At the end of last year I wrote a published piece entitled “The Allure of Investing in Aviation”. A client asked me this week whether, a year later, I stood by what I’d written.
To answer that, you have to decide whether or not you think 2018 was a good year for the airline industry as a whole. There were many highs, but some telling lows as well. There can be no doubt that we are still in a ‘supercycle’ of sorts, but this has to be balanced against both macro and sectoral environmental conditions.
The expectations as we headed into 2018 were that profitability would improve over the year, with 56 per cent of airline CEOs in a positive mood. However, this positivity has to be tempered by IATA’s adjustment of its own profit forecast from US$38.4 billion in December 2017 down to US$33.8 billion by June last year.
So what should investors be looking at? Is aviation still an attractive investment?
Resisting the headwinds
The industry has proved resilient over the course of a fairly tumultuous few years, certainly politically but also in the face of rising fuel prices (which rose to over US$80 a barrel by October 2018), increasing protectionism and a strong U.S. dollar (although, of course, that helps U.S. carriers).
Despite this, passenger demand is growing: airlines have robust load factors and RPKs have been growing at around 5 per cent annually since 2010. H1 2018 saw RPKs up by around 7 per cent and an industry-wide load factor of 81.3 per cent. Cargo traffic is also stable. This buoyancy is expected to continue in line with growth in GDP. Even though this represents a relative slowdown compared to 2017, it demonstrates the strong underlying demand.
“passenger demand is growing: airlines have robust load factors and RPKs have been growing…it demonstrates the strong underlying demand”
That said, profit margins have shown some continued retrenchment. Whereas before 2015 the accepted industry norm was in the region of 3 per cent to 4 per cent, margins reached around 8 per cent and were still around 7.5 per cent in 2017. Looking at the data available at the end of 2018, profit margins appear to be in the high 6 per cent range. This may indicate a passing peak, but at least at this level no one need have significant concern about covering the cost of capital.
Growing demand for new aircraft…
New orders may not have got back up to their 2013–2014 peak, but they also show no real sign of significantly slowing down. The order backlog is now equivalent to approximately 50 per cent of the in-service fleet or, to put it another way, 10 times the annual production figures (although 2017 engine-supply problems have distorted this). Sales of the A320 and Boeing 737 aircraft have hit new heights, but demand for widebodies remains sluggish (by way of illustration, the Reed Smith team worked on transactions involving 49 narrowbody aircraft in 2018, against 28 widebody transactions).
“The order backlog is now equivalent to approximately 50 per cent of the in-service fleet or, to put it another way, 10 times the annual production figures”
As demand for new and more environmentally friendly aircraft continues to rise (Boeing predicts there will be 42,700 industry deliveries over the next 20 years, up 3 per cent from its estimate of 41,030 a year ago) the fundamentals remain strong, and the industry generally has a positive story to tell.
… leads to growing demand for new aircraft financing
2019 will see demand for somewhere close to US$150 billion of investment in aviation, aircraft deliveries at close to record levels and there is an active sale and leaseback market and an active secondary and parts market. Aviation delivers predictable returns and set against the backdrop of the Fed, the ECB and the Bank of England suppressing interest rates, aviation has remained attractive to investors and funds looking for stable and appealing yields and relatively low default rates. As the Fed starts to increase rates and corporate yields in other sectors improve, aviation will start to face more competition for liquidity. Non-bank lenders such as insurers and pension funds, as well as private equity and hedge funds, are increasingly keen not just to invest in aviation, but to take on direct lending roles where traditional bank lenders can no longer always do so.
For the first time in a decade, Boeing’s aircraft finance benchmarks show no red ‘traffic lights’. Except for export credit and OEM finance, all lights are ‘green for go’, with other sources of financing more than bridging the gap. Interestingly, it is anticipated that operating lessors, who currently manage around 41 per cent of the global fleet, will be the largest source of aircraft finance. The AFIC product is also expected to provide approximately a further 5 per cent of support.
“Encouragingly, funds have also found opportunities to invest in the industry as well as the aircraft, showing an emerging commitment to the sector”
Encouragingly, funds have also found opportunities to invest in the industry as well as the aircraft, showing an emerging commitment to the sector. GIC’s acquisition of a 30 per cent stake in BBAM at the end of 2017 and investment in NAC in October 2018 are two examples, along with KKR’s US$1 billion investment in Altavair AirFinance in late 2018.
The flip side
For all the opportunities offered by the industry over the last years, there have also been casualties.
Airlines show some signs of having overextended and indeed some have failed with consolidation in Europe the result of insolvencies rather than mergers. In the wake of the Air Berlin and Monarch collapses in 2017, we have now seen Primera, Skyworks and Small Planet (to name a few) suffer a similar fate. Flybe may have been rescued, but Ryanair’s profit warning in January 2019 not only wiped €100m – €200m off its forecast, but painted a bleak picture of overcapacity and “record lower air fares” across European airlines more generally. WOW and Germania remain on the market but with further reductions to airfares predicted (by more than five per cent by some estimates) macroeconomic events such as Brexit or the protests in France could easily be the proverbial straw that breaks the back of some carriers. Airlines operating long haul routes have tended to be more resilient and a driver of consolidation through joint venture, such as the IAG-LATAM hook up. 2018 also saw airlines starting to hedge against the risk that fuel prices could be driven higher by the IMO 2020 regulations in the next 12 months.
The manufacturers have also stuttered this year, with more technical hitches and production issues than in recent history, especially with the A320neo and Boeing’s 737 Max. The regional jet and widebody markets also have structural deficiencies that are sometimes obscured on an industry-wide basis by the sheer volume of narrowbodies. The A380 and 747-8 in particular face uncertain retirements and investors who made bullish bets on residual values and a strong secondary market may look naively optimistic. While the current circumstances may have postponed the impact of the normal generation change on aircraft liquidity and values, it remains unclear if the neo and Max models will gain momentum and, if they do, what this will do to asset prices in older aircraft.
“Some sectors are becoming riskier, politically and socio-economically, and the competition is fostering increasingly aggressive transaction terms.”
As markets, traffic and patterns evolve, there will be changes in demand for different types of aircraft. Some sectors are becoming riskier, politically and socio-economically, and the competition is fostering increasingly aggressive transaction terms.
Because of the increased competition and niche investors, deal terms are becoming increasingly borrower-friendly, with low margins and, for lessors, low lease-rate factors. Fortunately, trading volumes are high and, because of the combination of strong demand, restricted supply and low fuel cost, airlines are typically interested in extending leases, even at the cost of immediate modernisation of their fleets.
Investors with interests in aircraft securitisation structures have found a shortage of liquidity and appetite in the market, leading to heavily discounted trades, although for those trading in metal rather than paper, the sale and leaseback market remains very active, dominated by single-aisle aircraft in particular. There are a number of new, smaller, entrants in this market who are becoming genuine players in this space, a market that is already in our view overheated. Some participants have criticised the new entrants, who they see as responsible for driving down lease-rate factors and for aggressive residual value expectations, but of course, the acceptability of low-level returns is often linked to a low cost of funds. If the industry does enter a downturn, this could clearly result in significant problems, in particular for new entrants with only limited experience of stressed markets and, specifically, without their own remarketing organisations.
Coming up roses… and tulips
The clue is in the name, but at some point we will inevitably find ourselves on the other side of the supercycle’s wheel. It would be glib to talk about tulip mania or even the dotcom bubble, but it wouldn’t be inappropriate to draw parallels with certain aspects of the crisis in shipping that continues to plague the industry following the end of a significant supercycle in 2008. Of course, at their core, shipping and aviation are industries with very different fundamentals, so at least for now there are no clear indicators of an imminent crash. The bottom lines look reasonably healthy, with positive net operating results every year since 2010 and solid returns on invested capital for the last three or four years. This restructuring and consolidation, probably stretching back to 2008, has created a stronger and more resilient global fleet. Especially in the US. However, yes, I do stand by what we wrote last year – our industry remains a very alluring prospect for investment and 2019 will see this trend continue.
We will inevitably eventually find ourselves on the other side of the supercycle’s wheel. And when that happens, we can only hope that the industry can respond in as mutually supportive way as the Canadian air traffic controllers did in sending pizza to their beleaguered and underpaid counterparts in the US.
And on that note, we wish all of our clients, readers, and the industry at large a very happy and successful 2019. If nothing else, consider this: according to Inmarsat’s annual Inflight Connectivity Survey, 57 per cent of respondents would use an online dating app during a flight to ‘match’ with other passengers. Who knew aviation could be so romantic?