year. Heading in the other direction, DAE has dramatically downsized its ambitions and cancelled virtually all of its outstanding orders with Airbus and Boeing, whilst another Middle Eastern lessor, Waha, has sold its portfolio to AerCap and taken a direct investment in that lessor.
The export credit agencies (“ECAs”) have continued to provide strong liquidity support to the sector over the past year and are expected to maintain similar levels of commitments through to the end of 2012. A new Aircraft Sector Agreement (“ASU”), which sets out the terms on which the ECAs provide their support, will significantly increase the cost of export credit support for most applicants thereafter and is expected to reduce the participation of the ECAs to more traditional levels that better reflect their role in supporting more challenging assets in more challenging times.
Asset trading activity has rebounded rapidly, with several large portfolios changing hands in recent months as lessors and investors de-risk and others seek to grow their balance sheets. This can be seen in the surge of non-Sale and Leaseback sale activity during 2010 and into 2011 (Chart 6).
Non-Sale & Leaseback Aircraft Trading Volumes
Over the next few years, as deliveries of new generation widebodies start to come on stream and the manufacturers raise their single aisle production rates, the industry’s demand for capital will increase significantly, with around $250bn required over the next three years and $500bn over the next five. 85% of this will continue to be provided by the commercial banks, lessors and ECAs, with lessors building their participation back to 40% or more and commercial lenders also rebuilding their exposure to historical levels in excess of 35% (Chart 7).
Delivery Financing Volumes
Looking to the Future
Macro economics is likely to shape the next 12-18 months in the financial markets and in global aviation. Whether it is the US, Greece, China or elsewhere, the chances of a global or regional shock are high, with consequent risks and opportunities for airlines, manufacturers and financiers. Airlines with appropriate cost structures and defensible markets will continue to thrive under adversity, taking market share from the inefficient and intransigent. Oil price will continue to play a dominant and potentially disruptive role, despite their being no rational justification for prices much in excess of $80 a barrel.
Expect more “strategic” campaigns for single aisle aircraft, as other US legacy carriers commence their long overdue re-fleeting process. However, with engine manufacturers back at broad market equilibrium for their new products, pricing should start to tighten and delivery slot availability will again become the main bone of contention amongst customers. For those airlines that do not see any benefit from going down re-engining route, the next 12 months will be defining, as more clarity is provided on the length of the transition period between current and “RE” models. The race to raise output to create additional delivery slots in the medium term will need to take full account of the capabilities of each component in the global supply chains, as the consequences of any disruption will be considerable. The OEMs should also take into account the growth of competing producers in emerging markets that, over time, have the potential to take a sizeable share of total supply.
The provision of liquidity to finance aircraft deliveries will continue to be impacted by wider events in the financial markets, but, absent major disruption, expect more new entrants to the aviation space and further improvements to loan terms and margins – although the impact of Basel III may put countervailing pressure on the latter. Greater participation from institutional investors such as pension funds and insurers is likely. Expect a larger share of financing also to come from emerging markets, with commercial banks and lessors alike seeking to grow their exposure. Globally, lessors will be called upon to support further strategic OEM campaigns, underscoring the value of their direct order pipelines.
There will be more lessor consolidation over the coming year, with potentially three or four lessors changing hands in the process. Asset trading will continue to grow as the cycle moves further into the recovery phase, with trends for in-production aircraft values also moving steadily upwards, supported by a lack of availability of most popular types. Additional distribution channels will start to open, potentially including ABS style structures, secured bonds and managed funds. In short, the sector will remain a deep source of attractive risk-adjusted returns for a wide range of investors and lenders, ensuring that the growth envisaged by airlines and the manufacturers will continue to be delivered.