As recovery starts to become a reality, finance options available to airlines are starting to increase, although the operating lease looks as if it will play an increasingly important role
During the downturn, many banks effectively turned their backs on the airline industry.Not surprising given the billions of dollars of losses that the industry was piling up. However, there are signs that the financial community is starting to take an interest again now that recovery appears to be underway.
"Recovery changes the mindset," says Chris Avery, senior analyst at JP Morgan in London. "There is every sign that markets are opening up again for medium-to-better airlines."
However, the recovery has so far missed out the world's largest airline market, the USA, where the shadow of Chapter 11 bankruptcy filings still hangs over the industry. Phillip Baggaley, a managing director at Standard & Poor's ratings agency warns that the massive debt burden that US legacy carriers and even some low-cost airlines have amassed during the downturn could well herald trouble in the future. Debt levels among the US majors have nearly doubled in the space of three years.
"They are unlikely to be paying down debt to any material extent through the next cycle," he warns, leaving carriers going into the next downturn with an added and potentially large burden. The exception, as is often the case, is Southwest Airlines, where debt levels have been trending downwards through the trough of the cycle.
Despite a recent credit downgrade from Standard & Poor's to reflect a tough competitive environment and the fuel price hike, JetBlue Airways also remains pretty healthy. The carrier arranged two enhanced equipment trust certificate financing deals last year for its new Airbus A320s. In contrast, outstanding orders for large jets from legacy carriers are few and far between, with Northwest Airlines being the major exception, although it has arranged manufacturer financing - a popular source of funding through the downturn.
For US majors, this means that financing options are limited. "US legacy carriers have few unencumbered assets that they could use to raise new debt," says Baggaley, pointing out that much of the recent financing for large regional jet orders was provided by the Brazilian and Canadian export credit agencies. Giant aircraft lessor GECAS, backed by the powerful GE Capital finance house, has also been stepping in to provide support.
Baggaley notes that some European banks continue to be interested if the deal is right. For instance, he says, an aircraft that is in demand such as the Boeing 737-800is now able to attract finance at lower advance rates than in the recent past. However, he warns that in future US carriers will have to make far greater use of operating leases than they have in the past, noting that this will effectively bring them into line with the rest of the world.
European equity
In Europe there are signs that the finance community is daring to take a fresh look at the airline and aircraft financing sector on the back of an upturn in traffic. Avery says that the French government's sale of stock in Air France late last year demonstrated that airline equity is again tradable. German flag carrier Lufthansa had earlier raised €750 million ($905 million) through a rights issue in June, although the markets were lukewarm to this move. "It was certainly a dampener as far as non-German investors were concerned. Investors need to understand why companies are looking for cash," says Avery, adding that Lufthansa's rationale - that it needed to finance fleet investment including the Airbus A380 - did not satisfy investors outside Germany.
The Asia-Pacific region, despite being hit by the SARS virus early in 2003, has been the star performer, with traffic surging ahead and a new wave of low-cost carriers starting up. However, some still sound a note of caution. Robert Martin, chief executive at Singapore Aircraft Leasing Enterprise (SALE), points out that the first deliveries for the Asia-Pacific low-cost airlines are only just starting to arrive. "I don't think people have really thought through how these new deliveries are going to be financed," he warns, noting that, in the past, the region's major airlines were typically national carriers backed by what was perceived to be sovereign debt. "This is not the case with the new low-cost entrants," he says.
"Airbus has signed up a number of orders on the assumption that financing will be provided by the commercial market, through operating leases or by the export credit agencies. So far none of these three has committed themselves," notes Martin. "We will soon find out which of these airlines has access to the finance markets." He notes the lack of equity in many Asia low-cost carriers means they will struggle to gain access to the capital markets.
Against this background, Martin feels that more urgency should be given to ratifying the Cape Town Convention, which is designed to ensure the rights of creditors in the event of default, including recovery of assets. He notes that so far in Asia Pacific only Pakistan has signed up. "My view is if ever this convention is needed, now is the time," he says, pointing to the move away from state-backed carriers to private firms. "People are going to want the comfort."
Martin says that SALE looks for carriers to have at least $50 million in equity, which he believes is necessary to get through the start-up phase.
Operating leases have often been the first port of call for low-cost airlines. "Typically, these operations don't have a lot of cash, so they often have limited access to debt and equity markets," says Klaus Heinemann, chief executive at Germany's debis AirFinance. "They often need 100% funding and the only way to achieve this is though operating leases."
Leaseback options
Increasingly, some carriers have been striking sale-and-leaseback deals with leasing companies, often on the back of significant discounts from the major manufacturers. UK low-cost operator easyJet is a notable example of this, with its Airbus A319 order struck back in 2002, while Ryanair has increasingly been going down the same path with its Boeing 737NG order.
"There is a definite trend in this direction from those that acquired aircraft at record [low] prices," says Gordon Dixon, chief executive at Oasis International Leasing. However, he adds that airlines that ordered aircraft five to seven years ago, when the market was approaching its peak, would be unlikely to be able to cover their costs if they now looked for leaseback deals, even though the aircraft would have only been delivered three to five years ago.
The advantages to the airline are quite apparent. John Morrissey, formerly of lessor GPA, who has recently been advising potential investors in the leasing sector. "It certainly makes sense for the airlines. You get out of the residual risk and seven years down the line, you can buy new aircraft." This leaves the lessor with the problem of finding new customers for the aircraft, however.
Lessors clearly have some concerns with the knock-on affect of these discounts. "This has clearly put pressure on residual values," says Heinemann of debis. "The business of operating leases has become much more difficult. The delta between the manufacturer's list price and the price actually paid has gone from the silly to the ridiculous."
He questions whether the deep discounts are really rational from the manufacturer's perspective. "It is now more difficult for those who rely on aircraft values, whether they be enhanced equipment transactions certificate investors, operating lessors or other providers of secured lending." His thoughts are echoed by Dixon of Oasis: "It is difficult to reconcile the prices we have seen over the last three to four years with the manufacturers' need to retain long-standing customers."
Value decline
The rate at which aircraft have been shedding their residual value has also led to warnings over the need for leasing companies to take a more aggressive stance in depreciating their assets. Morrissey, who has been vocal on the issue, claims that a typical industry depreciation rate of 3.4% annually over 25 years is simply inadequate. He warns that a huge gap has built up between the aircraft book values and the values that these aircraft will actually obtain in the real world.
Morrissey points to over-ambitious aircraft production rates as a key problem, and puts much of the blame on the willingness of export credit agencies to finance deals that they should be avoiding. He makes no bones about the fact that he sees the agency funding deals as a subsidy, contrasting the situation with the commercial property market, where banks pull the plug when they see over- capacity, acting as a natural check on over exuberance. "The taxpayer is funding aircraft purchases that commercial banks wouldn't touch," he says.
Baggaley at Standard & Poor's argues that the agencies have helped fill a gap to some extent, but notes that "it is certainly true in some cases that what they offer wouldn't be available on the commercial market". Martin at SALE, however, says that the export credit agencies have changed their tune now that they are increasingly dealing with private entities rather than government-backed concerns. "They have become more sophisticated and have beefed up their risk analysis," says Martin, adding that they have learned from the experiences of the collapses at Sabena and Swissair.
Whatever the reasons for the steep declines in residual values, it is an issue lessors have to deal with. Heinemann says that much depends on the inflation outlook. "If inflation is 3% for the next 20 years, then a depreciation rate of 3.4% per annum would not give you a headache. If there is no inflation, then you would get a headache," he says. "You should not just be looking at today's market, you should be looking at the long-term inflation picture. Our business is all to do with inflation. If you are going to approximate residual values for 25 years at average inflation rates of 2%, 3.5% and 0%, you would get three very different answers."
Natural selection
Many leasing companies have set their depreciation rates at closer to 5-6%, and so argue that they can withstand the current drop in residual values. "The success of any leasing company is ultimately determined by the selection of aircraft and the ability to market and manage them," says John Willingham, chief operating officer at lessor Boullioun.
Lessors also point out that acquiring aircraft at the right price is key. SALE, for instance, says that of 28 aircraft it has sold to date, all but one have been disposed of at above book value, the exception being an Airbus A310-200 that the lessor disposed of at the trough of the downturn.
SALE's Martin for one says that he presumes a very low inflation rate. "In the 1990s people were reselling widebodies at the same price that they had originally bought them. Those days are gone. If you are not seeing inflation in the ticket price, you are unlikely to see it in the price of aircraft," he says.
Working in a cyclical business always has its uncertainties, but as banks again contemplate lending large amounts of money to the industry, airlines and lessors can breathe a sign of relief, at least until the next downturn. Heinemann picks 2011 as a year to watch out for.
GECAS plays key role at troubled US carriers
As US carriers increasingly turn to bankruptcy, traditional lenders and capital markets are closing to them. But new players are stepping forward to play a key role led by GE, bringing together the power of leasing giant GECAS, an arm of GE Capital, and the GE Aircraft Engine business.
GE helped support America West Airlines through its crisis and helped finance the Air Canada reorganisation. GE is also the biggest creditor at United Airlines, with $1.6 billion at stake, and has become the single largest force shaping the US Airways struggle to survive. The company has nearly $3 billion at stake at US Airways, now in its second bankruptcy reorganisation since 2002, and it is GE Capital's financial targets and deadlines that US Airways must meet. GE is shaping regional carriers too.
GECAS says it has invested more than $7 billion in airlines around the world since the 2001 terrorist attacks. This puts it in sharp contrast to traditional lessors such as ILFC, which have played their portfolios with more of a banker's outlook, keeping risk under control and often looking overseas to contain their exposure to the throes of the US industry. When it comes to ILFC and its peers, says analyst Philip Walker of Fitch Ratings, "we're talking about companies that are pure-play financial companies".
Bryson Monteleone of the Morten Beyer & Agnew consultancy says that GE "has such a variety of services from the engines and engine overhaul to the lease finance that they are far beyond someone like ILFC. You don't see other (leasing firms) spooning out as much." GE sees its motivation as enlightened self-interest.
GECAS president Henry Hubschman says: "We have the global infrastructure and the staff expertise, and clearly we expect to make money from doing this." Therein lies much of the rationale: GE by contrast to other leasing firms is a captive financier and has an interest in its portfolio with GE equipment.
This explains the steps GE units have taken to support regional jet users who fly the Bombardier CRJ, powered by GE engines. In January, GECAS agreed to a deal with Independence Air, the troubled low-cost regional jet operator, for the early return of 10 aircraft and a $19.5 million, five-year secured term loan to its parent FLYi. GECAS will also restructure Independence aircraft rentals to defer a "significant" portion of payments until April 2006, a step that is widely seen as saving Independence from a looming bankruptcy. UBS analyst Robert Ashcroft says the move may just be good business in that the loan is backed by equipment that GE is "well-qualified to understand and if necessary to monetise", namely GE engines and spares.
Even where it is just one of several lessors, GE has become a major shaper of airline strategies to avoid bankruptcy. It signed a three-year $630 million loan with Delta Air Lines that the carrier said was secured by "substantially all of Delta's remaining unencumbered assets". In return, GECAS won agreement from Delta to take about 40 regional jets in the future, if the lessor wanted. The loan gave Delta slightly more liquidity than it was looking for, giving GECAS a say in Delta's future whether or not it is in forced into bankruptcy court. Analyst Phil Baggaley of Standard & Poor's notes that GE's would become a debtor-in-possession (DIP) credit facility in the event Delta is forced to file for reorganisation. A DIP financer can take an intimate role in the decisions a bankrupt company makes.
Of course, GECAS can be tough as well: it has taken back aircraft from some carriers, as Hubschman is quick to stress.
Report by COLIN BAKER IN LONDON
Source: Airline Business
