Airfinance Annual 2012 – Industry Review and Outlook
By Dick Forsberg, Head of Strategy
Despite better than expected financial performance from the airline industry in 2011, weakness in the world’s leading economies including several of the largest emerging markets, high fuel prices, the intractable Eurozone crisis and a largely dysfunctional international banking sector continue to exert pressure on the industry, which is expected to see profits cut in half in 2012 as the recovery stubbornly refuses to re-engage. The $3bn net profit forecast by IATA for its members this year, itself a fragile enough number, remains massively below the levels needed to finance the record levels of new capacity sitting on the manufacturers’ order books. Airbus and Boeing have both increased production rates during the past 12 months and will be raising output further whilst continuing to manage their near-term delivery skylines closely.
Questions over the availability of capital to finance all of the planned deliveries continue to be asked but, to date, few if any aircraft have failed to deliver due to a lack of funding. The continued support of the export credit agencies, an active lessor market and increased participation by a number of mostly Asian financial institutions ensured that the $70bn of deliveries in 2011 were funded and will doubtless also be there for the $85bn cheque that will have to be written in 2012.
Investors continue to be attracted to the commercial aviation sector, with recent transactions in the lessor space confirming that attractive risk-adjusted opportunities do indeed exist. The feedstock for most investment portfolios is delivering in ever-increasing numbers and continues to attract strong lessor interest, with sale and leaseback opportunities remaining heavily bid and direct orders on the rise. Some of the new products and sources of liquidity that will be required to support future deliveries are already starting to be seen and, as the recovery resumes, more may be expected to enter the market.
Although aircraft value recovery stalled towards the end of 2011 and by mid-year had yet to resume, the underlying cyclical nature of the industry remains intact, but deflected by the impact of wider market disruption. Whilst more than ever difficult to predict, it is likely that the next cyclical peak will occur around 2015.
As a general rule, 60-80% of air travel demand can be attributed to economic activity, with average passenger growth typically equivalent to GDP +1.5-2%. The balance comes through value creation from air travel, stimulated by liberalisation. The strength of the airline industry is therefore highly dependent on the global and regional economies, but gets an added boost from longer-term demographic and regulatory changes.
2011 was, to utilise a well-worn sporting cliché, 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 and, at the same time, capacity discipline began to weaken and ASK growth started to outpace RPKs. 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, Japanese earthquake and, later in the year, the widening ripples of economic turmoil stemming from the Eurozone.
IATI Passenger Growth by Region
Overall, passenger traffic increased by a still creditable 6% compared to 2010 (Chart 1) and, despite the rising capacity trend, load factor remained broadly unchanged and in excess of 78%. Most of the growth now comes from emerging markets, led by Latin America and the Middle East. Asian growth was depressed by the Japanese earthquake, whilst Europe’s real performance was much weaker than the data suggest, masked by recovery from the 2010 volcano disruption.
IATI Cargo Growth by Region
Meanwhile, cargo demand started to decline again in May 2011, led by a collapse in Asian markets, and has continued to shrink since then, with 2011 FTKs down by 0.7% compared to the previous year (Chart 2), with a further 2.1% decline being experienced in the first half of 2012.
Nevertheless, the $7.9bn net profit earned by the airline industry in 2011 was almost double what had been forecast mid-way through the year, an improvement achieved not through stronger revenue performance or lower fuel prices, but by tighter control of non-fuel costs, which fell by 0.5% on a unit basis. Thus, the airline industry managed to keep its head above water for another year despite the sustained challenges it continued to face.
IATI Airlines 2011 Profitability by Region
On a regional basis (Chart 3), Asia/Pacific continued to out-perform the rest of the world, generating the highest net margins and more than 60% of global profits, a higher proportion than in 2010 but 50% lower in dollar terms. Other emerging markets continued to out-perform more developed ones, especially in Europe, where weak demand and Eurozone difficulties further cut margins and put several major carriers into crisis mode.
IATI Airlines 2011 Profitability by Region
The trends so far in 2012 are mostly following the same patterns (Chart 4), with strong passenger growth (+6.5% for H1-12), weak cargo demand (-2%) and high load factors (78%). IATA forecasts an industry net profit of $3bn for the year but notes that it is highly susceptible not only to volatile fuel prices but also, more critically, to global economic performance, which is likely to be overly influenced by events in the Eurozone.
Recent indicators show that economic growth in key emerging markets, including China, India and Brazil, have all moved lower and, for various reasons, may stay at these more subdued levels for some time. This will have serious consequences for global recovery and, by association, the airline industry. Some of the slowdown in emerging markets is a function of globalisation, linked to recession and unemployment in developed markets and more conservative spending patterns arising from concerns over the future of certain Eurozone states as well as the currency union itself. However, other localised issues, which include political, economic, climate and infrastructure factors, are also playing significant in specific markets.
One continuing feature of regional market traffic growth patterns is the strong performance of the Middle East, where significant amounts of capacity are being added, particularly serving markets in Europe, Africa and Asia. Combined with strategic initiatives that include equity investment in airlines as diverse as AirBerlin, Qantas, Air Seychelles and even, potentially, Air France, the rapid network growth of the Middle East “super-connectors” has significant implications for the legacy carriers in these regions.
The US airline industry has continued to maintain domestic capacity discipline and has seen load factors and yields reach new highs and profitability, for the majority, improve. American Airlines’ bankruptcy filing in November 2011 marked a turning point in that airline’s struggle to remain competitive, although it took a change in the leadership of the business to make the necessary but long deferred move. There is little doubt over their ultimate emergence as a more efficient entity, although whether they continue as a stand-alone airline or become part of the US industry’s consolidation process remains to be seen. Their progress underscores the fact that, despite the challenges facing the industry, there are few outright airline failures. The majority of the world’s airlines are now run on a commercial basis, while most of those that remain extensions of government still enjoy the protection that goes with that doubtful status. When airlines do fail, their place is generally filled quickly by their competitors and their franchise is soon forgotten. Recent examples such as Malev and Spanair join a still short list of failures and, for the moment, the airline credit environment remains less difficult than in 2008-2009, although there is an increased weakness versus a year ago.
There was much relief in Seattle when the first 787 was delivered to ANA in September 2011. Since then, a further 14 have been delivered (by the end of July), leaving 844 more to go, with production ramp up still advancing much more slowly than had been anticipated. Another milestone has been achieved with the first aircraft leaving the final assembly line with no subsequent re-work required, although there are still 35 aircraft awaiting re-work before they can be delivered. Airbus are struggling to increase A380s deliveries as wing repairs and manufacturing ramp-up continue to be troublesome and they have also announced a further manufacturing delay on the A350 programme, with the service entry date now officially slipped into the second half of 2014.
2011 saw the firm commercial jet order backlog hit another record high, at more than 9,100 units, as net orders continued their rebound from the 2009 trough (Table 1). Much of the action was centred on the A320neo family, which notched up more than 1,200 firm orders during the year, almost half of the near 2,500 total. Overall, Airbus took around a 60% share, leaving Boeing with a third of the orders and some catching up to do in the single aisle market, although they out-sold Airbus 3.5 times in the widebody sector, securing a remarkable 200 orders for 777s alone. Bombardier, Embraer and COMAC accounted for most of the remaining orders, with the Chinese picking up a further 95 orders for the C919.
The lessor share of OEM order books has been rising again, with almost 500 lessor orders placed in 2011. Lessors now account for 17% of the backlog, including 21% of A320s and 19% of 737s, with peak deliveries due over the next three years, when placement of over 800 aircraft will be required.
Production rates were more evenly shared between Airbus and Boeing, with the former delivering 534 aircraft during 2011 compared to Boeing’s 477 (Table 2). Both represent small increases over 2010, with Airbus raising the A320 family production rate twice during the year and Boeing getting the first 787s and 747-8s into service. Embraer and Bombardier also managed small increases in output, whilst Sukhoi delivered the first of their SSJs.
In 2012, with the Neo firmly launched, Airbus is focussed on ensuring that their remaining A320ceo delivery positions are sold whilst accepting that this is Boeing’s year to rebalance the single aisle books with 737Max sales. Having secured a significant number of expressions of interest for the Max by the end of 2011, Boeing has steadily been converting these into orders and, by the end of the Farnborough Air Show, had secured a credible number of orders and commitments for the re-engined 737 family.
The buzz at this year’s Farnborough Air Show was noticeably muted, with chalet attendance well below the usual crush, even on the early days. Nevertheless, the 675 net orders and commitments announced (Chart 5) were actually more than were booked at the last Farnborough show (647), although well below the 900 orders taken at Paris last year. However, whereas 2/3rds of the Paris total were A320neo orders, the combined A320neo and 737Max tally accounted for just 50% of this year’s Farnborough total, reflecting a revival of interest in other models and markets.
Total Order & Commitments
Boeing took over half of the show total with 393 orders and commitments, of which 308 were for 737Max. Their biggest boost came from United-Continental, which announced 100 Max and 50 NG orders. Boeing is now well on the way to closing the gap opened up by Airbus on the Neo, as only 29 more A320neos were added at Farnborough. By the end of July, Boeing had 649 firm orders for Max compared to 1425 firm orders for Neo, with an additional 245 and 159 MoUs respectively (Chart 6).
Other Airbus commitments announced at the show included 57 A320ceos, whilst Boeing booked 85 more NG orders, confirming continued strong demand for the current production models. Around 600 A320ceo orders and commitments have now been placed since the launch of the Neo. Cathay Pacific endorsed the re-defined A350-1000 with an order for 10 plus additional conversion of 16 existing A350-900 orders into the -1000. Whilst Airbus also added 14 new A330s, Boeing had no takers for their widebodies, although they did confirm that plans for the 787-10 are advancing and likely to be confirmed ahead of any upgrade to the 777. By the end of July, Airbus had secured 270 net orders in 2012, whilst Boeing’s tally stood at 700.
Although Airbus remains committed to a further increase in its single aisle production rate to 42 a month from the start of 2013 and Boeing will step 737 rates up to the same level in early 2014, neither manufacturer now appears ready to ramp up any further, which in the case of Airbus at least is a notable reversal of their position less than a year ago. A combination of market conditions, the uncertain macro-economic outlook and concerns over supply chain sustainability have led to a more muted, and arguably more rational, vision of the coming years as they transition from current to new generation products and a less bullish outlook will help to allay market concerns around over-production and the implications for values.
Backlog Cancellation Rates
The 9,000-plus backlog represents over 40% of the operating fleet and thus bears the hallmark of a bubble. Although the industry has been adept in absorbing capacity to date by switching its application between growth and replacement depending on the cycle, weakening demand and lower airline profitability increases the likelihood that there will be further deferrals and cancellations. The cancellation rate for firm orders has already increased from 1.2% of the backlog in 2010 to 3.7% in 2011, following the pattern of the last cycle, which peaked at 4% in 2005 (Chart 7). In mitigation, both Airbus and Boeing will be managing their near-term delivery skylines to balance deferrals and accelerated delivery positions to the best of their ability (they have been extremely successful in this since 2008/09) and ensure that they have customers to take delivery of everything that they build. It is still highly unlikely that the OEMs will build whitetails in the near term, however any further rate increases will put additional strain on the delivery process.
In further mitigation, a record 12% of the backlog is not due to deliver until the next decade and both A320ceos and 737s are sold out through 2015. Also, the re-fleeting of the US majors that has finally got underway will help to underpin the order books and production rates through at least the middle of the decade.
Strong demand and lengthy backlogs continue to allow the OEMs to raise their list prices ahead of inflation, although net pricing does not necessarily follow an identical path. Airbus raised most of their list prices by around 4% at the start of 2012, but increased Neo and A350-1000 prices by 6-7%. Boeing similarly raised sticker prices this year by between 5.5% and 7%, with the 787 taking increases at the higher end.
Neo/Max 2012 list prices vs current models
Airbus is pricing the A320neo family at a gross premium of 9.5-10% relative to the Ceo, while Boeing has set a premium of between 9.5% and 13.5% for the 737Max compared to NG family members (Chart 8). There is evidence to suggest that Airbus has indeed been achieving pro rata sales price premiums on its neo sales, although additional incentives from the engine providers to launch their products and secure market share may have narrowed the gap during the initial launch phase. Boeing is also expected to achieve premiums for the Max proportionate to the operating cost savings that can be achieved.
Ascend CMV: BV Values Trend
Reflecting the deteriorating performance of the global economy and financial markets, general aircraft value recovery has stalled since Q3-2011, partly reversing the improvement that had been under way. To date, the value recovery cycle is running at least 12 months behind “schedule”, with Ascend CMVs for most popular asset types declining relative to base values over the past 12 months (Chart 9). Some values have taken more severe reversals, with the A319 the most significant outlier, whilst a few types have bucked the trend and recorded improving market value trends – these include the E190 and A330-300, both of which are increasingly finding their way into lessor portfolios.
Airbus has become more focussed on supporting the residual values of the current A320 family, which have been under pressure as production rates are increasing at a time when the market is dealing with a growing lessor pipeline, shortening lease terms, some early terminations following airline failures and concerns over the approaching transition to the neo. The most severe pressure has been on A319s, where increased lessor availability has met with declining demand as airlines up-scale to A320s to secure lower seat-mile costs. The resulting decline in A319 lease rates has been especially painful and, whilst the worst now appears to be over, has spilled over into the A320 market as well, especially in respect of the placement of direct lessor orders. The recent move by Allegiant to acquire 10 A319s from Cebu Airlines (who, like easyJet, spirit, Volaris and others are up-scaling to A320s) exemplifies the current A319 market situation, which Allegiant describes as “A319 asset values have significantly declined and now mirror the environment we saw when we first began buying MD-80s”.
Conversely, demand for Boeing’s 737NG family has remained strong, with values and placement lease rates achieving significant margins over the corresponding A320 family members. Lease rates and acquisition prices for sale and leaseback transactions of all types have been significantly less stressed than has been the case for placements, however, reflecting the still strong demand for portfolio volume growth amongst the lessor community.
Market Lease Rates
Market Lease Rates
Age of Retirement
Two value-related themes have been taken up by industry commentators over the past year which, taken at face value, might raise additional concerns over aircraft value trends and need to be properly understood. The first is that placement lease rates appear to have settled at levels that are considerably below historical rates. This ignores the fact that lease rates have benefitted for some time from very low interest rates. When normalised to a constant interest rate, the relative movements between different aircraft types clearly still follow the industry cycle and are actually small for younger aircraft (Chart 10a), although greater for older ones and with a discernible divergence between an A320 and a 737-800 that confirms recent market pressures (Chart 10b). Nevertheless, the absolute quantum of lease rate should always be considered in the context of the prevailing interest rate and, on that basis, market levels have continued to move broadly in line with the cycle.
Percentage of Delivered Fleet Remaining in Service
The second “topic du jour” is that of aircraft economic life and, specifically, whether there is evidence that aircraft are being retired earlier, with obvious implications for values and depreciation rates. The short answer is that the long-term retirement trend has continued to move to the right, with aircraft remaining in service for longer than they did ten and twenty years ago (Chart 11). Over the past decade, the proportion of commercial jet fleets that are retired before they have reached 25 years has fallen from 65% to 50%, with 60% of aircraft still in service after 25 years, the same percentage as a decade ago (Chart 12).
Average Retirement Age
The average retirement age for single aisle aircraft has fallen slightly over the past decade, whilst widebody retirement age has remained virtually constant. However, single aisle behaviour has stabilised over the past 4-5 years and the average retirement age remains comfortably above 25 years (Chart 13).
Retirements closely correlated with oil price
It can also be clearly demonstrated that the level of retirement is closely correlated with fuel price (Chart 14), so an elevated rate of retirement is to be expected in the current environment and may continue for some time.
Nevertheless, large numbers of aircraft remain in active service well beyond the 25 year mark, whilst instances of aircraft being retired very early in their lives remains extremely low and occur for specific, usually economic, reasons.
The volume of commercial jet deliveries stepped up in 2011, requiring more than $70bn of financing. As in previous years, commercial banks, lessors and export credit agencies took care of the majority of the requirements, with lessors accounting for 37% of the total (Chart 15) but tapping both commercial bank and export credit markets for part of their own funding.
2011 Delivering Financing
A resurgence in bank lending was evident at the start of 2011 when a number of new as well as some familiar names (re-)entered the aviation space, but has since been overtaken by events in the wider financial markets and had significantly shrunk again by year-end. Reduced liquidity, lenders’ flight to quality, more restrictive debt terms and the return of liquidity premiums are again evident, putting those airlines and lessors with large-scale near term financing requirements under pressure. Commercial banks are demonstrating a range of appetites for aviation depending on their location and regulatory environment, but the majority are, to a greater or lesser extent, constrained by the wider challenges of the financial markets and less active than a year ago The exceptions lie mostly in Asia, where Chinese and, more recently Japanese, banks have become significant investors and lenders to the aerospace sector. The greatest surprise in 2011 was the speed with which the sleeping giants of the Japanese financial markets awoke and re-engaged in the space. Their energy levels, especially at SMBC and Mitsubishi/MCAP, have outpaced most Chinese entities, which have found themselves constrained by higher political events in China, which are slowing decision making and preventing greater participation – for the time being.
Lessor activity is more evenly split between direct orders and sale/leasebacks than was the case in 2010 and the market is fast returning to “business as usual”, with most financing opportunities heavily bid by lessors old and new. The sale of RBS Aviation Capital to SMBC at the start of 2012 sent a strong signal to the market that investor interest remains high in the space and that attractive risk adjusted returns can be made with prudently managed portfolios.
Lessors are once again ordering new aircraft in increasing numbers and made up just over 40% of the total order volume at Farnborough, with 278 commitments. GECAS added 100 737s and ALC announced 75 737s plus 2 ATR72s, with Avolon in third place with up to 50 737s and A320neos. Whilst GECAS and ILFC still lead the lessor league table by a significant margin, a number of newer, but already substantial, entrants feature in the top 20 list (Table 3) and there are now nine lessors with between $10bn and $20bn of committed assets, reflecting the significant diversification that has taken place in the sector over the past decade. Three Chinese lessors appear in the Top 20, along with two Japanese-owned entities. Together, these two countries now account for 1,300 aircraft valued at $40bn. The Top 20 lessors hold firm orders for over 5,500 aircraft, valued at almost $80bn in current dollars, which represents around 1/3rd of their total commitments.
Delivering Financing Volumes
For the ECAs, 2012 is expected to see a final surge of support before returning to their former role as lenders of last resort when the new ASU comes into force in 2013. They will continue to support not only airlines but also much of the lessor community, which is expected to increase its contribution to market liquidity in 2012 and beyond, moving from around 35% of the forecast $85bn total required to finance new deliveries this year to closer to 40% over the longer term, when new sources of liquidity will also be required to close a growing financing gap as the annual volume rapidly passes $100bn (Chart 16). Over the next 5 years, $550bn will be required, with the 10 year figure exceeding $1.2 trillion. 50% of the delivery dollars will be required to finance narrowbody aircraft, with 40% for passenger widebodies and 10% for freighters and RJs.
Looking to the future
The industry has experienced a stall and reversal of the cyclic recovery that had been under way, primarily due to the Eurozone crisis and its depressive effect on the global economy and financial markets. Emerging markets still rely on positive economic activity in Europe and North America and slowdowns in the key aviation markets of China, India and Brazil will remain a cause for concern. However, the size and growth of emerging market populations coupled with rising disposable income will continue to provide the stimulus for strong underlying traffic growth over the longer term and both passenger and cargo demand are expected to maintain their historical relationships with GDP growth. The growing role of low cost airline models that make air travel affordable to new emerging classes of air travellers will become increasingly important and the geographic shift in the balance of market dominance from Europe and North America towards emerging markets is now a dominant and immutable fact.
Irrespective of oil price trends, the airline industry is likely to see profitability decline over the next 12 months at least. At the same time, the rate at which new capacity is delivered continues to increase, although the OEMs appear to have backed off plans for further rate increases for the moment. The industry will need to raise almost $100bn to finance new deliveries in 2013 and considerably more than $100bn a year thereafter. Whilst banks, lessors and the ECAs will continue to be the principal sources of liquidity, new channels will have to be developed beyond the still-elusive capital markets.
Pressure on asset values will continue to be felt until the wider economy shows tangible signs of recovery. For the next 18 months at least, managing capacity will be a critical focus for airlines and, with production rates due to increase further, more retirements of relatively young aircraft should be expected. This does not, however, imply a permanent reduction in economic lives and the majority of current generation of aircraft will remain in active service until at least 25 years of age.