Aircraft As an Investment Opportunity

Aircraft as an Investment Opportunity By Donald P. Schenk ver the past few years, fundamental two years ago, assumes that financial con- Ochanges have occurred in the airline and straints will not limit the airline industry’s financial services industries, changes that risk ability to acquire its projected fleet. limiting the airline industry’s ability to re- As can be seen in the third chart, the 25 per- Risk creates an place its aging fleet while meeting forecasted cent reduction in 1994 deliveries is an indi- exceptional traffic growth (see Figure 1). Fortunately for cation of what would happen if capital this audience, this risk creates an exceptional constraints continue to affect the industry. investment opportunity for aircraft lessors. investment 3. Airlines spent $119 billion over the three- This article reviews the relevant develop- year period of 1990 to 1992. Of this total, opportunity for ments in the airline and financial services in- $99 billion was financed externally. This is dustries and explains why aircraft are good a major accomplishment, but the cost has aircraft lessors. investments at this point in the cycle. Ed Greenslet, the author’s partner and the pub- lisher of The Airline Monitor, prepared the Figure 1 forecasts used in this paper. WORLD ESTIMATED VALUE OF AIRCRAFT DELIVERIES Then Year Dollars Billions 60 48.3 AIRLINE INDUSTRY DYNAMICS 50 45.2 45.5 40 38.7 Following is a brief review of the airline de- 31.2 32.7 velopments that have had the largest impact 30 27.8 on the financial community and its willing- ness to support the industry. 20 1. Over the last four years, the U.S. airline industry lost over $11 billion, while purchas- 10 ing a record number of aircraft. Every major airline, except Southwest, lost its in- 0 vestment grade credit rating, restricting the 1994 1995 1996 1997 1998 1999 2000 major airlines’ access to credit and increas- Source: Jan ’94 Airline Monitor ing the cost (see Figure 2). With the spread of deregulation through- Figure 2 out the world, we predict the airlines in Eu- rope and Asia will endure a period of U.S. INVESTMENT GRADE MAJORS extended losses similar to those experi- enced by the airlines in this hemisphere. 1988 1994 2. Greenslet’s latest forecast is that worldwide capital expenditures in the 1990s will total American Southwest $429 billion, or almost three times the Delta amount spent in the 1980s. This estimate, Northwest while $15 billion less than our estimate of United Airlines USAir JOURNAL OF EQUIPMENT LEASE FINANCING 11 been high to the airlines’ balance sheets, 5. The Big Three’s inability to raise external and the capital deficiency has caused capital in sufficient amounts has forced record cancellation and deferrals of aircraft. them to focus on profits. One result of this The Big Three must Repairing this damage will require record focus has been that they have increased profits or massive sales of equity. Ideally ticket prices to a level that allowed South- make record profits the solution will come from profits, but the west and its emulators to steal a growing share of the U.S. market. if they are going to post deregulation earnings history is not encouraging. Over that 17-year period, the However, the Big Three must make record regain their airlines’ profit margins have shrunk, while profits, if they are going to regain their in- the losses have widened. vestment grade rating. Without that rating, investment grade 4. By the early 1990s, American, Delta, and it is hard to see how they will attract suffi- United—the Big Three—had developed in- cient capital, other than in the form of rating. formation systems and route structures leased aircraft, to fund the required aircraft that were superior to their European and purchases. Asian competitors. These assets gave the As can be seen in Figure 3, which was Big Three the opportunity to dominate the adopted from work provided by Philip Bag- world’s aviation community. It appeared galey of Standard & Poor’s, the hoped-for that these airlines only needed sufficient strong earnings will have to persist for aircraft to exploit their hard-won fran- some time for these airlines to restore their chises. Unfortunately, their recent losses capital structures to normal investment may rob them of the ability to achieve this grade ratios. potential. 6. Northwest, TWA, and United each have re- sponded to the overwhelming need to re- duce costs by trading wage concessions for Figure 3 employee ownership (see Figure 4). This employee involvement has tremendous po- SELECTED OPERATING RESULTS tential for the industry if it creates a produc- TO PRODUCE BBB CREDIT RATING tive employee/management relationship. There is a risk, however, that if the employ- ($ million) Required Pre-tax Required Required ees and management fail to change their Interest Coverage Operating Margin Operating Income historically divisive approach to solving problems, the savings will be lost when AMR 2.49 17.5 $2,517 wages snap back. 1992 Pro Forma TWA’s recent steps to reengineer itself are a Delta Air Lines 2.49 10.8 $1,296 most encouraging development. This effort 1993 Pro Forma is led by the chairman of the board and the union leadership. It is an unprecedented UAL Corp. 2.49 11.7 $1,503 effort by an old-line airline to change its 1992 Pro Forma culture so that all employees act as owners Source: Standard & Poor’s High Yield Directions, Jan. 1994 and have the ability to implement both money-saving and revenue-enhancing ideas. The effort is in its early stages, but Figure 4 we expect to see a very different and much more competitive airline within the next ANTICIPATED EMPLOYEE few months. STOCK OWNERSHIP PERCENTAGE 60% However, the potential for an absence of 53 - 63% good will was apparent at United Airlines 50% when the pilots tried to renegotiate the 45% terms of the employee buyout. Sharehold- 40% ers, whether they are employees or out- siders, all too frequently look at short-term 30% market swings as a report card on manage- 30% ment. If that happens, the potential for cre- ating productive employee management 20% through employee ownership may be lost. 11% 10% 7. The concentration of assets in the Big Three has exacerbated an otherwise difficult fi- 0 nancing environment, because prudent Northwest Southwest TWA United lenders limit the size of their exposure to 12 VOL. 12/NO. 2 • FALL 1994 any given company. Because each one of Southwest. Since banks have never been these three airlines has purchased as much known for their charity, few new loans are as $3 billion of aircraft in a given year, being booked. The availability and credit capacity is easily consumed at even Even if this federally mandated problem the largest and most supportive financial were eliminated, U.S. banks would not be ex- cost of alternative institutions. pected to return as a dominant source of financing because of banks’ aversion to sources of capital long-term financing. During the 1980s, most banks were not will have a material concerned about their inability to forecast the airline industry’s future, because they be- impact on airlines’ lieved that they could rely on the value of use of leased aircraft FINANCIAL INDUSTRY DYNAMICS their collateral, but over the last few years, aircraft values fell by 30 to 70 percent, de- and the profitability of Independent forces have had an equally pending on the type and age of the plane. significant impact on the financial commu- These market value losses would not have the leasing business. nity. The financial industry has been going been a problem had not several airlines gone through its own period of deregulation and bankrupt and used that opportunity to extract earnings problems. The availability and cost concessions from both lenders and lessors. of alternative sources of capital will have a Finally, the threat of bankruptcy for North- material impact on airlines’ use of leased aircraft west Airlines and GPA exacerbated a difficult and the profitability of the leasing business. situation for most banks: Bank loans to these Following is a brief review of what has hap- two companies represented a significant pro- pened to the traditional sources of capital and portion of the banking system’s exposure to their likely role as a source of funding over the the airline industry. In both cases, the banks remainder of the decade. All evidence leads us saw the market value of their exposure fall to believe that aircraft leasing holds excep- from par to approximately the same level as tional profit opportunities at this point in the their Latin American exposure. airline industry cycle. U.S. Insurance Companies Insurance companies have been the pri- mary source of long-term fixed rate financing for the purchase of new aircraft by U.S. airlines and, to a lesser extent, for carriers in the UNITED STATES rest of the world. Unfortunately, the insurance industry suffered from the combined effect of The United States has been and will remain sizable insurance losses and non-aviation the largest source of capital in the world, and credit losses from its investment portfolio. its importance to the aviation community is The resulting capital constraints have limited unquestioned. Thus, this section deals with their ability to purchase assets with less than the most important segments of the U.S. mar- investment grade credit ratings, which elimi- ket, and then with Asia and Europe. nates most airlines. Because the insurance industry has largely U.S. Commercial Banks restricted its financing to financially stronger airlines and to the purchase of new aircraft, it Historically, U.S.

Load more