US airlines will need to think about different forms of raising money as tighter credit markets mean more expensive capital market financings
Capital market financing activity in 2007 came in like a lion, but went out like a lamb due to increased pricing which resulted from tightening credit markets stemming from the US sub-prime crisis. As a result, certain capital market financings were pulled in the second half of 2007, including one from US Airways.
Going forward, uncertain market conditions could result in fewer capital market financings, as the costs of these deals have risen relative to the economic benefits realised by their issuers. This could prove problematic as these financings are not only used to finance aircraft, but internal operations as well. Cash will be key to weather any looming US recession, or further increases in costs, not to mention that US carriers will begin taking delivery of more aircraft in 2009 that will need to be financed starting now.
"Until the last quarter, 2007 was a banner year for the capital markets," says Cecilia Park, head of transportation structured finance at UBS based in New York. She recently cut her capital market financing estimate, which includes both airline enhanced equipment trust certificate (EETC) financings and operating lessor securitisations, to $1-2 billion from an earlier estimate of $3-5 billion at the end of last year. Park also says that if oil prices of nearly $100 per barrel are sustained, this could put tremendous pressure on airline credits, which the EETC market partly depends on.
However, Patrick Käufer, managing director in global capital markets at Morgan Stanley in New York, remains particularly bullish about the EETC market, which is tapped primarily by US airlines. EETC financings dried up like a desert stream following the 2001 terror attacks due to weak investor appetite, and it wasn't until 2007 that the market experienced a renaissance in offerings. Käufer expects $5 billion of EETC offerings this year, roughly 20% higher than in 2007, which was the largest year of EETC issuance since 2001. The three largest previous years were 1999 with $5.4 billion, 2000 with $9 billion and 2001 with $10.2 billion.
"The focus has been on the widening of spreads on EETCs, but there are still very low treasury rates and the capital markets are still open for airlines," says Käufer. He adds: "Yes, deals have become more expensive during the past six months. But remember, these are mainly sub-investment grade companies that are getting market access and pricing much better than any other single-B rated company." Last year three US airlines, which recently emerged from Chapter 11 bankruptcy protection, managed to raise money through EETCs. Käufer says EETCs will be needed for further refinancing needs of once bankrupt airlines and to fund new aircraft deliveries, as US airlines have solid order books. "Also, if consolidation or mergers were to take place, EETCs could help provide needed financing," says Käufer.
United, Southwest, Continental, Northwest Airlines and Delta Air Lines all carried out EETCs last year. But some of these offerings were initially conceived during an economic climate far different from that in which the airlines found themselves when the financings actually closed. By the time financial issues in the sub-prime market and rising fuel costs began to impact the industry, airlines had expended considerable effort and expense to structure and document these EETCs, so pulling out of these deals wasn't a wise option.
What resulted was increased pricing across the board. Also the amount of financing raised tended to be smaller than in previous deals. One of the positive features of an EETC is that an airline is able to raise a large sum of money, in most cases $1 billion plus, in a single transaction, unlike in typical commercial bank structures.
These challenges were best demonstrated in the October offering of Southwest, with a Baa1/A- credit rating (Moody's/Standard & Poor's), which is among the industry's highest. The financing was supported by strong collateral, Boeing 737-700s - a darling in the aircraft market. The $412,100,000 Class A notes priced at an interest rate of 6.15% and the $87,900,000 Class B notes priced at 6.65%. "Pricing on this deal was high for an EETC involving Southwest and 737 collateral relative to pricing that might have been obtained for a similar deal a year earlier," said an analyst at the time the deal closed. "This increased pricing is due to increased conservatism toward the aviation industry, particularly due to rising fuel prices and passenger demand which, while currently strong, may also exhibit increased elasticity in the wake of increased fuel prices and the fallout in the sub-prime market."
The $500 million offering was also small compared with previous offerings in 2007 before the sub-prime crisis hit the global markets. In April, Continental, a weaker credit than Southwest, issued a $1.146 billion EETC to finance 12 Boeing 737-800s and 18 Boeing 737-900ERs, scheduled for delivery from January 2008 to March 2009. In June, United, also a worse credit than Southwest, refinanced the mortgage and related debt of 13 used widebodies, which are less desirable collateral than Southwest's 737s, by issuing a $694 million EETC.
Northwest also closed a $454 million EETC in October. Again the deal was a smaller offering compared with previous issues. Banking sources indicate pricing on the debt closed wider than initially anticipated with the Class A notes priced at 7.027% and the Class B notes priced at 8.028%. Again the main reason for the wider pricing was turbulence in the credit markets, which has had a disproportionate impact on cyclical industries such as the airlines.
Alternative financing
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So while Käufer believes there is still potential for EETC financings of good issuer quality, structure and collateral, there is no denying that the deals will be more costly for airlines, as recent deals prove. But this doesn't mean airlines are completely stuck. There are alternative sources of financing available to them, including operating leases and the commercial banking market.
A leasing source speculates that some of the orders placed by lessors at the end of 2007 belong to US airlines. The source suggests these lessors already hold agreements with certain airlines, which need to re-fleet but didn't want to irritate labour relations by announcing large orders. While operating leasing could prove an attractive financing option, it won't solve all an airline's needs. Airlines will also need to tap the commercial banking market, which is also being impacted by the credit crunch. The result has meant increased costs of funding for the banks, and difficulty syndicating big ticket financings.
While pricing for top tier airlines has changed only slightly and it is the lower tier airline financings that are really being impacted, the amount of financing being raised on all deals is having to be scaled back due to tighter lending criteria. This was demonstrated on the recent British Airways financing. Ideally, BA wanted to raise $2 billion, say bankers, but in the end settled for $1.7 billion as the credit crunch impaired the amount it could raise in the market.
While many bankers argue that higher pricing, tighter lending conditions and increased conservatism are long overdue corrections needed in the banking market, this doesn't help the airlines, which will need to cough up the extra cash in the wake of increased costs and possibly weaker traffic in 2008. Furthermore, certain banking sources suggest increased banking conservatism will make raising financing even more difficult for US airlines due to these carriers' recent and endless dance with Chapter 11. The best approach for these airlines will be a diversified approach to financing, through operating leases, the debt markets and if they can get it, the capital markets - even if at a higher price, as the days of raising $1 billion in the capital markets in a single, cost-effective transaction are certainly on hold for now.
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Source: Airline Business
