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Special Report - Aircraft Financing: Risk and Reward

Special Report - Risk and Reward

How to finance new aircraft is always an important decision for airlines. The shocks and stresses of the modern aviation environment make the decision critical

New aircraft are the lifeblood of a growing industry intent on delivering improvements in reliability, environmental performance and fuel efficiency.

Some 12,000 new aircraft are scheduled to be delivered through 2020. They are expensive machines that represent an investment of $1.3 trillion. For an industry that has averaged a loss of $5 billion a year over the past decade, paying for those aircraft is a considerable undertaking.

An airline looking to obtain a new aircraft has a number of options, but each one comes with its challenges. Whether buying an aircraft directly through a secured loan or using one of a variety of leasing opportunities, airlines need to find the right financing vehicle for their business model. “It is a vital decision for any airline CEO,” says Brian Pearce, IATA Chief Economist. “Airlines must get the financing right for a sustainable future.”

The current financial environment is not making life any easier. Kostya Zolotusky, Managing Director of Capital Markets Development at Boeing Capital Corporation, agrees there was a concern over liquidity in 2009, but believes the situation is gradually improving. “The cost of capital is a little more expensive than it was in the 2004-2007 timeframe but, relative to historical norms, its cost and availability are reasonable,” he notes.

Zolotusky believes the market is generating opportunities, and new structures are enhancing financing options. For example, the adoption of the Cape Town Convention may move Enhanced Equipment Trust Certificates (EETC) beyond their US homeland. A stronger US Export-Import (Ex-Im) Bank, the emergence of Chinese banking finance, and the first aircraft-secured Islamic bond transactions also offer plenty of potential. Regulatory frameworks such as Basel II—an enhanced banking agreement that determines the level of capital banks must hold—further improve prospects. Basel II basically allows banks some flexibility in the risk associated with aircraft financing, thereby encouraging deals. “Overall, there is good creativity,” says Zolotusky.

But such innovation sparks an even bigger question: is having access to these creative ideas and what is effectively subsidized finance a good thing for the industry at large? At its root, acquiring new aircraft should be a simple matter of supply and demand. But it rarely is that simple.

At the recent IATA AGM, David Bonderman, founder of the Texas Pacific Group, pointed out that even if airlines go bust, the number of aircraft in the skies doesn’t change. There is never any rationalization in the industry and over-capacity, partly made possible by easy financing, remains the biggest danger. “In most industries, losers lose and go out of business, whereas in the airline business the losers lose but don’t go out of business—they just come round with another name,” Bonderman says.

“1,340 aircraft will be delivered this year and only 500 are for replacement,” agrees Giovanni Bisignani, IATA Director General and CEO. “The discipline of chasing profits, not market share, is the only way to protect the bottom line.”

Buying Time

Aircraft cost a lot of money. But their worth is not only tied up in the nuts and bolts of a state-of the-art asset. Having aircraft on the books involves a lifetime of financial management. The question for airlines is whether taking the trouble to buy an aircraft still represents a shrewd investment?
Kostya Zolotusky, Managing Director of Capital Markets Development at Boeing Capital Corporation, says that an aircraft is an extremely valuable asset. Even if aircraft are expensive they represent good value. “It’s not necessarily the airplane price that matters most but rather how much value can we deliver through the improved efficiencies and capabilities of our products,” he concludes.

Airbus has a similar view, emphasizing that the mobility of aircraft, unlike fixed real-estate, makes it possible to use them anywhere in the world. They can be easily moved to another customer. Like Boeing, the European manufacturer helps customers find financing and is also sourcing new financing possibilities.

Max Sukkhasantikul, Consulting Analyst at the Frost & Sullivan Aerospace & Defense Practice, notes that the commercial life of an aircraft could be as much as 25-30 years if converted to serve the freighter markets. “On its completion of service life, it can be sold for recycling, where at least 50% of its materials can be recycled, which account for approximately 80% of the aircraft weight,” he adds.

Pre-delivery payments

Such value doesn’t come cheaply. Buying an aircraft requires a huge capital outlay even before it arrives. Pre-delivery payments (PDPs) are typically a percentage of list prices. Considering that a smaller aircraft from Airbus or Boeing is about $75 million on the book, airlines will typically have to pay out $15-20 million over two or three years in advance of the aircraft delivery.

It is not easy to obtain PDP financing from traditional sources in the current market, according to most financial commentators. The cost can easily go significantly above Libor (the inter-bank lending rate). Some lenders do finance 100% of PDPs, but these deals tend to be for airlines with stronger credit ratings. For all airlines, utilizing internal resources is a drag on liquidity and PDPs are a deadweight cost that does not increase airline revenue or reduce costs prior to delivery of the aircraft.

Additionally, loans mean a high level of debt and that could be fatal in recessions like the one just witnessed or one-off events such as the ash cloud that shut down European airspace in April.
Owning an aircraft also requires an airline to take residual risk. Assuming a typical depreciation policy that sees an aircraft being depreciated to 15% residual value over 25 years, a $75 million aircraft will be worth $11.25 million at the end of its useful life. Selling it on won’t be easy either.

“Traditional markets such as China, Russia and India don’t want old aircraft any more,” says Chris Tarry, Analyst at CTIARA. “And it is very difficult for African carriers to find the finance to buy them.

“At the same time, depreciation is now commonly worked out at the 16-20 year period rather than 25 years,” he continues. “So we don’t know how the mechanisms at play now will work through the system.”

Currency concerns

The risk is heightened for airlines whose functional currency for accounting purposes is not US dollars. At the time of acquisition, the cost of the aircraft will be translated into home currency at the prevailing exchange rate. As aircraft prices are denominated in US dollars and fixed assets are recorded at historical exchange rates, fluctuations in currency could have a considerable effect on the impairment analysis of the aircraft.

Despite such problems, the data does not show any significant increases in the number of aircraft retirements. So most old aircraft do find a home. For example, some US airlines are flying aircraft that have fully depreciated and are out of their accounting life. “It’s also true that an old aircraft holds its value,” says Brian Pearce, Chief Economist at IATA. “Aircraft residual values in many cases look high compared with the cash flows generated by the airlines operating the asset.”

 Opportunities in Leasing

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