Liquid returns

It seems hard to believe that it was just a few years ago that airlines were struggling to find willing investors. Following on from the recovery in lease rates and residual values seen in 2004, airlines and aircraft are back in favour with the banks, attracted by the popularity of the low-cost sector, healthy traffic growth and, perhaps above all else, a confidence that they will be able to place assets back in the market if anything goes wrong.

Against this background, capital seems to be flowing freely. As Finnair chief financial officer Lasse Heinonen puts it: “There is a lot of liquidity in the market.” And, perhaps GECAS president Henry Hubschman sums up the fear of many, when he says “there is a lot of liquidity in the air finance market, much of it chasing poor deals that may have implications down the road.”

Even in North America, where over half the industry is in Chapter 11 bankruptcy protection, airlines are still able to attract money. “The Chapter 11 mentality of North American airlines is getting a lot of large banks that have traditionally been airline financiers for aircraft and working capital shifting to being debtor-in-possession [DIP] providers,” says Steve Udvar-Hazy, chief executive of ILFC. “They might previously have ­provided capital for aircraft and/or working capital, but are finding it more profitable to lend to distressed carriers. Their loan is secured on the pledge of the remaining assets in the business, therefore the risk is low.”

There is clearly plenty of money going into Chapter 11 carriers. CitiGroup and JP Morgan, for instance, are seeking out partners for a $3 billion loan to United Airlines, with GE Capital acting as syndicate agent for the deal which will involve a $2.7 billion loan for six years and a $300 million revolving credit facility.

Udvar-Hazy says that Chapter 11 carriers are effectively draining resources from healthy carriers to their less robust peers. “A lot of [financial] capacity has shifted to DIP that should really be going towards the transformation and updating of airline fleets.” He points to fellow leasing giant GECAS as a prime example. “GECAS has shifted a lot of capital to this type of financing, now it almost seems like over half of their new cash is restructuring financing in the from of DIPs.”

Hubschman says that working with airlines in bankruptcy protection has risks, but there can still be a rationale for working with them. “The question is, does the airline have a plan for becoming profitable again. Do they have strong management? Can we help them?” GECAS is taking 25 aircraft back from US Airways as a result of the latter’s merger with America West, but is confident that it will be able to place them given today’s benign market conditions. Even so, Hubschman feels that some airlines are abusing the bankruptcy protection process. “The problem is that some airlines are chasing Chapter 11,” he says.

Leveraged leases are out

Hubschman says that GECAS is becoming increasingly fastidious when it comes to the North American market. “We are becoming much more selective in the USA. We are not doing leveraged leases – from a risk-adjusted view they don’t make sense.”

Leveraged leases have been popular in the USA in recent years as they allow the owner of the aircraft to write off the purchase cost against tax over a period of time. However, there is a risk of the owner being landed with a significant tax bill if the airline goes bust. Clearly, this is not exactly an outside risk in the USA. For example, Walt Disney and electrical goods manufacturer Whirlpool have been hit by write-downs believed to be in the region of $100 million as a result of their involvement with leveraged leases to US carriers.

There is still life in the US airline industry outside Chapter 11, however. American Airlines, which is the only US major to have stayed out of bankruptcy, issued $225 million of stock – its first placement for 13 years – in November, and also issued bonds to the value of $800 million to help finance American’s New York JFK airport terminal. “We felt very good about that,” says Beverley Goulet, American’s vice-president corporate development and treasurer.

Goulet admits that the cost of money is an issue for the likes of American. “The risks in the business are reflected in the cost of capital,” she says, adding that for American, the focus is on cost-cutting and repairing the balance sheet. “As we continue to make progress, this will also be reflected in the cost of capital,” she says.

Even the more healthy US carriers such as American are still some way off being classed as financially healthy, and Goulet says that with few unencumbered aircraft, a move towards more operating leases is not a priority at the moment. “We can’t even contemplate that at this point,” she says.

Outside the USA, the picture is far more robust. Although there have been no share offerings from major carriers in Europe since Lufthansa’s badly received rights issue in 2004, it is a different story with second-tier carriers. Italian leisure carrier Eurofly completed a successful IPO in December last year, selling 6.3 million shares (or just under half the company) at €6.4 ($7.7) each. As industry analysts are quick to point out, Italy-based Eurofly is the type of carrier that would have struggled to launch an IPO a few years ago when liquidity was tight. Much the same could be said for German low-cost carrier DBA, which is looking at the possibility of an IPO to finance its intended purchase of 40 Boeing 737-700/800s.

Elsewhere in Europe, fast-growing East European low-cost carrier SkyEurope floated on the Vienna and Warsaw stock exchanges in September, raising €60 million. The carrier met 80 institutional investors in the run-up to the launch, with more than half electing to participate in the share offering.

Family Trust-owned UK low-cost carrier flybe, which has built a profitable operation based on turboprops and regional jets, is also looking at a possible IPO either late this year or in 2007. In Germany, Air Berlin is said to be considering an IPO this spring, with the aim of raising €600 million to €700 million.

Asia has been the real hot spot for airline financiers this year, however – particularly India. Jet Airways carried out a successful IPO in February, floating one-fifth of the carrier and raising $367 million in an offering that was 16 times oversubscribed. National carrier Air India has secured government approval for an IPO, while the country’s second largest private carrier after Jet Airways, Air Sahara, has hired Ernst & Young to support its cash raising efforts.

A good example of the ability of Indian start-ups to attract blue chip investors is SpiceJet, which attracted Goldman Sachs and the Dubai government investment arm Istithmar to an $80 million convertible foreign currency bond issue in December. Meanwhile, another Indian low-cost start-up, Air Deccan, is looking to launch an IPO in 2006.

IPOs in fashion

Elsewhere, Panamanian carrier COPA launched a successful IPO in December, selling 14 million shares at $20 each, above initial estimates that had been in the $15 to $17 price range. Nine million of these were sold by Continental Airlines, which netted a much-needed $172 million and reduced its stake in COPA from 49% to about one-third of the carrier. Mexican government holding company Cintra is hoping to sell Aeromexico through the stock exchange in 2006, having completed the sale of the carrier’s sister airline Mexicana to hotel chain Grupo Posadas last year.

Despite the increased opportunities in the capital markets, the operating lease remains a key tool for airlines. “The overall share of leasing is projected to increase – some say as high as 40% of the total world fleet – as airlines distance themselves from ownership and residual value risks,” says Harry Forsythe, vice-president marketing at AWAS.

“The operational lease, has, if anything, become even more attractive – they are the only source of 100% funding,” says Klaus Heinemann, chief executive of AerCap. “The capital markets are, in general, looking for 15% to 25% equity.”

Jeff Knittel, president of CIT Aerospace, says that the flexibility offered by operational leases is becoming increasingly attractive, adding that airlines are also interested in a “more balanced strategy” and the ability to meet short-term requirements. A number of Indian carriers, despite the huge orderbook emanating from that country, have been active in the leasing market as they seek to add capacity while waiting for new aircraft deliveries to arrive.

However, not all carriers are looking to ramp up their leasing activities. Finnair’s Heinonen says the carrier, which has around half of its aircraft on lease, “may be looking to do a little bit less leasing in future”. He explains: “After 9/11, we increased the amount of leasing in order to help manage risk.” With economic conditions now more benign, this is no longer necessary.

EasyJet, meanwhile, says that in 2006 it will finance a small number of aircraft through its own cash generation, and is also looking to renegotiate both operating leases and debts that “look expensive”. Lessors are quick to point out, however, that while lease rates are going up, so is the cost of capital, given the tightening of interest rates in the USA.

Hard bargains

With the market working in their favour, lessors are able to drive a hard bargain. Deutsche Bank reports that a number of US carriers in Chapter 11 are trying to convert finance leases into operating leases, but are getting a lukewarm reception from lessors who know that they can place aircraft elsewhere at higher rates.

With the market moving in favour of the lessors, some have seen signs that the sale-and-leaseback option that has become such a popular tool for low-cost carriers becoming a harder sell. “Unrealistically high pricing on the sale side has led to a wane in popularity,” says Forsythe. “As ever, those who brought at the peak of the cycle will be hardest hit in the next downturn.”

However, Heinemann at AerCap says that sale-and-leaseback continues to prove popular. “Effectively it creates an operating lease – airlines have practically no other opportunities for 100% funding.”

David Power, managing director of lessor Orix Aviation, says “sale-and-leaseback is certainly still popular,” pointing to the volume discounts that have been achieved by airlines that are not available to most lessors. As regards the residual risk taken on by the lessor in these types of deal, he says, “that is not a problem as long as the purchase is acceptable – that is what lessor’s do.”

Some see clear risks to these residual values, however. Chris Tarry of consultancy CTAIRA warns that “ordering behaviour reflects the late 1980s”, with unsustainable order momentum and a risk of expectations moving ahead of reality and over-ordering. “Over supply will put pressure on fares and affordability” he warns.

With this in mind, he says that aviation is not a particularly favoured sector from an investment point of view. “Even within the more positive segments and subsegments there is a need for selectivity,” he says. “Asia offers structural growth, but there is a need to transfer this into investable returns.” ■

COLIN BAKER / LONDON

Source: Airline Business