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 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. 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 in- dustry 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 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 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 fi- nancing 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. air- lines and, to a lesser extent, for carriers in the 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. commercial banks have been a significant source of financing for the Figure 5 airline industry (see Figure 5). They have pro- vided seasonal working capital facilities, SELECTED AMERICAN BANKS medium-term aircraft loans, and tax capacity ACTIVE IN AVIATION for aircraft leases. Bank of America Of course, the banks spent most of the 1980s dealing with their own credit and earn- Bankers Trust ings problems and now must comply with in- Chase Manhattan ternationally mandated capital adequacy tests Citibank and federally imposed reserve requirements for lesser quality credits. As a result, no U.S. First National Bank of bank can make a profit on anything but short- NationsBank term financing to any major airline other than

JOURNAL OF EQUIPMENT LEASE FINANCING 13 likes the aircraft industry. Therefore, Wall many of the traditional tax investors removed Street and leasing companies are likely to find significant capacity from the market. The re- ways to structure investment grade transac- cent growth in corporate and bank profits Public debt tions, bringing this source of money back to should help this situation, as will the increase the table. in the marginal tax rates. As a result, we ex- markets have been pect that significant tax equity will become available in the near future. less important than U.S. Public Markets the institutional The U.S. public market has been the pri- Employees mary source of equity capital for the airline markets because industry since airlines seem to be unable to Airline employees have become a much earn any equity capital on their own. This more significant source of equity than they have the public markets market has had a history of increasing an air- been in the past. The theoretical basis for this line’s stock price during critical periods in an- view, however, is the belief that wage conces- like debt instruments ticipation of the increased earnings that are sions are the functional equivalent of capital. expected to follow (see Figure 6). that have a single We can only hope that this market remains maturity. as accommodating in the future. However, most airline stocks are at least 30 percent below their 1993 highs, and few analysts are recom- mending the purchase of these securities. JAPAN Public debt markets have been less impor- tant than the institutional markets because the public markets like debt instruments that During the mid-1980s, Japanese financial have a single maturity. However, this struc- institutions were an important source of fund- tural problem was solved for large borrowers ing. Japanese banks benefited from having by the application of securitization tech- low capital requirements, an accommodating niques to aircraft financing. central bank, strong earnings, and a willing- ness to lend long term. In fact, the interna- U.S. Tax Equity tional minimum capital standards were supported by some U.S. banks in order to make Japanese banks less competitive, and The passage of the alternative minimum unfortunately for the airline industry, the new tax and the absence of taxable income for standards were effective. Moreover, these increased capital require- ments were phased in just as the Japanese Figure 6 stock and real estate markets crashed, the Japanese economy slipped into a recession, EQUITY AND EQUITY-LINKED OFFERINGS SINCE 1991 and credit losses soared. The result is that Japanese financial institutions became a Amount much more modest source of capital, but one Date Issuer Type of Issue (millions) which is likely to return once their problems March 1994 Northwest Air Corp. Common $260.0 are solved (see Figure 7). Dec. 7, 1993 Common 153.6 June 17, 1993 Delta Air Lines Discount convertible notes 498.8 April 28, 1993 USAir Group Common 207.5 Feb. 11, 1993 AMR Corporation Convertible preferred 1100.0 Feb. 4, 1993 UAL Corporation Convertible preferred 600.0 June 24, 1992 Delta Air Lines Convertible preferred 1000.0 EUROPE Feb. 10, 1992 Common 78.3 Jan. 30, 1992 AMR Corporation Common 427.5 European banks have been one of the most May 17, 1991 USAir Group Convertible preferred 200.0 consistent sources of aircraft finance over the April 11, 1991 Zero coupon convertible bond 118.5 past 15 years. These banks benefit from stable April 8, 1991 Delta Air Lines Common 484.8 internal policies, which have been noticeably March 14, 1991 UAL Corporation Common 219.0 absent in many American banks. As a result, March 8, 1991 AMR Corporation Zero coupon convertible bond 516.5 the European banks are expected to remain a Jan 24, 1991 AMR Corporation Common 262.5 major source of capital for the remainder of the 1990s (see Figure 8). Source: New York Times/Aviation Daily

14 VOL. 12/NO. 2 • FALL 1994 Moreover, these banks are likely to remain lines but fortunately for lessors, manufactur- an important source of tax equity for their own ers have limited capital and can provide help domestic airlines. only for short periods. As a result, their in- volvement over the next couple of years will ECAs have always decline dramatically and will not become sig- nificant again until the next cyclical downturn. been lenders during troubled

market conditions. EXPORT CREDIT AGENCIES

Export credit agencies (ECAs) have always IRLINES AND ROFITS been lenders during troubled market condi- A P tions. Consequently, they have been much more active over the past two years as private Like most observers, this author expects sources of capital have withdrawn from the airline profits to increase over the next few markets and airlines bought aircraft that re- quired financing. In addition, the ECAs have recognized the Figure 7 critical role of operating lessors, by financing three of the largest—GPA, International Lease SELECTED JAPANESE FINANCIAL INSTITUTIONS Finance Corp. (ILFC), and Ansette—during ACTIVE IN AVIATION this difficult period. Banks Trading Companies Investment Banks

IBJ ITOCHU AirLease Nomura Long Term Credit Bank Nissho Iwai Mitsubishi Bank Ryoshin Mitsubishi Trust Orix OPERATING LESSORS Sanwa Operating lessors have played a critical Sumitomo role in meeting the airline industry’s capital needs during the 1980s. Their function was Figure 8 well-conceived as a source of risk capital, and as such, they were very profitable during the SELECTED EUROPEAN BANKS ACTIVE IN AVIATION growth years. ABN-AMRO Bank NV Deutsche Bank Equally predictably, this risk capital bore the brunt of the current downturn, and most Barclays ING lessors either have been acquired or have gone Bayerische Landesbank Nat”l. Investment Bank of the Netherlands out of business. At a minimum, GE Capital and ILFC will continue to be important Credit Agricole National Westminster Bank sources of capital for the industry (see Figure Credit Lyonnais Westdeutsche Landesbank 9). The challenge for this group is to develop Credit National strategies that will allow each lessor to share in the industry’s profits during this cyclical upturn. Figure 9

SELECTED EUROPEAN BANKS ACTIVE IN AVIATION

Exit Business Active During 1993 Chrysler Finance CIT Concord Asset Management GATX AIRCRAFT AND Electra Aviation GE Capital/GP A/Polaris ENGINE MANUFACTURERS Security Pacific Leasing ILFC

When the financial community abandons United Aviation Services Pegasus the airline industry, manufacturers have been Westinghouse Finance lenders of last resort. Unfortunately for air- Whirlpool Finance

JOURNAL OF EQUIPMENT LEASE FINANCING 15 years. Management is obsessed with cost con- owning and leasing aircraft is a good busi- tainment. The world’s economies appear to ness—one that can provide superior returns to be improving. And airline capacity is being sophisticated investors. Airline capacity is brought in line with demand. However, it is doubtful that the industry being brought in will ever be able to earn a return on invested assets equal to the average earned by all in- line with demand. dustrial companies because of the lack of im- provements to the industry’s economic structure. It is an industry that sells a com- AIRCRAFT AS INVESTMENTS modity product, has no limits to competition, has high fixed costs, and has low marginal costs. It appears close to impossible to earn an Despite all the fundamental reasons that adequate profit under that set of circumstances. airlines will have difficulty making a reason- able return on invested assets, we are con- This pessimistic thesis completes the background for showing why we believe that vinced that aircraft can provide above normal

Figure 10

USING THE CAPACITY FORMAULAS TO MEASURE EXCESS CAPACITY IN THE WORLD FLEET (Assumes That Utilization Remained Constant After 1973)

(A) (B) Memo: Passenger Total Actual (B minus Then To Total ASM’s ÷ ASM’s per day ÷ sum of Aircraft Aircraft Aircraft A equals) add: Obtain: Required by 365 = Aircraft Operating Factors: Required Required in the Surplus incl. Fleet Traffic - RPM’s ASM’s Utiliz. Speed Seats for World for World World Aircraft Aircraft Total of non- Load ASM’s per Day in Hours per per Airline Airline Fleet Airline in the with Surplus Airline Year Billions Factor (bil.) (bil.) per Day Hour Aircraft equals Fleet (incl. cargo) Fleet Fleet Brokers Aircraft Operators 1970 287 55.1 522 1.430 8.99 365 121 3,597 3,671 3,673 2 10 12 3,766 1971 310 54.0 573 1.570 9.04 367 125 3,800 3,887 3,886 (1) 10 9 3,999 1972 352 57.3 615 1.686 8.88 368 129 3,999 4,082 4,080 (2) 2 0 4,194 1973 394 58.0 679 1.861 8.89 370 135 4,191 4,284 4,282 (2) 15 13 4,426 1974 405 59.4 681 1.865 8.85 370 135 4,219 4,325 4,494 169 53 222 4,517 1975 425 59.1 720 1.972 8.85 376 137 4,339 4,461 4,705 244 74 318 4,678 1976 464 60.2 772 2.114 8.85 374 142 4,513 4,648 4,856 208 84 292 4,890 1977 506 61.5 823 2.255 8.85 376 146 4,642 4,810 4,957 147 101 248 5,082 1978 573 64.7 885 2.424 8.85 378 151 4,798 4,983 5,135 152 115 267 5,280 1979 639 65.2 980 2.685 8.85 382 156 5,092 5,292 5,471 179 119 298 5,607 1980 645 62.3 1,036 2.838 8.85 384 163 5,121 5,343 5,753 410 135 545 5,708 1981 655 62.4 1,050 2.878 8.85 383 171 4,962 5,215 6,006 791 133 924 5,631 1982 674 62.5 1,079 2.955 8.85 385 175 4,967 5,291 6,086 795 188 983 5,730 1983 702 63.1 1,111 3.044 8.85 380 174 5,202 5,537 6,238 701 174 875 6,009 1984 753 63.7 1,181 3.237 8.85 381 174 5,510 5,882 6,338 456 209 665 6,364 1985 818 64.6 1,266 3.467 8.85 383 175 5,842 6,278 6,658 380 178 558 6,735 1986 870 63.9 1,363 3.733 8.85 383 175 6,290 6,801 7,033 232 138 370 7,271 1987 971 66.3 1,464 4.011 8.85 383 174 6,800 7,390 7,413 23 133 156 7,867 1988 1,041 66.5 1,565 4.287 8.85 382 176 7,193 7,844 7,852 8 157 165 8,325 1989 1,079 66.9 1,612 4.418 8.85 382 177 7,383 8,087 8,307 220 215 435 8,561 1990 1,154 66.4 1,738 4.760 8.85 381 176 8,017 8,811 8,908 97 224 321 9,291 1991 1,117 65.5 1,705 4.672 8.85 382 177 7,808 8,667 9,316 649 573 1,222 9,129 1992 1,217 65.8 1,848 5.064 8.85 382 180 8,313 9,246 9,985 739 521 1,260 9,739 Estimated 1993 1,277 66.7 1,915 5.247 8.85 382 182 8,533 9,504 10,124 621 808 1,429 10,005 1994 1,349 67.7 1,992 5.459 8.85 382 184 8,756 9,766 10,291 524 806 1,330 10,274 1995 1,425 68.2 2,091 5.728 8.85 382 188 9,031 10,082 10,510 428 676 1,104 10,598 1996 1,509 68.3 2,210 6.054 8.85 383 191 9,371 10,465 10,793 329 442 771 10,988 1997 1,600 68.4 2,340 6.411 8.85 383 194 9,770 10,909 11,135 226 192 418 11,440 1998 1,696 68.5 2,476 6.783 8.85 383 195 10,251 11,436 11,553 117 145 262 11,974 1999 1,797 68.6 2,619 7.176 8.85 384 196 10,768 12,001 12,001 0 123 123 12,547 2000 1,904 68.7 2,772 7.594 8.85 384 197 11,343 12,626 12,499 (127) 86 (41) 13,180

Source: Individual Carrier

16 VOL. 12/NO. 2 • FALL 1994 returns for those investors who view them as As with all investment decisions, it is im- an asset—such as a common stock, bought possible to foresee the future. However, we be- when the price is low and sold when it is lieve that a thorough understanding both of high—instead of as a unit of production. the forces affecting the airline industry and the Aircraft prices The airline industry must grow because it demand for various aircraft types will enable fluctuate around is a critical component of world economic leasing professionals to make prudent invest- ments that will provide above normal returns growth. However, most sources of capital are their intrinsic value avoiding this industry. The investors who over a three- to five-year investment horizon. were burned during the last few years are not just as all other ready to reinvest. Donald P. Schenk is president and CEO of Air- It is difficult to remember that an asset’s in- line Capital Associates Inc., New York City. asset prices do. trinsic value is the discounted present value of the cash flow it can produce for its owner, and that this value is distinct from the appraised value or the current market value. This intrinsic value may fluctuate, but it tends to fluctuate less than the current market value of an asset that is driven by the forces of supply and demand. Generally, investors have difficulty in an- ticipating change in markets and thus place a heavy emphasis on current market conditions. As a result, at the top of cycles, investors focus on the immediate cash generating capacity of an asset, and traders seem to act as if there will be no end to the upward price movement. When the market is bad, the opposite occurs. Our thesis is that aircraft prices fluctuate around their intrinsic value just as all other asset prices do, irrespective of whether these assets are stocks, real estate, or currencies. Equally relevant is our view that aircraft prices have over-corrected and are at or near their bottom (see Figure 10). However, as in any investment strategy, it is critical to correctly forecast the direction of both the market and to invest in the best as- sets. To help identify the best assets, those as- sets that are most likely to increase in value, Airline Capital Associates has developed an valuation model that allows the user to esti- mate the intrinsic value at any point in its eco- nomic life. This model assumes that aircraft should be worth the discounted present value of its fu- ture cash flow when used in revenue service, and then allows for adjustments in those val- ues for subjective factors such as the manufac- turer of the plane, the supply/demand imbalance, and the popularity of the aircraft.

JOURNAL OF EQUIPMENT LEASE FINANCING 17