EAS431 Aviation Finance Study Guide (5CU)
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Release V1.2 CONTENTS
SECTION 1: COURSE GUIDE 1.1 Introduction ...... 1 1.2 Course Description and Aims ...... 2 1.3 Learning Outcomes ...... 2 1.4 Overall Assessment ...... 3 1.5 Learning Materials ...... 4
SECTION 2 : STUDY UNITS
STUDY UNIT 1 Overview ······································································································ SU1-2 Learning Outcomes ···················································································· SU1-3
Chapter 1: Overview of the Aviation Industry ······································ SU1-4 1.1 Introduction 1.2 Key factors and challenges affecting travel demand 1.3 Evolution and performance of global airline industry 1.4 Challenges, boom and bust of aviation industries 1.5 The competitive landscape in the transportation industry 1.6 Summary ····························································································· SU1-13
STUDY UNIT 2 Overview ······································································································ SU2-2 Learning Outcomes ···················································································· SU2-2
Chapter 2: Evolution of the Aviation Industry ······································· SU2-3 2.1 Evolution of the Aircraft Manufacturers Industry 2.2 History of the aircraft manufacturers Aircraft engine manufacturers with engine launch history Point-to-Point versus Hub-and-Spoke networks The making of B787 The making of A380
2.2 The Economic and Business Model of Airlines Full Service Carrier (FSC) Low Cost Carrier (LCC) Charter Carrier (CC) 2.3 Airline’s Performance and Profitability ‘White doves’ in the airlines industry Fate of parked or stored aircraft 2.4 New Market Entrants Case study of successful low-cost carriers (LCCs) Definition of Cost per RPM and Cost per ASM Threats to LCC’s business model LCC yield management Review of Europe LCC consolidation 2.5 Summary ····························································································· SU2-29
STUDY UNIT 3 Overview ······································································································ SU3-2 Learning Outcomes ···················································································· SU3-2
Chapter 3: Overview of the Costs Structure of Airline Businesses ····· SU3-3 3.1 Aircraft Economics Direct Operating Costs versus Indirect Operating Costs Fuel Costs Maintenance Costs Other Costs 3.2 Key Aircraft Operating Economics Break-even load factor Operating leverage Cost escapability Profit profiling Dynamic fleet management Economics of fleet commonality Spare provisioning Cabin crew training 3.3 Asset Utilisation and Fleet Size Scheduled versus Charter versus Low-cost operation Effect of fleet size on economics The impact of alliance on economics Impact of external factors Spare provisioning 3.4 Summary ····························································································· SU3-16
STUDY UNIT 4 Overview ······································································································ SU4-2 Learning Outcomes ···················································································· SU4-2
Chapter 4: Overview of Investment Appraisal ···································· SU4-3 4.1 Aircraft Finance and Investment Return on Capital (ROC) Return on Invested Capital (ROIC) Weighted Average Cost of Capital (WACC) Lease versus Buy decisions Net Present Value (NPV) NPV calculations for investment appraisal 4.2 Sources of Aircraft Financing Impact of operating lease 4.3 Aircraft Leasing Aircraft financing spectrum The world of lessor versus lessee Finance Lease Japanese Leverage Lease (JLL) US Leverage Lease European Leverage Lease Extendible Operating Lease Wet Lease Sales and Lease Back Enhanced Equipment Trust Certificate (EETC) Comparison between aircraft manufacturers and airlines 4.4 Aircraft Residual Value Factors influencing aircraft residual value Key model inputs for residual value forecast Investment Trends and Consideration Case review: Timing of SIA A345 All business class reconfiguration Garuda new brand image in 2010 4.5 Reference ····························································································· SU4-18
STUDY UNIT 5 Overview ······································································································ SU5-2 Learning Outcomes ···················································································· SU5-2
Chapter 5: Overview of the MRO Businesses and External Factors affecting the aviation industry ·································································· SU5-3 5.1 Global MRO Market Outlook in 2010 Global MRO market share Global MRO spending 5.2 International Regulatory Bodies Federal Aviation Administration (FAA) European Aviation Safety Agency (EASA) Japan Civil Aviaition Bureau (JCAB) Other local regulatory bodies Association of Asia Pacific Airlines (AAPA) Trends and effects of market deregulation History of market deregulations 5.3 Effects of Currency Exchange Rates Case review: Lufthansa dilemma case in 1985 5.4 Summary ····························································································· SU5-17
STUDY UNIT 6 Overview ······································································································ SU6-2 Learning Outcomes ···················································································· SU6-2
Chapter 6: Overview of External Shock Factors ····································· SU6-3 6.1 Price of Jet Fuel Correlation between jet fuel and cruel oil prices 6.2 Nature Catastrophe Case review of Iceland volcanic disruption 6.3 Bankruptcy Law US Bankruptcy Code 6.4 Boeing & Airbus 20 Years Forecast Reports 6.5 Emerging Trends & Development Technology advancement of new aircraft model: B747-8 example 6.6 Summary ····························································································· SU6-16
Reference ···································································································· SU6-19
EAS431 Aviation Finance
COURSE GUIDE EAS431 COURSE GUIDE
SECTION 1: COURSE GUIDE
1.1 Introduction
Welcome to your study of EAS431 – Aviation Finance, a 5 credit unit (CU) course.
This Study Guide is divided into two sections – the Course Guide and Study Units.
The Course Guide provides a structure for the entire course. As the phrase implies, the Course Guide aims to guide you through the learning experience. In other words, it may be seen as a roadmap through which you are introduced to the different topics within the broader subject. This Guide has been prepared to help you understand the aim[s] and learning outcomes of the course. In addition, it explains how the various materials and resources are organised and how they may be used, how your learning will be assessed, and how to get help if you need it.
Course Schedule To help monitor your study progress, you should pay special attention to your Course Schedule. It contains study unit related activities including Assignment, self-evaluations, and examinations. Please refer to the Course Timetable in the Student Portal for the updated Course Schedule.
NOTE: You should always make it a point to check the Student Portal for any announcements and latest updates.
You need to ensure you fully understand the contents of each Study Unit listed in the Course Schedule. You are expected to complete the suggested activities either independently and/or in groups. It is imperative that you read through your Assignment questions and submission instructions before embarking on your Assignment. It is also important you comprehend the Overall Assessment Weighting of your course. This is listed in Section 1.4 of this Guide.
Manage your time well so you can meet given deadlines and do regular revisions after completing each unit of study. They will help you retain the knowledge garnered and prepare you for any required formal assessment. If your course requires an end-of-semester examination, do look through the Specimen or Past Year Exam Paper which is available on Learning Management System.
Although flexible learning – learning at your own pace, space and time – is a hallmark at SUSS, you are encouraged to engage your instructor and fellow students in online discussion forums. A sharing of ideas through meaningful debates will help broaden your learning and crystallise your thinking.
1 EAS431 COURSE GUIDE
1.2 Course Description and Aims
This course aims to provide a good understanding of the various factors affecting the aviation industry profitability, financial health and financial standing. Some of these elements are within the industry’s control while other challenging factors, e.g. fuel price, nature catastrophes affecting travel demand, regulatory guidelines, etc. are beyond the aviation industry’s limits.
This course will outline the value-chain within the aviation industry players from aircraft manufacturers, MROs, aircraft lessors and airline operators’ perspective. We will review the complex decisions on aircraft acquisition, fleet replacement with network planning, aircraft financing options and aircraft economics using various common tools and methodology.
1.3 Learning Outcomes
Knowledge & Understanding (Theory Component) • Appraise the general financial status of the aviation industry. • Distinguish the types of financing model for aircraft acquisition and the key factors affecting the airline financial standing. • Evaluate the future trends of industry directions through industry and data analysis from key forecast organization and external shock factors that threaten the industry’s profitability.
Key Skills (Practical Component) Choose and apply business tools when tackling real business problems. Appraise the industrial trends and situations for business forecasting and decision making. Examine the external shocks that may reshape the competitions and industrial landscape.
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1.4 Overall Assessment
The overall assessment weighting for this course is as follows:
Assessment Description Weight Allocation
Assignment 1 Online Quiz 1 15 %
Assignment 2 Online Quiz 2 15 %
Examination Open Book Written Examination 70 %
TOTAL 100%
SUSS’s assessment strategy consists of two components, Overall Continuous Assessment (OCAS) and Overall Examinable Component (OES) that make up the overall course assessment score. For SST courses: 30% OCAS and 70% OES.
(a) OCAS: Assignment 1 & 2 are weighted at 50% each. Both Assignment 1 and 2 combined will constitute 100% of OCAS.
(b) OES: The Examination is 100% of this component.
To be sure of a pass result you need to achieve scores of 40% in each component. Your overall rank score is the weighted average of both components.
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1.5 Learning Materials
Other recommended study material The following learning materials are required in order to complete the learning activities:
1 Reference 1. Competitive Strategy (1980) by Harvard Business School Books Michael Porter’s Five Forces Industry Analysis
2. Kellogg on Strategy by David Dranove & Sonia Marciano Industry Analysis- Page 16 – 17 on Porter’s Five Forces Framework Chapter 9, page 203 on Examples In Action : Southwest Airlines
3. Long Range Planning by Thomas C. Lawton, Elsevier Science publisher Volume 32, Number 6 on ‘The limit of price leadership : needs-based positioning strategy and the long-term competitiveness of Europe’s low fare airlines’, page 573 – 586, 1999.
4. Buying The Big Jet by Paul Clark, 2nd Edition, Ashgate publisher Chapter 6, page 171 on Aircraft Economics
5. Magic Numbers by Peter Temple, Wiley publisher Chapter 9, page 53 on Margins Chapter 16, page 97 on Gearing Chapter 19, page 114 on Return on Capital Employed Chapter 23, page 143 on Free Cash Flow Chapter 29, page 180 on Weighted Average Cost of Capital (WACC)
2 Journal(s) / 1. The Journal of Air Transportation World Wide by Thomas Magazine(s) C. Lawton Volume 5, Number 1 on ‘Flying Lessons: learning from Ryanair’s cost reduction’, page 89 – 106, 2000.
2. Airline Fleet Management, March-April 2010, Issue 66, Page 39 – Page 41 AFM Interview with Kostya Zolotusky, MD, Capital Market Development, Boeing Capital Corporation, USA. 3 Website(s) 1.http://www.boeing.com/bcc/sitemap/af.html 2. http://www.airbus.com/en/corporate/gmf2009 3. http://www.iata.org/WHATWEDO/ECONOMICS/Pages/index.aspx 4. www.icao.int (Source : International Civil Aviation Organisation) 5. en.wikipedia/wiki/Airbus_A380 (Source : wikipedia) 6. en.wikipedia/wiki/Boeing_B787 (Source: wikipedia)
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EAS431 Aviation Finance
STUDY UNIT 1
EAS431 STUDY UNIT 1
OVERVIEW
Given that global airlines as a whole has hardly exceeded an average 5 per cent net operating return after the Gulf War, it is critical to understand what are the inherent business nature and external shock factors that are affecting the viability of the aviation industry. Given the complexity of the aviation industry involving government policies, regulatory invisible hands, strategic key economic assets and air security interests, infra-structure development constraints and highly intensive capital investment, one would expect a very high barrier to entry for any new market entrants. Thus, it is interesting to understand and review in contrast why legacy scheduled airlines are experiencing heavy loses during market downturns whereas some new market entrants, for example, Low Cost Carriers (LCCs) and charter services, are thriving with healthy operating profits and potential growth.
Subjected to external shocks and economic uncertainties affecting the air travel demand, failed airlines filing for bankruptcy in the fragile state of the aviation industry is becoming a norm. Recent incidents of the six days Iceland’s volcanic ashes disruption of air travel is a vivid example which brought the European airline to the brink of bankruptcy with a combined losses of US$1.7 billion to the combined global airlines.
We also witnessed the latest industry consolidation between the United Airlines and Continental Airlines merger (after Delta bought Northwest Airlines) announced on May 2, 2010 to form the world’s largest airline under ‘United Airlines’ branding with a global footprint and network reach with operational economic of scale. Rival competitors like American Airlines are under pressure to seek similar merger partners and scale to compete in US domestic and international markets.
With the heavy dependence of a globally integrated manufacturing and business supply chain environment (for example, JIT manufacturing systems), the significance and multiplier economic repercussions, in the event of the collapse of main stream scheduled airlines will severely paralysed the distribution networks, business supply chain, manufacturing capabilities and inflate transportation costs.
SU1-2 EAS431 STUDY UNIT 1
LEARNING OUTCOMES
At the end of this unit, you are expected to:
State the history and financial performance of the aviation industry.
Account for the key factors and challenges facing the air travel demand and growth potentials
Explain the evolution and financial performance of the global airline industry
Explain the challenges, nature of the boom and bust cycles of the aviation industry
Discuss the competitive landscape of the transportation industry
SU1-3 EAS431 STUDY UNIT 1
CHAPTER 1: OVERVIEW OF THE AVIATION INDUSTRY
1.1 Introduction
Overview of the aviation industry in terms of air travel demand, grow and profitability of the airlines industry.
Figure 1 Review of the air traffic growth across various regions globally (Source: Estimated figures of IATA)
12.00% 10.00% 8.00% 6.00% 4.00% Average growth in 2.00% passenger traffic (1996-2006)
Asia Pacific Middle East North America Latin America 0.00% Europe Africa World
Figure 2 The correlation between the airline revenue changes versus World Economic GDP growth (Source: Estimated figures of IATA & ICAO)
20
15
10 % Change in Airline Revenue % World GDP 5 Growth
0 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
-5
SU1-4 EAS431 STUDY UNIT 1
Figure 3 & 4 Review of passenger traffic flow and air freight distribution related to regional markets and global key trade partners (Source: Estimated figures of IATA)
40.00% 35.00% 30.00% 25.00% 20.00% 15.00% 2006 International 10.00% Air Passenger 5.00% Traffic
Asia Pacific Middle East North America Latin America 0.00% Europe Africa
40.00% 35.00% 30.00% 25.00% 20.00% 15.00% 10.00% 2006 International 5.00% Air Freight Traffic
Asia Pacific Middle East North America Latin America 0.00% Europe Africa
Figure 5 Review of the global airlines profitability and financial performance (Source: Estimated figures of IATA and ICAO)
15 15
10 10
5 5 Airline Net Profit/Losses in US$ Billions 0 0 Airline Operating -5 -5 1998 2000 2002 2004 2006 Profit Margin
-10 -10
-15 -15
SU1-5 EAS431 STUDY UNIT 1
Figure 6 Breakdown of financial performance and value-chain of complementary players within the aviation industry (Source: Estimated figures of IATA, ATA and other reports)
30% 25% 20% 15% % of ROIC (1992 - 10% 1996) 5%
Leasing Ground Catering Airports Airlines 0% Aicraft GDS
1.2 Key factors and challenges affecting the air travel demand and growth potentials
Figure 7 Airline traffic growth vs World GDP growth (Source: Estimated figures of IATA, ICAO and World Bank)
16% 14% Airline 12% Traffic % 10% Change 8% versus Previous 6% % Change in 4% World GDP 2% Growth
0% 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 -2% -4%
SU1-6 EAS431 STUDY UNIT 1
Most forecasts consensus seems to agree that average air traffic growth of around 5 per cent annually for the next 10 - 15 years.
General decline in GDP of major developed economics resulted in decline in air traffic growth in mature markets like US. Emerging markets like China and India with tremendous GDP growth in double-digit figures have made air travel become more affordable for the new millions of potential passenger!
The Asia currency crisis in 1997/1998 only affects traffic volume of Asian carriers, whereas SARS epidemic in 2003 affecting Cathay Pacific Airways and airlines in China more severely than others. The recent Iceland volcanic ashes disruption of air travel in grounding of aircraft and shut down of airport operations affected EU airlines (to the brink of bankruptcy) and Asia airlines badly and costs US$1.7 billion lost to the global airline industry.
Review of the high fuel prices shock and impacts
In Jan 2000, jet fuel price jump from 40 cents per US gallon a barrel to 75 cents per US gallon a barrel which hits the airlines operating profits and account for about 12 percents of the total costs although net profits were maintained largely due to sale of aircraft assets and diversification of non-core investments. In 1981, fuel expenses accounts for about 30 percents of total airline operating expenses.
Note the fuel price prices fluctuations in summer 2000, end of 2000, 2004, 2005, Aug 2006 which have significant impacts to the cost of air travel and air transportation.
Some of the airlines have adopted fuel price hedging strategy and practices, e.g. SIA, Cathay Pacific, PAL, etc. While some has been more successful than others, the hedging is a double-edge sword, like placing a bet (but airlines are not fuel industry experts) using the various alternative derivative instruments, and has caused wide swing in the operating profitability of the airlines. SIA and PAL have been rather successful in hedging their fuel positions and have realized some handsome profits which contributed positively to its net profits in some quarters.
Some airlines resort to fuel management through operations by ‘fuel tanking’. Given the high costs of fuel in India, most airlines would avoid refuelling in India. The high fuel price has raised the unit costs of local Indian airline operators (per Kingsfisher’s C.E.O. complaint and claims) which made it uncompetitive for out- bound sectors against other international airline operators for international routes.
Given the uncertainty in the future of fuel price and its wide spread fluctuations, airlines have started to adopt and pass on the additional costs of high fuel prices as ‘fuel surcharges’ to the passengers in line with the fuel price trends and freighter industry practices.
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1.3 Evolution and financial performance of the global airline industry
World’s scheduled airlines suffered cumulative net losses of US$20.3 billion between 1990 and 1993. With seven years of good profitability of US$40 billion from a relatively long world economic upswing between 1994 and 2000, the aviation industry experienced a severe setback in the aftermath of 9/11 terrorist attacks in US.
ICAO financial data shows the Debt/Equity ratio decline from a high of 2.90:1 in 1993 to 1.42:1 in 1999 with stronger balance sheets that allows the replacement of Stage 2 aircraft but reverse back to 2.46:1 in 2003 and 2.41 in 2004.
Figure 8 Global Airline financial results (Source: Estimated figures of ICAO, IATA and others)
20 15 Global Airlines 10 Operating 5 Results in US$ Billions 0 Global Airlines Net Results in -5 US$ Billions -10
-15 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
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Figure 9 Review of Net/Operating Profits by type of airline operators (Average 2003/2004/2005) (Source: Estimated figures of ICAO and others) Financial 0.1 Performance of 0.08 0.06 Type of Aviation 0.04 Operators as % 0.02 of Operating 0 Revenue -0.02 Operating Margin -0.04
-0.06 Carriers Flag Service Full CostCarriers Low Carriers Regional CharterCarriers CargoCarriers
Net Margin
Figure 10 Operating Profits as % of Revenues by region of airline (Source: Estimated figures of ICAO and others)
10% 8% 6% 4% 2% Asia Pacific 0% Europe -2% North America -4% -6% -8%
-10% 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
SU1-9 EAS431 STUDY UNIT 1
US Airlines hit hardest by Gulf War recession and 9/11. After 9/11, EU airlines recovered fairly well in 2002 but were hit by strong EURO currency, Iraqi war, and SARS epidemic event. Asian economics and airlines recover remarkably well after 1997 Asian crisis whereby 18 members of the AAPA (Association of Asia Pacific Airlines) reported collective after-tax profit of US$1.88 billion for 1999/2000 (except MAS and RBA) through cost control and better employee productivity, a four-fold increase from previous year, in contrast with the combined loss of US$1.21 billion in 1997/1998.
Given the high barrier-to-entry factors due to operational complexity, highly capital intensive investment, political and regulatory interests, many find it intimidating and difficult to gain market entries (given the high failure rates and bankruptcies) while competing with mainstream airlines, without a strong financial backing and effective business models. The huge success of LCC models across different regions has prompted many past sceptics to review the aviation industry structure and airline business models. We have noticed an interesting trends of being small is beautiful and profitable (e.g. Southwest Airlines, Ryan Air, AirAsia, etc.) while being big and inflexible (due to aircraft fixed assets) with high overhead unit costs are doom for failure in an adverse external shocks situation (e.g. high fuel price, terrorist attacks, war, volcanic ashes nature disasters) that could cripple the air travel demand significantly.
Most of the national flag carriers (e.g. PAL, JAL, MAS, ANZ, etc.) are government owned as there are considered as national strategic economic key assets and air transport/access with air security interests which are rarely ‘allow to fail’ in bankruptcy as the multiplier effects have a bigger and significant economic impact ‘larger than’ the airline businesses itself. As such, we have witnessed the re- nationalisation of MAS and Air New Zealand. Subsidies was approved by EC to aid Olympic Airways, TAP Air Portugal, Iberia, Air France and Aer Lingus between 1992-1997 totalled US$8.94 billion. Of the five airlines being ‘rescued’, two of them managed to be privatised, one of them was profitable but two of them continued to be loss-making for years.
A US Commission reporting to the President and Congress in August 1993 suggested a review of the large taxation on airlines, cost of modernisation of airport infra-structures and air traffic control (ATC) systems. They also called for a review of Chapter 11 bankruptcy provisions, which is used a ‘back door’ to confer unfair cost advantages on a number of unviable airlines which sought protection from their creditors.
An EU Commission was suggesting the followings in their 1994 report:
1. Ease the framework of foreign ownership and control restrictions in bilateral agreement; 2. Develop financing options for airline finances; 3. Improve the access of EU airlines to credit insurance.
SU1-10 EAS431 STUDY UNIT 1
1.4 Challenges, boom and bust nature of the aviation industry
Airlines aircraft selection campaign processes and timeline (1-year for narrow bodied aircraft and 2-years for wide bodied aircraft: SFE & BFE selection processes; certification approvals, integration pitfalls between vendors, etc.). Below is an Anatomy of a Campaign schedule:
A. Phase 1: Airlines will issue Request for Proposal (RFP) in their specific formats requesting for information pertaining to their specifications and configurations.
B. Phase 2: Proposal: Having shortlist a few supplier candidates, the airlines will set and review the milestones in collaboration with suppliers to ascertain the production and delivery deadlines.
C. Phase 3: Airlines will conduct a formal campaign that will send teams to audit and conduct a survey at the supplier’s facility to review the production capability, working processes, certifications, integration and other issues prior to internal evaluation and decision making.
D. Phase 4: Once the supplier is selected, the airline will issue a LOI or MOU pending further contract negotiation.
E. Phase 5: Once the airline working teams and suppliers have clear the negotiation, the final BAFO will be forwarded to the airline management team for approval and signature.
1.41 Desynchronised Cycles : The inherent cyclical nature in the aviation markets is a critical destabilising act in managing the demand and supply balance at any critical moments, be it in the boom or bust cycles. The desynchronised timing of one year (for narrow bodied aircraft and up to two years for wide bodied aircraft) production lead time between airline operators ordering commitment and aircraft delivery by manufacturers is a critical test of airlines management’s foresight in forecasting the demand downstream in one or two years time. The aircraft manufacturers have been adopting new manufacturing, design, IT and supply chain technologies with the hope of improving its productivity and reducing the production lead time and cycles.
SU1-11 EAS431 STUDY UNIT 1
Figure 11 Desynchronised cycles of the aviation industry (Source: Estimated figures of IATA, ICAO and others)
1300 20% 15% 1000 Net Orders 10% 700 5% Deliveries 400 0% -5% Net Operating 100 Results in US$ -10% Billions -200 -15% 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004
1.42 Changing Environment and External Shock Factors : The aviation industry has been subjected to challenging market environment and external shock factors as follows:
A. Economic boom and bust cycles in global and regional markets B. Newly-deregulated local environment C. Open-sky bilateral agreements between government D. New aircraft launches with passenger’s appeal E. Environment noise Stage 2 aircraft Ads for replacement F. Carbon emissions pollution and control G. War and terrorism H. High fuel prices I. US financial crisis and Asian currency crisis J. Flu/diseases epidemic K. Volcanic ashes environmental danger L. Infra-structure renewal, costs and capacity constraints: Airports, and ATCs M. Resources constraints: Commercial pilots training (3-5 years) as demand outstrips supply in India and China.
1.5 The competitive landscape in the transportation industry
Michael Porter’s Five Forces industry analysis: Outline the complementary and alternative transportation options using:
1. Land transportation (China government announced in June 2010 that it would invest $149 billions in high-speed rail constructions across China) 2. Sea transportation 3. Rail (high speed train) transportation
SU1-12 EAS431 STUDY UNIT 1
For an ‘apple-to-apple’ analysis required in-depth analysis of the different costs base apart from the operator’s generic maintenance costs, operational costs, equipment costs, etc. :
1. We need to address the existing and renewal of infra-structure costs (building of highways, ports, high-speed trans-national rail network, airport/ATC, etc.) which is taken for granted but essential to operational viability. 2. Regulatory constraints on safety, security and environment considerations, etc. 3. ICA regulatory and constraints on border’s security and control. 4. Environmental disruptions, etc.
READ:
Competitive Strategy (1980) by Harvard Business School Michael Porter’s Five Forces Industry Analysis Kellogg on Strategy by David Dranove & Sonia Marciano Industry Analysis- Page 16 – 17 on Porter’s Five Forces Framework
1.6 SUMMARY
Given the complexity of the airline businesses, it seems that management foresights and skills in having the flexibility, adaptability and balance of the right type/mix of aircraft performance at the right time with the available capacity to address the market demand fluctuations and uncertainty are critical to the airline survival, profitability and ability to withstand the challenging and dynamic market environment, especially in a demand downturn situation.
Note that air travel demand and load factors are keys to airline recovery. Danger of high fuel prices and external shocks may lead to weaker demand, which always post as threats in the backdrop of the airline operator’s mind.
SU1-13
EAS431 Aviation Finance
STUDY UNIT 2
EAS431 STUDY UNIT 2
OVERVIEW
To study the viability and long-term sustainability of the aviation industry, we need to understand and analyse the aircraft manufacturer’s business models and direction as key strategic suppliers and partners to global airline industry as there is hardly any comparable substitute of new manufacturers entry into the market given the huge barrier-to-entry in this high risks, high tech, highly regulated and highly capital intensive industry. Successful ‘block-buster’ aircraft models could boost the company’s earnings, industry leadership and dominance for years while failed models with poor performance and lack of passenger appeals after extensive capital investments could bring down the company future as re-development of new aircraft models require years of research and development, performance validation and huge capital funding.
Since there are only a few major reliable (viable and sustainable throughout the production life cycle) and credible aircraft manufacturers, the airlines will have limited choices of which type of aircraft models will be available in the market place over time, less their desired choices.
An analysis of the airline’s performance gives us an overview of the major key parameters that weights on the airlines profits and losses and operating margins. A few ‘white doves’ airlines have consistently demonstrated years of healthy profitability dismiss the mystifying assumptions that airline’s business are hardly profitable. Another good example are new market entrants, for example, Low Cost Carriers (LCCs) and Charter services, are thriving with healthy operating profits and potential growth.
LEARNING OUTCOMES
At the end of this unit, you are expected to:
Explain the evolution of aircraft manufacturers industry Discuss the economic, strategic and business models of airlines Identify the airline’s performance and profitability State the threats and growth of new market entrants: Low-cost carriers and charter carriers
SU2-2 EAS431 STUDY UNIT 2
CHAPTER 2: OVERVIEW OF THE AVIATION INDUSTRY
2.1 Evolution of the Aircraft Manufacturers industry
History of aircraft manufacturer players
Prior to the rise of major European commercial aircraft manufacturers, there were three US manufacturers but Lockheed ceased making commercial aircraft in 1981 whereas McDonnell Douglas was acquired by Boeing in 1997. Netherlands’ Fokker bankrupt. Today, Boeing & Airbus Industries (European consortium challenge the competitors in late 1970s with the A-300) are the dominating manufacturers of long-haul and medium-haul aircraft whereas regional and commuter aircrafts are by Brazilian, British, Canadian and Swedish – Bombardier (Canada), Embraer (Brazil).
Figure 1 The cyclical nature between aircraft orders and deliveries is mainly due to the limitation of the aircraft production cycle (Source: Estimated figures of IATA & ICAO)
1400 1200 1000 800 Net Orders 600 Deliveries 400 200 0 1980 1985 1990 1995 2000
Figure 2 History of Airbus aircraft Family (Source: Estimated figures of Airbus) Note that some of the aircraft design has been 20 years old since inception.
Airbus Launched Seating Delivered Baclok A300 1969 266-285 561 0 A310 1978 210-250 255 5 A320 1984 189 2915 260 A321 1989 185-220 422 243 A330 1987 375 515 355 A340 1987 239-475 348 41
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Figure 3 History of Boeing aircraft Family (Source: Estimated figures of Boeing) Note that some of the aircraft design has been more than 20 years old since inception. B747 despite its popularity has been based on a 40 years old technology! Boeing Launched Seating Delivered Baclok B707 1954 141 1010 0 B717 1955 106 155 0 B727 1962 106-125 1831 0 B737 1967 110-125 5626 2072 B747 1968 416-500 1397 125 B757 1978 200 1049 0 B767 1981 224-409 960 51 B777 1990 279-550 693 353
Figure 4 Comparative Overview of largest aircraft between Airbus A380-800 and Boeing B747-400 (Source: Estimated figures of Airbus and Boeing) The below table reviewed diverse views between the Hub-And-Spoke and Point- To-Point network concepts.
Figure 5 Aircraft engine manufacturers with engine launch history (Source: Estimated figures from engine manufacturer’s report) Note that some of the engine design of popular models has been more than 20 years old since inception. Manufacturer Engine Model On Aircraft Launched General Electric CF34 CRJ-100 1983 CF6 A300 1971 CFM56 B737 1981 CT7 Saab 340 1978 GE90 B777 1995 Pratt & Whitney JT8D B737-100 1964 PW2000 B757 1994 PW4000 B747 1987 V2500 A319 1988 Rolls-Royce RB211 L-1011 1966 Trent700 A330 1995 Trent800 B777 1996
Aircraft design and availability has a huge impact on the airline’s network management for existing routes and future market growth.
Network management phases below highlight the various aircraft configurations and performance needed in the network configurations in Network Design:
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A. Network Strategy – Target market segments, competition, market entry development and positioning, political risks, fleet planning
B. Network Design – Point-to-point versus hub-and-spoke, connectivity
C. Alliance – Key partners, network reach, performance analysis
D. Network Planning – Connectivity optimisation, baggage handling for interlining routes, fleet maintenance, spare pooling, crew rotation planning
Figure 6 Point-to-point network configurations (Source: Rough representation of a European airline network)
Figure 7 Hub-and-spoke network configurations (Source: Rough representation of a European airline network)
New aircraft and new engine development is highly risky, highly intensive capital investment in R&Ds and production capabilities. Aircraft manufacturers and engine manufacturers are starting to share the R&Ds, production work and financial risks through joint collaboration and JVs with international partners leveraging on their expertise for new product development.
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For B767 development, Boeing collaborated with a German and Italian firm. Boeing has also worked closely with the Japanese partners on the development of B777 and B787. Engine manufacturers, e.g. GE and P&W has jointly developed some of the new engine variants with great successes while Rolls-Royce has single-handle developed the successful Trent engine family.
Figure 8 The making of Boeing B787 (Source: Boeing reports)
Boeing 787 total firm orders 787-3 787-8 787-9 Unspecified Total firm orders 0 671 195 0 866
Figure 9 Estimated order book of Boeing B787 (Source: Boeing reports)
Orders and deliveries by year 2004 2005 2006 2007 2008 2009 2010 Total Net orders 56 235 157 369 93 -59 15 866 Deliveries ------
The 787-3 and 787-8 were to be the initial variants, with the 787-9 entering service in 2010. In 2007, the list price was $146–151 million for the 787-3, $157–167 million for the 787-8 and $189–200 million for the 787-9.
Customer-announced orders and commitments for the 787 reached 237 aircraft during the first year of sales, with firm orders hit 677 by July 2007. This makes the 787 the fastest-selling wide-body airliner ever before entry into service.
The 787 uses the same technology proposed for the Sonic Cruiser (abandoned SST project). Boeing claims the 787 will be near to 20% more fuel-efficient than the 767. One third of the efficiency gain will come from the engines, another third from aerodynamic improvements and the increased use of lighter weight composite materials, and the final third from advanced systems. The most notable contribution to efficiency is the new electrical architecture which replaces bleed air and hydraulic power sources with electrically powered compressors and pumps, as well as completely eliminating pneumatics and hydraulics from some subsystems (e.g., engine starters or brakes).
Boeing selected two engine types, the GE’s GEnx model and Rolls-Royce Trent 1000, to power the 787, both placed in pods. For the first time in commercial aviation, both engine types will have a standard interface with the aircraft, allowing any 787 to be fitted with either a GE or Rolls-Royce engine at any time. Engine interchangeability makes the 787 a more flexible asset to airlines, allowing them to
SU2-6 EAS431 STUDY UNIT 2 change easily from one manufacturer's engine to the other's if required. The engine market for the 787 is estimated at US$ 40 billion over the next 25 years.
The 787's all-composite fuselage makes it the first composite airliner in production. In comparison, the B777 contains 50% aluminum and 12% composites, the new airplane uses 50% composite (mostly carbon fiber reinforced plastic), 15% aluminum, and other materials. The 787 fuselage was designed to be assembled in one-piece composite barrel sections. Each barrel would be manufactured in one piece and joined end to end during final assembly. The composite barrel approach was a departure from the multiple aluminum sheets and fasteners used on existing aircraft, and eliminated the need for some 50,000 fasteners used in conventional airplane assembly.
B787 Production – Global Partnership The B787 is assembled in Boeing’s factory in Everett, Washington. The final assembly employs just 800 to 1,200 people to join completed subassemblies and to integrate systems. Subcontractors are assigned to do more assembly themselves and deliver completed subassemblies to Boeing. Boeing would then perform final assembly. This approach results in a leaner and simpler assembly line and lower inventory.
As many of the major 787 components and systems pre-installed before delivery to Everett, final assembly time is reduced to three days. This is less than a quarter of the time traditionally needed for Boeing's final assembly process.
B787 major components The B787's tail fin is manufactured at Boeing’s plant in Frederickson, Washington, the ailerons and flaps at Boeing Australia, and fairings at Boeing Canada Technology. For economic reasons, the wings and central wing box are manufactured by Japanese Mitsubishi Heavy Industries companies in Nagoya, Japan. This was a new and daring step for Boeing, which has historically guarded its techniques for designing and mass producing commercial jetliner wings. The horizontal stabilizers are manufactured by Alenia Aeronautica in Italy; and the fuselage sections by Global Aeronautica and Boeing's Charleston facility in North Charleston, South Carolina (USA), Kawasaki Heavy Industries in Japan and Spirit AeroSystems, in Wichita, Kansas (USA). The subcontractors are all designing with CATIA V5 software.
The passenger doors are made by Latécoère (France), and the cargo doors, access doors, and crew escape door are made by Saab (Sweden). Japanese industrial participation is very important to the project, with a 35% work share, and many of the subcontractors are supported and funded by the Japanese government. On April 26, 2006, Japanese manufacturer Toray Industries and Boeing announced a production agreement involving $6 billion worth of carbon fiber. On February 6, 2008, TAL Manufacturing Solutions Limited, a subsidiary of the Tata Group (India)
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announced a deal to deliver floor beams for the 787 from their factory at Mihan, near Nagpur, India to assembly plants in Italy, Japan and the United States.
Messier-Dowty (France) builds the landing gear, which includes titanium forged in Russia, and brake parts from Italy,[ and GE Aviation in Yakima WA builds several actuators for the landing gear. Thales supplies the integrated standby flight display and electrical power conversion system. Honeywell and Rockwell-Collins provide flight control, guidance, and other avionics systems, including standard dual head up guidance systems. Future integration of forward-looking infrared is being considered by Flight Dynamics allowing improved visibility using thermal sensing as part of the HUD system, allowing pilots to "see" through the clouds. Hamilton Sundstrand, Connecticut (USA), provides power distribution and management systems for the aircraft, including manufacture and production of Generator Control Units (GCUs) as well as integration of power transfer systems that can move power from the Auxiliary Power Unit (APU) and the main engines to the necessary parts and machinery of the aircraft.
B787 Assembly milestones On June 30, 2006, Boeing celebrated the start of major assembly of the first 787 at Fuji Heavy Industries' new factory in Handa, near Nagoya, Japan.
On January 12, 2007, first major assemblies, forward fuselage, center wing, and center wheel well built by FHI and KHI were shipped from Nagoya, Japan. They were delivered to Global Aeronautica in Charleston, South Carolina. On March 14, 2007, the first production vertical tail fin was rolled out at Boeing's Composite Manufacturing Center in Frederickson, Washington. On April 16, the first production all-composite nose-and-cockpit section (Section 41) was rolled out at Spirit Aerosystem's plant in Wichita, Kansas. Comprising the cockpit area, nose landing gear well, and the forward-most section of the passenger area, this oval- shaped section is 21 feet (6.4 m) in height, 19 feet (5.74 m) in width and 42 feet (12.8 m) in length. The first horizontal stabilizer manufactured by Alenia Aeronautica at its facility in Grottaglie, Italy to Everett on April 24. On May 8, 2007, Vought rolled out completed rear Sections 47 and 48 from its factory in Charleston, SC.
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Figure 10 Boeing B787 1st Flight from Boeing hangar (Source: Boeing)
The Making of Airbus A380 (Source: Airbus reports)
Airbus is still fundamentally capturing the work within the EU community and consortium partners, e.g. A380 aircraft, only with recent political move of developing the assembly line of 1st A320 aircraft in China delivered in 2009.
In contrast, Boeing B787 aircraft project has lobbied participants from international partners with the political objectives of creating jobs locally in promoting the aircraft sale. Incidentally, the first launch customer for B787 is ANA, Japan.
Figure 11 Estimated A380 Order Book (Source: Airbus)
A380 firm net orders, by year[
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Total
A380- 78 0 34 10 10 24 33 9 4 0 202 800 Orders A380- 7 10 0 0 10 -17 -10 0 0 0 0 800F A380- Deliveries 0 0 0 0 0 0 1 12 10 4 27 800
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Figure 12 Airbus A380 Customers (Source: Airbus)
Airline First commercial flight Number in service Air France 20 November 2009 3 Emirates 1 August 2008 8 Qantas 20 October 2008 6 Singapore Airlines 25 October 2007 10
A380 Production – Major structural manufacturing and R&Ds are kept within EU consortium partners
The A380 final assembly is done in Airbus Industries facility in Toulouse. Major structural sections of the A380 are built in France, Germany, Spain, and the United Kingdom. Due to their size, they are brought to the assembly hall (the Jean- Luc Lagardère Plant) in Toulouse in France by surface transportation, though some parts are moved by the A300-600ST Beluga ‘ Guppy’ aircraft used in the construction of other Airbus models. Components of the A380 are provided by suppliers from around the world; the five largest contributors, by value, are Rolls- Royce, Safran, United Technologies, General Electric and Goodrich.
The front and rear sections of the fuselage are shipped to the United Kingdom. The wings, which are manufactured at Filton in Bristol and Broughton in North Wales, are transported by barge to Mostyn docks, where they were shipped out. In Saint- Nazaire in western France, the ship trades the fuselage sections from Hamburg for larger, assembled sections, some of which include the nose. The ship unloads in Bordeaux. Afterwards, the ship picks up the belly and tail sections by Construcciones Aeronáuticas SA in Cádiz in southern Spain, and delivers them to Bordeaux. From there, the A380 parts are transported by barge to Langon, and by oversize road convoys to the assembly hall in Toulouse. Roads and canals were widened and replaced; and new barges were developed to deliver the A380 parts. After assembly, the aircraft are flown to Hamburg Finkenwerder Airport (XFW) to be furnished and painted. It takes 3,600 l (950 US gal) of paint to cover the 3,100 m2 (33,000 sq ft) exterior of an A380. Airbus sized the production facilities and supply chain for a production rate of four A380s per month. The list price of A380 ranges between US$ 317.2 - 337.5 million.
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Figure 13 Airbus A380 1st Flight in Singapore Changi Airport (Source: Airbus)
Summary notes for both B777 and A380 EIS schedule
Both A380 (2 years) and B787 (2 and a half years) experienced aircraft EIS delays for launch customers which costs the aircraft manufacturers heavy penalties and hundred of billions of losses for delivery delays. The delays have huge impacts on airline’s EIS preparation, network development which resulted in fleet planning disruptions. The A380 delay resulted in the earnings shortfall projected by Airbus through 2010 to €4.8 billion. Given a major downturn in air travel due to US financial crisis leading to a global meltdown, a reversal of the economic boom before 2008, these aircraft delays maybe a blessing in disguise for the airlines which may have to pus out the aircraft delivery in these sharp decline of air travel demand and pay the aircraft manufacturers compensation instead.
Note that the closely watch Greece national debt issues in May 2010 may snowball from EU to global debt markets, followed by Spain and Portugal debt financial woes in EU posts an imminent threat to the aviation industry growth in the near future.
Aviation Employment and Labor Trends
Boeing Employment History in addressing cyclical demand and production capacity adjustment but has reasonable backlog orders (firm and options demand forecast) as cushions for resources planning, production planning and employment (contractual workers) planning.
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Figure 14 Boeing Employment History (Source: Boeing)
Figure 15 Comparison of profitability between aircraft manufacturers and airlines (Source: Boeing)
What are the future directions of aircraft and engine manufacturers?
1. Developing new and light-weight material technologies for structure 2. Develop new manufacturing technologies for faster production cycles 3. Develop new computer-aided design system that will expedite and validate the design cycles and processes 4. Develop new fuel efficient and alternative bio-fuel technologies with low carbon emissions 5. Develop technology for tracking aircraft flights over sea using provides satellite (GPS) based positioning, navigation, and timing (PNT) services globally to enable performance-based operations for all phases of flight routes instead of ground stations tracking. It may give the airlines potential savings of flying ‘the shortest routes’ through the artic thereby saving fuel costs and time.
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6. Develop new ATC systems and regulatory framework which can provide more accurate data, more flexibility and enhanced capabilities of managing the air traffic systems especially in major congested hubs.
2.2 The economic and business model of airlines
Three main type of airline business models categorised by their how they generate their revenue streams, its product offering, value-added services, revenue sources and target customers:
2.2.1 Full service carrier (FSC) a. Core business : Passenger, Cargo, Maintenance b. Hub-and-spoke (HS) network : Optimize hub connectivity activities to cover various feeding and demand categories (of city-pairs) c. Global player : Domestic, international and intercontinental markets are covered by short-, medium- and long-haul flights from the hubs d. Alliances development : The network reach is virtually enlarged by interlining with partner carriers as part of the global multi-HS systems, e.g. Star Alliances, One World, etc. e. CRM : Most carriers have their own frequent flyers loyalty programs to retain most valuable and loyal customer base. f. Yield management and pricing : Sophisticated pricing and yield management systems are in place to maximise network revenues. g. Multi-channel sales : Indirect off-line sales (via intermediate travel agents who also served the passenger’s hotel arrangement) and Direct off-line sales (via airline’s call centre or offices). h. Distribution systems : Supported by major Global Distribution Systems (GDSs) : Galileo, Amadeus, WorldSpan, Sabre.
2.2.2 Low-cost carrier (LCC) a. Core business : Passenger b. Point-to-point network : No interlining networks for on-going flights are provided. Normally operates within a specific range of flight radius domestically or within a region. c. Secondary airports : City-pairs are connected mainly from secondary or tertiary airports which are less expensive in terms of land tax, handling fees and less congestion than main airport hubs. d. Single aircraft fleet : Operate one type of aircraft for benefits of commonality e. Aircraft utilisation : High level of aircraft utilisation and quick turnaround time at the gates f. No frills service : The product is not differentiated as they do not offer lounge services at airports, choice of seats, in-flight services and they do not have a frequent flyer program.
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g. Minimised sales/reservation costs : All tickets are electronic and the distribution system is via internet or direct telephone sales centre. h. Ancillary services : LCC is increasingly generating revenue sources via luggage charges, in-flight meals, advertising space, credit card fess, leg-room seating allocation, telephone operation, gaming on board, etc. These additional sources represent about 16 per cent (259 million EURO) of Ryanair’s 2005/2006 total revenue. As for easy Jet, it represent about 41.3 per cent of the airline’s total revenue in 2004.
2.2.3 Charter carrier (CC) a. Core Business: Passenger b. Point-to-point network: Utilising larger aircraft and longer-haul destinations to maximise traffic capacity for lower unit costs c. Load factor: Higher load factor than LCC to maximise economy of density and the flights normally operate close to 100 per cent seat occupancy d. Distribution costs: Low costs as the flight is normally charter by tour organising groups with low administration and finance fees. e. Aircraft utilisation: High aircraft utilisation for longer range destinations f. Asset costs: Low aircraft leasing costs as the aircraft is usually on short-term lease with aircraft lessor with no penalty for short notice return. g. Airport fees: Low landing fees as these airports are the ‘underserved’ airports which will give the charter services preferential rates as it brings along economic and social prosperity to the local community.
2.2.4 ‘Must have’ and ‘Nice to have’ features distinguish the passenger market segmentations and their aircraft selection criteria.
2.2.4.1 Figure 16 For short-haul carrier
Short-haul Carrier Must Have Need To Have Nice To Have Optimal Economic Value 1 Competitive Passenger Appeal 2 Cabin Flexibility For Differentiations 3 Excellent Customer Perception 4 Ease Of Freight & Baggage Handling 5 Ease To Maintain X Crew Friendly Cabin Environment X Advance Flight Deck & Avionic Systems X Spares Pooling Available X Excellent Technical Assistance X Future Design Development Potential X
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2.2.4.2 Figure 17 For Low-cost carrier
Low Cost Carrier Must Have Need To Have Nice To Have Low Operating Cost 1 Rapid Turn-around Time 2 High Despatch Reliability 3 Easy, Rapid Loading Procedures 4 Simplified Cabin Definition 5 Early aircraft availability X Fleet Compatibility and Commonality X Large Overhead Storage Volumes X Good Field-Length Performance X
2.2.4.3 Figure 18 For aircraft Lessor
Aircraft Lessor Must Have Need To Have Nice To Have Good Volume Discount Pricing 1 Good Residual Value 2 Low Reconfiguration Costs 3 Flexible Component Standardisation 4 Highly Demand By The Market X Good Choice Of Powerplant X Good Operational Flexibility X Adaptable & Configurable For Wider Market X Possibly To Extend Life As A Freighter X Unlikely To Be Technically Obsolete Soon X
The analysis of the airline’s economic model, strategic directions and business models reveal some insights of the critical parameters which differentiate the airline’s brands, service level, differentiation factors, competitive advantages and cost structures.
2.3 Airline’s performance and profitability
Airline financial results are highly sensitive to changes in costs or revenues because of historically high level of operational and gearing. Financial gearing is expected to decline in future as increasing portions of the airline’s assets are financing by operating lease, rather than with debt. Airlines high operating gearing arise from the fixed nature of high operating expenses and overheads against relatively small margins on sale, resulted in large fluctuations in operating results especially when the air travel demand is weaken by sudden and external shock events, e.g. the Iceland volcanic ashes disruption, war regions ‘no-fly’ zones, etc. aggravated by the uncertainty in high fuel prices.
Despite having some risks management provisioning and a continuous drive to build an agile and flexible organisation structure, workforce and resources base,
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most of the airlines experienced hardship, especially when the prolonged business decline hits its key yield products or services. Most airlines are unable to shed these inherent fixed costs and reconfigure the aircraft configurations within a short span of time (for example, SIA A345 routes to USA), the aircraft assets cannot be sold immediately for reasonable returns in a distress market and labour expenses cannot be terminated at ease without union’s support. Out-sourcing, contractual programmes or/and operating lease are an option as a trade-off to address the huge mismatch of the cyclical demands.
‘White doves’ in the airlines industry
Below are examples of some the historic profit margins of some of the airlines leaders which consistently exceeds the average 5 per cents profit margin and 7.5 per cents WACC. This trend is however being dented by the drastic downturn in premium air travel demands due to the US financial crisis in 2008 whereby even SIA reported its first yearly loss in 2009!
Figure 19 Reported profit margins of Singapore Airlines (Singapore) (Source: Singapore Airlines Annual Report)
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Figure 20 Reported profit margins of British Airways (UK) (Source: British Airways Annual Report)
Figure 21 Reported profit margins of Southwest Airlines (USA) (Source: Southwest Airlines Annual Report)
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Figure 22 Reported profit margins of FedEx Freighter (USA) (Source: FedEx Annual Report)
Price war from increased competition and over-capacity resulted in decline in yield, aggravated by increased fuel prices raise the break even points to above 60 per cent. Increased competition also leads to overcapacity (i.e. supply) which can be alleviated by removal of uneconomic routes, grounding of uneconomic aircraft and market consolidation.
Fate of parked or stored aircraft
Most of aircraft that were park at the desert were either broken up for spares or scrapped. Number of parked aircraft increased doubled to 1,000 in year following the Gulf War, as air travel demand decline and aircraft deliveries accelerated. By 1995, there are still 730 aircraft parked which comprises of 45 Stage 1 and 230 Stage 2 aircraft. By 2005 after 9/11, 668 aircraft = 6 per cent of total IATA member airline fleet . Average parked age was 23.6 years (B727s & early B737s Classic).
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Figure 23 Trends of Parked Aircraft (Source: Airbus)
For example, the Sonoran Desert in the Tucson (USA) area serves as an ideal graveyard for airplanes. It has a dry, clear and virtually smog-free climate that helps minimize corrosion. It has an alkaline soil so firm that airplanes can be towed and parked on the surface without sinking.
Figure 23.1 Picture of aircraft parked at US deserts (Source: AviationExplorer.com - The Website For Aviation Enthusiasts)
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Four Categories of Mothballed Planes
The airplanes are divided into four categories, depending on their future prospects:
Category 1000 planes are preserved with an eye toward possibly flying again, should international political conditions warrant.
Category 2000 planes are maintained for spare parts. Some parts from older aircraft, are available nowhere else.
Category 3000 planes are kept in near ready-to-fly condition, awaiting a more-than-likely new deployment.
Category 4000 planes are destined for “static display” in museums, town squares or Air Force base entrances. Most, however, will be sold as scrap metal, eventually finding new life as razor blades, soft drink cans or car fenders.
Ranking of most important financial issues by airline finance director of 25 major airlines: 1. Control of costs 2. Access to capital market 3. Foreign currency exposure 4. Fleet replacement and price of new aircraft 5. Industry losses and inconsistent profitability 6. Cost of funds/low yield on surplus funds 7. Debt/Equity ratio : Gearing 8. Return on investment
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2.4 New market entrants
New business models and paradigm shifts of Low-cost carriers (LCC) & charter carriers (CC) are reshaping the aviation industry’s competitive landscape through market deregulations, ‘destructive’ technology adoption and revolutionary business models based on pricings as commodities, economic of scale (negotiation power of aircraft prices, MRO, flexibility of fleet management of large single aircraft type fleet , adoption of e-commerce distribution systems without legacy high G&A overhead costs, etc.) and needs-based demand to harvest market shares in existing pie, Important point to note is that these LCCs and CCs are also being identified as ‘new economic creators’, especially by local authorities, for ‘growing the pie’ by making air travel affordable with substantial economic and social community multiplier impacts.
Figure 24 Unit Costs comparison between LCCs and full service carriers (FSC) in US (Source: IATA)
Figure 25 Unit Costs comparison between LCCs and full service carriers (FSC) in Europe (Source: IATA)
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Figure 26 Business models between Low fare (LCC) versus full service airlines (FSC) Low Cost Carrier (LCC) Full Service Carrier (FSC) Brand focus – No frill, low fare Brand Equity – Pricing power with services Online & direct booking – low Engage travel agents for customer servicing distribution costs Simple ticket structure and ticketless Complex fare structure check-in Point-to-point service Interlining network is an important network leverage element of service Mainly located at secondary, low Focus on main airports fees airports High aircraft utilisation – quick Lower utilisation on short haul turn-around time Short-haul focus Mix of long and short-haul Simple product concept – Complex and integrated services offering chargeable for all ancillary services business passengers flexibility, comfort and loyalty programs Focus on ancillary revenue Focus on primary products, brand equity generation – advertisement, etc. and loyal customer base Fleet commonality Mixed fleet
Figure 27 Cost advantages of Low-cost carriers (LCC) versus Full service carriers (FSC) % Cost Reduction Cost Per Seat Full Service Carrier 100 Low-cost Carrier Operating Advantage: Higher Seating Density 16 84 Higher Aircraft Utilisation 2 82 Lower Flight & Cabin Crew Costs 3 79 Secondary Airport With Lower Fees 4 75 Single Fleet Type/Outsource Maintenance 2 73 Distribution Fees: No Agent or GDS Commissions 6 67 Reduce Sale/Reservation Costs 3 64 Product/Service Features Outsource handling, min. station fees 7 57 No frills and in-flight catering services 5 52 Other Savings Lower GSA expenses 3 49
Lower-cost carrier versus Full service carrier 49
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Charter carriers which enjoy a relatively bigger market share than LCCs in Europe are distinguished by their pattern of operations, target markets and organisational structure. The key difference between the two is that a scheduled airlines (LCCs) offer a consistent, repetitive service for a specific city pairs at a specific time schedule, whereas a charter airline will alter its schedule according to demand, season and other variables. Thus, a scheduled airline decides and is committed to fly (via pre-sold tickets) whereas a charter is told to fly. Charter airlines are link/related to travel agents, tour operators, etc. in effect as a contracted-in process without much risks for the charter airlines. European Third Package of Deregulation (1993) abolished the distinction between scheduled and charter carriers, permitting the latter to designate their flights as schedule if they so wish.
Cost advantages of Charter carriers compared to Low-cost carriers
Cost Advantages of Charter Carrier versus Low-cost Carrier
1. Use larger capacity aircraft • 180-350 seating versus 130-160 seating capacity 2. High daily aircraft utilisation • Long flight routes, stopover, over-night flights
3. Matching capacity to demand • Not affected by seasonal demand issues 4. High passenger load factor • 85%-100% versus 75%-95% level • Pre-sold to holiday tour operators – guaranteed revenues • Low flight cancellation possibility 5. Very low sales or advertising fees
• Most capacity sold to large tour operators with pre-booking • Vertical integration with large tour operators
BUT
• Some level of in-flight service catering • May not have bargain power for lower airport fees without regular schedule
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Case study of successful LCCs: Southwest (USA), Ryanair (EU) or AirAsia (Asia)
Case Study of Southwest
Southwest Airlines low-cost, no-frills model
• Single Product Fares: Low, Simple, Unrestricted, Point-to-point, No interlining In-flight: Single class, no seat assignment, high density, no meals, snack & light beverages Frequency: High Punctuality: Very good Distribution: Travel agent (16%) & Ticketless (84%) • Single Operation Aircraft: B737 single type – three variants, High utilisation (11
hours/day) Sectors: Short but growing (1994-390miles average, 2003- 560miles average) Airport: Secondary or uncongested airports for 20mins-30mins gate turn-around Staff: Competitive wage with profit-sharing scheme, high morale Growth: 10%-15% growth per annum
Figure 28 Comparison of B737-300 operating costs of US carriers in 2003
Airlines Cost/Seat Average Seats/Aircraft Daily Mile Sector utilisation (Miles) (Hrs) Delta 8.9 560 127 6.4 US Airways 7.9 460 126 8.4 Continental 6.7 800 124 7.6 United Airways 6.2 620 125 7.9 Southwest 4.4 500 127 14.3
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Definition of Cost per RPM and Cost per ASM
Cost per RPM (revenue-passenger mile) = Cost per ASM (available-seat mile) / load factor
Difference across airlines in cost per ASM (available-seat mile) reflects differences in:
Average length of flight (cost per ASM declines with distance) Fleet composition (cost per ASM is smaller with bigger aircraft) Input prices, especially wage rates Input productivity, especially productivity Overall operating efficiency
Southwest strategic business models and unique value creation propositions:
Costs :
Southwest efficiencies in low aircraft turnaround time at the gates down to 30 minutes increase the aircraft utilisation rates significantly and reduce the need for more aircraft to meet the demand to achieve the same number of RPMs. Southwest single fleet type of B737s enables more efficient maintenance of its aircraft, lean inventory hold, efficient crew training and aircraft EIS due to fleet commonality. Southwest pays wages that are below the industry average but its employees are among the most satisfied in the industry given its flexible and enjoyable working environment. Southwest labor force are cross-utilised (like GE MRO shops) and are allow to multitask which allows it to maximise its resource planning capabilities. Southwest strategic point-to-point service to serve the underserved and new markets using secondary airports with minimal slotting and gate fees, not to mention the traffic congestions resulting in delays. Southwest avoid ‘over-serving’ the customers and offer a ’no frill’ service dedicated to getting you from point A to point B on time. Southwest uses its first mover advantage to defend its market share by consistently leveraging on its low cost strategy (instead of selling tickets at higher due to its dominance or monopolised routes position) to build frequent departure frequencies to target passenger’s loyalty given their highly valued flexibility and choices.
The relevance and ability of strategies to withstand the test of time:
New entrants JetBlue and mainstream airlines, e.g. United Ted, Delta Express, etc. have mimic and imitated the same business practices, tactics and culture to compete for businesses but never in the same route segment
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as Southwest. However, sooner or later, these players will eventually eye Southwest market segments as there are limited ‘under-served’ city pairs. (Similar to the argument that Dell’s PC businesses can be easily imitated by Gateways and IBM but both the latter have failed to capture market shares from Dell.)
The mainstream hub-and-spoke airlines exploited its financial troubles and Chapter 11 option to negotiate for wage concessions from union, thereby narrowing the labor cost gap.
Fleet commonality has its advantages but the aging and outmoded B737s fleet is no longer fuel efficient.
Threats to LCC’s business models:
1. High fuel costs is a major denominator of cost factors across the airline players. LCCs and airlines with low cash flow inputs are especially vulnerable to high fuel prices due to their higher fleet utilisation costs than mainstream airlines. Fuel hedging is one of the means to address the issue but no investment bankers or fuel traders will be willing to take up a high risks exposure with the cash-strapped airlines given the increasing fuel prices. 2. Higher labour costs (Southwest lay off 32,000 workers first time in 33 history) 3. Emergence of competitive charter services (larger share of market than LCCs in Europe) due to its unique cost advantages – some estimated that the charter carrier’s unit costs is close to half of the LCCs!
LCC’s Yield Management
1. No-explicit market segmentation (only time of booking and choice of flight, except early birds prepaid passengers get cheaper tickets! Commitment out front with no refund policy. Strategy to build up the base load to cover operating expenses. Unfair advantages to the LCCs that can cancel or postpone flights without much recourse, passengers at the losing end but if you are only paying a few bucks, what can you expect? Lower passenger’s expectation in the T&Cs policy) 2. No-product differentiation 3. Price versus demand is a continuum function. LCCs modify the selling price of each flight as a function of departure date 4. Booking classes : Only one price for single class cabin 5. Internet distribution : Purchase via internet for transparency, choices and urgency. No distribution costs without signing up to Sabre, Galileo, or other reservation systems at an average cost of USD 3.00 per reservation.
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Ryanair ‘no frill’ LCC recipe for success
Lower fares = more passengers = lower costs = lower fares
Examine the long-term viability of Ryanair’s strategies of :
1. Needs-based positioning – create and stimulate air traffic demand, London- Venice of ‘The Ryanair effect’. Manage the low breakeven load factor, stimulate high load factor demands and not the yield management. 2. Premised on price leadership 3. Strategic pitfalls of cost reduction efforts. Single B737 fleet commonality gives significant cost efficiency in managing the pilot and flight crew resources. Cost reduction is like a religion for the management teams. How sustainable is the Ryanair model if lower costs are achieved through lower service standards and lower wage rates?
Ryanair cost-savings model
RyanAir cost reduction model:
1. Fleet commonality: lower pilot and cabin crew training costs, economic of scale of cheaper parts and equipment through volume purchase, better bargaining power for outsourcing maintenance 2. Maximize aircraft utilisation: fewer aircraft used to generate higher revenue, lead to higher capacity and great staff efficiency
3. Point-to-point service: direct, non-stop, no baggage or passenger transfer costs 4. Minimise capital outlay: outright purchase of used or new aircraft of a single type 5. Secondary airports: Less congestion and lower fees, better punctuality and faster gate turn-around 6. Simple product offering: no frills, no assigned or multi-class seating 7. No loyalty programme: no associated costs for loyalty programme 8. Non-participation in alliance: no code sharing, baggage or passenger transits that may decrease punctuality and increase handling costs 9. Customer service costs: outsource capital intensive activities, e.g. passenger and aircraft handling, etc. 10. Travel agent fees: reduce associated travel agent commissions and use direct internet booking system
11. Personnel costs: link passenger-staff ratio, employee compensation link to productivity-based pay incentive
Note that while there are a few exceptionally successful LCC models, it is not always bright and sunshine for new LCCs entrants. From a free market long-term industry structure perspective, easy market entrance during market deregulations with over-capacity will eventually lead to ‘destructive’ industry price wars and consolidations.
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Figure 29 Review of LCCs consolidation and bankruptcies in Europe (Source: Estimated figures of IATA, ICAO and others)
Year Airline Country Event 1999 All Airlines UK Bankruptcy Color Air Norway Bankruptcy Debonair UK Bankruptcy 2002 GO UK Merger with RyanAir 2003 Air Lib France Bankruptcy Buzz UK Merger with RyanAir Goojet Sweden Bankruptcy 2004 Air Polinia Poland Bankruptcy Basic Air Netherlands Re-branded as Transavia Duo Airways UK Bankruptcy German Express Germany Merged with dba Flying Finn Finland Bankruptcy GetJet Poland Bankruptcy Jetgreen Ireland Bankruptcy Skynet Airlines UK Bankruptcy V-Birds Netherlands Bankruptcy VolaireWeb Italy Bankruptcy 2005 Air Andalucia Spain Bankruptcy EuJet Ireland Bankruptcy Intersky Denmark Bankruptcy Maersk Air Austria Merged with Sterling 2006 Air Wales UK Bankruptcy Budget Air Ireland Bankruptcy Flywest France Bankruptcy 2007 LTU Germany Merged with Air Berlin
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READ:
Kellogg On Strategy by David Dranove and Sonia Marciano, Wiley publisher Chapter 9, page 203 on Examples In Action : Southwest Airlines
Long Range Planning by Thomas C. Lawton, Elsevier Science publisher Volume 32, Number 6 on ‘The limit of price leadership : needs- based positioning strategy and the long-term competitiveness of Europe’s low fare airlines’, page 573 – 586, 1999. The Journal of Air Transportation World Wide by Thomas C. Lawton Volume 5, Number 1 on ‘Flying Lessons: learning from Ryanair’s cost reduction’, page 89 – 106, 2000.
2.5 SUMMARY
In retrospect, we take some comforts that both the aircraft manufacturers collaborate closely with the airlines to complement each other vision in shaping the directions and future of the aviation and air travel industry.
The entry of Airbus Industries have exerted significant influences, creativity and innovation within the aviation industry through market competitions challenging the envelope for new innovative technologies adoption (fly-by-wire technology), two engines type long-range aircraft design, etc. Imagine if Boeing were to stick to their internal product designs (given their industry dominance power in the past) as a product-orientated manufacturer, the airlines will have to reshape their network planning, network management and fleet strategies (either hub-and-spoke or point-to-point) as there are no viable aircraft products to meet their desired city pairs range, capacity and performance. Today, A380 and B787 were designed based on key customer’s inputs to help shape the final design and framework of these successful models.
Having a good control of unit costs and flexible contractual agreement on ‘break away’ clauses with labour, aircraft leasing, fuel hedging (price and volume), of major fixed and variable cost components are key to the ‘flexibility’ and ‘scalability’ of operations in adapting to the dynamic changes in the business models during changing times in the volatile market environment.
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EAS431 Aviation Finance
STUDY UNIT 3
EAS431 STUDY UNIT 3
OVERVIEW
Facing the onslaught of price competitions from the LCC and CC, we need to understand and analyse the airline’s costs structure in order to identify where are the potential areas of improvement in cost-saving as well as potential revenue generation, for examples, baggage charges, allocated seating, etc. and revamp the business models and cost management for long-term profitable and sustainable strategies.
LEARNING OUTCOMES
At the end of this unit, you are expected to:
Explain the fundamental cost structure of an airlines Explain the key parameters affecting the direct operating costs and indirect operating costs of aircraft economics Discuss the importance of various key aircraft operating economics, economics of aircraft asset utilisation, fleet size, network planning and management
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CHAPTER 3: OVERVIEW OF THE AIRLINES COSTS STRUCTURE
Cost Structure Of Airlines Businesses 3.1 Aircraft Economics
To understand the cost structure of the airlines, we need to first understand the aircraft economics which account for the unit operating costs of specific aircraft type. Economic analysis is use to measure the effectiveness of the aircraft on either a route or network and sophisticated modelling is use to compare the two key and most significant elements: revenues and the network effect. We need to understand the effect of the operating environment, the aircraft cabin configuration and route structure in order to examine what drives the economics of aircraft.
The key to analysing aircraft operating costs is to find ways to manage them, rather than minimising costs, somewhat against the intuitive feel. It maybe worthwhile if the rewards or return in terms of better reliability of operation (dispatch reliability) or great market opportunity is much more substantial despite the higher costs. You reap what you sow!
Thus it is important to examine the effect of aircraft type selection and the trends in cost evolution in terms of cost components, their measurement, and how they vary in accordance to the type of operation.
In general, operating costs can be divided into two main categories:
1. Direct operating costs (DOC): Costs which vary with the type of aircraft used. 2. Indirect operating costs (IOC): Costs that are not affected by aircraft type.
Direct Operating Costs Indirect Operating Costs Fuel Direct Burden (IOC) Flight Crew Cabin Crew Passenger Services = Total Operating Catering (DOC) Landing Fees + Costs Navigation Fees Ticketing, Sales & Promotion Insurance Ownership Handling (Traffic) Interests General & Depreciation Administration Rental Ground Handling
Figure 1 Classification of Direct operating costs and Indirect operating costs
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3.1.1 Fuel Costs (DOC)
Fuel components comprise of price of fuel, the rate of consumption of the aircraft, the network operated and the characteristics of the fuel itself.
Airlines are hostage to the fuel pricing fluctuations and any prediction of pricings is close to betting on the casino. The correlation between the rise of the crude oil price and the aviation fuel price is close to 90% in the 2000s. The uncertainty of the fuel price and increasing trends has made fuel efficiency a top priority in fleet planning. Airlines is increasingly begin to hedge with cautions some of their fuel position for their operational requirement or take an option of buying fuel on the futures market. SIA, PAL, and some airlines have done relatively well and reap some profits in a positive hedge position while others have post losses. Another consideration is the ‘price at the pump’ which is subjected to local government taxes. The high fuel taxation is obviously the case which made airlines operating out of India uncompetitive in international routes.
As a result of the highly volatility and uncertain of the high fuel prices, the airlines industry has called for new alternative sources of fuel supply and has been working closely with the engine markets to drive the experimental test using non-food crop based bio-fuels to power the engines. Virgin Airlines and JAL have been conducting some flight tests with engine manufacturers in evaluating the performance of these bio-fuels. Even if the results are encouraging, it will take a number of years to develop the bio-fuels production, years to grow sufficient volume of crops for meaningful production, to establish the economics and viability of developing a sustainable bio-fuels supply pool. Note that while the industry is actively pursuing the new development of the alternative bio-fuels supply, once the engines are designed, modified and configured to run on bio-fuels, it is an irreversible process and may affects some of the economic values and life-cycle performance of the engines.
3.1.2 Aircraft Fuel Consumption:
Given the fuel/oil price shocks that significantly impact the airlines operational costs (to the extent that it may not be profitable to operate the routes or aircraft types, e.g. B747 vs. B777, and shifted the breakeven load factor margins), the fuel efficiency is a key function in the aircraft design. B787, A380, A350, new aircraft models (through the use of light-weight composites and aerodynamic designs) and new generation of engines are driving to achieve lower fuel consumption through technological improvement.
Although the airlines could achieve some fuel consumption efficiency operationally through cruising at some specific optimal altitudes and cruise speeds, as per Continental Airlines case, it is not being widely practised as it would affect the on- time arrival performance of the aircraft.
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3.1.3 Fuel Characteristics
The measurement of fuel in an aircraft is based upon the volume of the holding tanks. The most usual density used is 6.7 pounds or 3.04kg per US gallon.
3.1.4 Network Design and Operation
Each aircraft is designed for an optimum payload and range characteristic. Operating at off-optimum conditions (e.g. take-off, landing, low attitude manoeuvres in holding patterns in congested air space) carries some penalty as fuel burn varies according to how the aircraft is used, just like the car.
3.1.5 Maintenance Costs (DOC)
Maintenance Costs can be divided into:
1. Direct Maintenance Cost (DMC): Labour and material costs associated with maintenance of the airframe components and engines. 2. Indirect Maintenance Cost (IMC): Overheads, administration, tooling, test equipment and facility, record keeping, supervision and quality control, etc. IMC are a function of how a maintenance facility is organised and varies between airlines practice. IMC is usually account for between 50% to 200% of DMC.
DMC – Line Maintenance: Daily or weekly routine checks which are calendar- related, the ratio of man-hours to flight hours is highly dependent upon the utilisation achieved. Line Maintenance accounts for 10% - 15% of DMC.
DMC- Airframe Maintenance: The aircraft manufacturer issues a Maintenance Planning Document (MPD) which defines tasks (in packages or blocks) and time interval covering the aircraft structure, systems and components. The maintenance schedule comprise of a number of checks, referred to as ‘A’, ‘C’ and heavy checks (i.e. ‘D’ check per Boeing) as shown below.
Figure 2 Aircraft scheduled block maintenance for major checks
4
th
CCheck
2
3
1
nd
rd
st
CCheck
CCheck CCheck
Year1 Year2 Year3 Year4 Year5
9 A Checks 9 A Checks 9 A Checks 9 A Checks
HeavyCheck
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It is possible to reduce the overall number of maintenance days over the five-year cycle by ‘equalising’ the ‘A’ checks over the first three ‘C’ checks as shown below.
4 Figure 3 Aircraft maintenance checks equalised scheduleth
CCheck
Year1 Year2 Year3 Year4 Year5
9 Equalised 9 Equalised 9 Equalised 9 Equalised A Checks A Checks A Checks A Checks HeavyCheck
DMC- Engine Maintenance: The maintenance is a function of both operating hours as well as cycles, or take-offs. The engines are subjected to maximum power output during take-off resulting in wear and thermal stress, especially in hot and high- altitude airfields and short runways. Engine maintenance can be carried out in modular overhauls. Engine overhaul is expensive as it contains expensive Life Limited Parts (LLPs) which must be scrapped once they have reached the specified life limits.
Factors influencing maintenance costs:
1. Airline may decide whether to do the maintenance in-house (heavy investment for MRO set-up) or to outsource the maintenance to a third party workshop, e.g. ST Aerospace, Lufthansa Technics, etc. ADs are mandatory but most SBs are optional.
2. Aircraft is subjected to higher wear and tear in non-optimal operations. Aging aircraft could account for sudden cost surprises at various intervals as shown below.
Figure 4 General maintenance costs trend of aging aircraft (Source: Boeing, Airbus and others)
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3. Geographical environments in deserts or runways with high FOD post potential risks resulting in higher costs.
4. The structure of the route network determines the utilisation pattern of the aircraft fleet. Short-haul operators may incur twice the DMC with higher utilisation compared to long-haul operators using the same aircraft type. Any daily or weekly checks consume virtually the same number of man- hours irrespective of utilisation. Te effect is that the man-hours per flight hour would triple if daily utilisation reduced from 8 to 2 hours per day.
3.1.6 Crew Costs (DOC or partially IOC)
1. Flight Crew (DOC) 2. Cabin Crew (DOC or IOC) 3. Flight Crew Productivity
3.1.7 Landing Fees (DOC)
1. Aircraft dependent fees 2. Traffic dependent fees
3.1.8 Navigation Fee (DOC)
3.1.9 Insurance Costs (DOC)
Ownership Costs 1. Depreciation 2. Loan payments and other acquisition costs
3.1.10 Handling Costs (DOC & IOC)
3.1.11 Passenger Service Costs (IOC)
3.1.12 Ticketing, Sales and Promotion Costs (IOC)
3.1.13 General and Administration Costs (IOC)
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Operation Breakdown Fixed Cost: Variable Cost:
DOC: Ownership DOC: Fuel Insurance Landing Fees
Flight Crew (%) Navigation Fees Cabin Crew (%) Maintenance (%) Maintenance (%) Flight Crew (%) Catering (%) Cabin Crew (%) Catering (5) IOC: Passenger Service (%) Ticketing (%) IOC: Passenger Services (%) Handling (%) Ticketing (%)
G&A (%) Handling (%)
Evolution trends of operating costs:
1. G&As are on increasing trend 2. Aircraft leasing is an increasing trend 3. Fuel is increasing a main factor given the rising fuel prices
Figure 5 Composition of operating costs (Source: IATA)
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3.2 Key Aircraft Operating Economics
3.2.1 Break-even Load Factor
Break-even load factor (BELF) is the fundamental measure of operating performance.
BELF = (Total operating cost/Available Tonne Kilometres)/ (Operating revenue/Revenue Tonne Kilometres) or
BELF = (Total fixed operating cost/Available Tonne Kilometres)/ (Operating revenue – Variable costs)/Revenue Tonne Kilometres
3.2.2 Operating Leverage
The overall profitability and operating leverage requires a good grasp of the fixed and variable costs in proportional to the level of activity performed. Step changes in fixed costs and variable costs investment maybe required for activity expansion. There is a potential danger of profitability erosion if there are immense competitions, excess supply and price elasticity after taking discounts into consideration.
Figure 6 Illustration of breakeven point of operating costs
3.2.3 Cost Escapability
Escapability is a popular method which help to identify and assess which costs are completely avoided if part of the operation is dispensed and did not operate, e.g. fuel, some maintenance costs, landing and navigation fees, catering, handling and crew allowance, etc.
Fan Diagram is focus on unit cost analysis but does not account for the revenue, technology level and the network effect in range capabilities. As aircraft size changes, so do their revenue-earning abilities and different degree of risks as well. As a rule of thumb, as stage length increases, unit costs improve as fixed costs are
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more wide spread and aircraft are more efficient when cruising in optimal conditions for a longer period.
Figure 7 Illustration of sample Fan Diagram
Fan diagram gives a snapshot of the aircraft positioning using the seats as a KPI to focus on unit cost measurement by dividing the operating cost by the number of seats.
Using Aircraft A as the reference datum, we can gauge whether competing products/aircraft in the other four quadrants are better or worst in either trip cost or unit cost.
The Fan diagram however does not offer insights in revenue, technology level and the network effect.
The concept of equivalent cost takes into account of revenue calculation and simulates the cabin configurations between two different aircraft.
Another popular modelling tool is the profit profile which takes into account the revenues and incorporated a spill calculation. As demand increase, the profit profile suggest when it is economically better to either increase aircraft size or add additional frequencies.
Figure 8 Illustration of sample Profit Profiling (1)
Profit Profiling (1)
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Figure 9 Illustration of sample Profit Profiling (2)
Profit Profiling (2)
As spill grows beyond the current capacity, a decision must be made concerning capacity. As shown in the diagram, adding a second frequency will instantly reduce the profits due to the costs of operating the second aircraft.
Profit profile does not takes into account of demand stimulation effect of the provision of additional frequencies, i.e. a two-frequency operation versus a single frequency operation. It also do not take into account of network effects and the corresponding two ways direction of a route.
Figure 10 Illustration of Sizing model used for the assessment of different aircraft size against break-even loads
Economic Size Modelling Capacity
Profit Breakeven
Capacity Capacity Profit Profit Uneconomic Step-up Economic Step-up Cost
Cost Cost
90 Seat Aircraft 120 Seat Aircraft 160 Seat Aircraft
3.2.4 Dynamic fleet management was first introduced by aircraft manufacturers in late 1990s as an optimising technique when they began to design operational commonality into the aircraft family line. The technique was also know as follows:
1. Demand Driven Dispatch (D3) by Boeing 2. Adaptive Aircraft Assignment (A3) by Sabre 3. Dynamic Capacity Management by Ortec of the Netherlands
The concept involves an operational mechanism which continuously analyse the demand variation throughout the network and adapting the way in which each aircraft type is assigned to individual sectors with an attempt to better match supply and demand by manipulating capacity according to late change in demand.
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The goal is to achieve the overall optimisation of profitability for the entire network through the best balance of supply and demand, assuming that a network route must offer aircraft swapping opportunities and similar aircraft technology.
Changing the aircraft assignment before departure is all about timing as it entails significant impact and operational challenges. Changes in the forecast of the aircraft locations throughout the system will change and complicate the maintenance planning. Moreover, a sufficient number of qualified cabin crew need to be available, per regulatory requirement, at the swapping points throughout the network to ensure that there is effective substitution of aircraft and crew to operate the flights. Other challenges involves having the correct catering levels.
3.2.5 Economics of Fleet Commonality
It is important to identify and qualify the difference between cost savings derived from pure economies of scale compared to those associated specifically with the fleet commonality in design and operation.
We also need to qualify the different forms and degree of commonality which contribute to quantifiable costs savings. In general, it can be divided into two main category as presented in the below chart in (a) Introduction costs and (b) Day-to- day operating costs.
Fleet Commonality Savings Introductory Costs: Daily Operational Costs:
Spares Flight Crew Training Crew Training Spares Inventory overheads Ground Support Equipment Maintenance Overheads
Savings derived from commonality:
3.2.5.1 Spares provisioning Commonality is time dependent as aircraft from the same family may vary in configurations as delivery is spread over years. Major benefits are derived from technical publications, maintenance system knowledge and vendor relationship, followed by improve delivery lead time and improve maintenance TAT and limited benefits from the spares initial provisioning.
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3.2.5.2 Crew training Operating multiple aircraft types require separate group of pilots with different aircraft rating qualifications. Mixed Fleet Flying (MMF) is the operational practice where one pool of pilots is permitted to fly different types concurrently. Pilots are able to fly short-haul and long- haul sectors. This practice can ease ‘currency’ training, which is necessary if a prerequisite number of take-offs and landings have been performed within a 90-day period. Huge savings are derived from flight crew training and further benefits are extended to crew deployment and resource planning. Airbus has developed a Cross Crew Qualification (CCQ) for the process of qualifying the crew for a new aircraft type or another family by focusing on the differences between the new and currently- qualified aircraft, rather than undergoing a full type rating for the new type. The normal 25-day type rating can be reduced to as little as a single day, depending on the transition.
3.2.5.3 Ground support equipment Main savings are derived from outstation operation which is a function of the intensity of use and degree to which aircraft from the same family serve the same city-pairs route. A potential saving could be realised from pool sharing of compatible equipment which another operator who may have invested in and available for use.
Figure 11 Breakdown of on-aircraft and off-aircraft maintenance costs
Example of Maintenance Cost Breakdown On Aircraft: Off Aircraft:
Line Maintenance (14%) Components (30%) A Checks & C Checks (6%) Engines (35%) Heavy Checks (15%)
3.3 Asset Utilisation and Fleet Size
Airline industry is a labour intensive ‘Service’ industry and hence labour costs account for 25-35 per cent of total operating costs I USA and EU). Capital costs of depreciation, rentals and interest charges amount to about 15 per cent of total costs. A new B747-400 costs US$200 millions in 2005.
Aircraft utilisation and asset productivity in terms of ATKs per aircraft has increased due to operating longer average sector using the same size of aircraft between 1985 to 2002.
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The average price of aircraft has increased at an average of 8 per cent a year between 1970 and 1995, 1970’s B737-200 costs US$4 million vs. 1995’s B737-500 costs US$28 million but 2000’s B737-500 costs US$30 million (due to Airbus competition), faster than the rate of inflation of consumer prices in industrial countries. Thus, there is a drive to increase the utilisation of aircraft.
Average aircraft utilisation for the world’s airlines increase from 2,000 block hours per aircraft in 1985 to 3,000 hours in 2002, by 1.9 per cent a year.
Refer to Study Unit 2 on the comparison chart of B737-300 operating costs of US carriers
3.3.1 Scheduled vs. Charter vs. Low-cost operations
Maximising aircraft utilisation is a key parameter in spreading fixed costs.
3.3.2 The effect of fleet size on Economics
Economic of scale, maintenance and operational savings and start-up costs on commonality fleets are a significant consideration for spreading the fixed and variable costs over the number of aircraft. Moreover, access to an inventory spares pool managed by other operators or service providers of the same aircraft types will reduce the inventory holding costs to support the fleet operations at various regional and strategic geographical hubs.
3.3.3 The impact of alliance on Economics Easier way to expand in scope and achieve critical mass and network reach is via formation of alliance but not always successful, e.g. KLM/Northwest and BA/US Air alliance.
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3.3.4 Problem of external factors Aviation businesses have witnessed and experienced various external shocks which had put risk management and operational flexibility at a height in every airline management agenda. External shocks deliver market uncertainty and business risks such as:
3.3.4.1 High fuel price: Although fuel hedging is adopted by some major airlines but it is good as reading a crystal ball on oil pricing trends in future trends
3.3.4.2 Effect of currency exchange: The FOREX impacts depends on the size of the international vs. domestic revenue income base.
3.3.4.3 Outsourcing of training and maintenance: Non-core businesses could be outsourced to centre of excellence service providers
3.3.4.4 Diversification of businesses to spread risks, e.g. KingFisher, PAL.
3.3.4.5 Nature catastrophe like the recent Volcanic ashes disruption of air travel and European and trans-Atlantic flights
3.3.5 Spare provisioning (IP)
A recommended IP is always introduced during aircraft entry into service (EIS) from aircraft manufactures and OEM component manufacturers (GE, Honeywell, Thales, etc.) to ensure that there are sufficient spare inventory to support a replacement in case of any anticipated component failures, e.g. SIA A380 EIS.
Pooling might be a solution but major Tier-1 carriers have their concerns as it involve the age of the equipment and the standard of maintenance practices which differs amongst airlines, i.e. SB or AD not incorporated, Engine LLPs (1st time vs. multiple times overhaul restrictions) etc.
Other creative programmes from OEMs, Lessors, 3rd MRO shops and inventory stockists: PBH programmes, GE Engines On-Point Solution or on inventory consignment ‘pay as you use’ programmes.
READ: nd Buying The Big Jet by Paul Clark, 2 Edition, Ashgate publisher
Chapter 6, page 171 on Aircraft Economics
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3.4 SUMMARY
Undoubtedly, airlines continue to strive towards achieving lower unit costs of operations through consolidations as a competitive edge to competitions and survival. United Airways and US Airways have failed two attempts for merger talks due to inability to settle the union’s disputes and wage compensation issues. Eventually, United Airways merged with Continental Airways on May 2010 having compromised on most of the wage rates and compensation issues.
In time to come, we will witness more mergers and consolidations as global airlines strive for economic of scale and scope. However, cross-borders merger and acquisition, for example, SIA and Qantas or SIA and BA, have major obstacles and roadblocks as there are huge spread and differences between local compensation policies and wage rate conditions in different countries. BA recent union strike in May 2010 was the writing on the walls of developed country’s union dispute (ground handling/cabin crew/pilot) of below-industrial wage compensation. These roadblocks and issues if resolved appropriately could turn around to be the major competitive advantages most airlines are seeking for in a global service industry and economy.
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EAS431 Aviation Finance
STUDY UNIT 4
EAS431 STUDY UNIT 4
OVERVIEW
Facing the emergence of low-cost carriers and charter airlines competing for the market shares in the same pie on the same city-pair routes, investment decisions on procuring the right type of aircraft with the right economics, operating costs and operating performance for specific market segments are critical to the survival of the business models. Ryan Air has demonstrated from time to time again that its unique operating strategies with the right aircraft type and aircraft economics have fended off new ‘me-too’ market entries competing in the same city-pair routes/segments.
LEARNING OUTCOMES
At the end of this unit, you are expected to:
Explain the various aspects of investment appraisal and investment consideration Understand the primarily sources of aircraft financing Explain the importance of residue values, airline credit rating, technology evolution and asset valuations that influence the aircraft useful life cycle and valuation of each aircraft type State the aircraft economics and the various factors that may affect the aircraft residual values from an airline operator or/and leasing company perspectives
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CHAPTER 4: OVERVIEW OF THE INVESTMENT APPRAISAL
4.1 Aircraft Finance & Investment
4.1.1 Return on Capital (ROC)
Return on capital (ROC) is defined as the operating profit after taxes and adjusted for operating lease, expressed as a percentage of end-of-year invested capital.
Net Operating Profit – Adjusted Taxes
ROC = ______
Debt + Equity – Cash
When the return on capital is greater than the cost of capital (usually measured as the weighted average cost of capital, WACC), the company is creating value; when it is less than the cost of capital, value is destroyed.
4.1.2 Return on Invested Capital (ROIC)
Return on invested capital (ROIC) is a financial measure that quantifies how well a company generates cash flow relative to the capital it has invested in its business. It is defined as a percentage of net operating profit minus adjusted taxes (NOPAT) divided by invested capital. The capital invested includes all monetary capital invested: long-term debt, common and preferred shares.
Net Operating Profit – Adjusted Taxes
ROIC = ______
Invested Capital
4.1.3 Weighted Average Cost of Capital (WACC)
The weighted average cost of capital, WACC, is a way of computing a discount rate by blending the borrowing rate with the shareholder’s expected return on investment.
D E WACC = Rd x ------+ Re x ------D + E D + E
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Where Rd = Company borrowing rate (e.g. LIBOR + 3%) Re = Shareholder’s expected return on equity (normally 12%-15%) D = Debt E = Equity
None of the regional airline groups as a whole exceeded the weighted average cost of capital (WACC) of 7.5 per cent return over the past decades.
4.1.4 Lease versus Buy Decision
Main considerations of the financing for the acquisition of an aircraft are”
1. Cost 2. Cash flow consideration 3. Taxation issues 4. Options of source of financing through debt, equity or leasing 5. Flexibility
Whether an airline lease or purchases outright an aircraft, we can use the Net Present Value (NPV) methodology for comparison of the expected return of investment, from projections of future revenue and costs:
1. Calculate the NPV of the lease alternative/option 2. Calculate the NPV of the buy alternative/option 3. Choose the alternative/option with the lowest NPV cost or highest positive NPV revenue
4.1.5 Net Present Value (NPV)
For investment appraisal considering the time value of money, two widely used methods involved NPV and IRR (Internal rate of return).
Present Value Calculations:
CF t = Cash flow at Year t t = number of the period I = Initial investment r = Discount rate
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1 PV of $1 in 5 years time, r @8% = ------= 0.68 (1 + 0.08) power 5
1 PV of $1 in 5 years time, r @10% = ------= 0.62 (1 + 0.10) power 5
NPV is the summation of all future cash flows in the period considered minus initial investment.
If NPV > 0 : The investment maybe worth doing and choose projects via highest NPV ranking If NPV < 0 : It is not worth investing in this project
As shown above, for a given discount rate r, there will be an NPV of a future series (summation over a period) of cash flows which maybe positive. As we increase the value of the discount rate, the present value of the future cash flows decreases. The internal rate of return, IRR, is the discount rate at the point whereby the discount rate increases reduce the NPV to zero. Although the IRR portrays a return on capital, it cannot distinguish between projects of varying size. In the eye of many, the IRR maybe flaw and must be interpreted with caution because it can generate two results when the cash flows oscillate between positive and negative values.
4.1.6 NPV calculations for investment appraisal.
We will evaluate a simple NPV comparison between lease versus purchase options and another example of NPV of tax paying lessee.
Actual calculations would take into consideration of taxation issues, purchase progress payments, commitment fees, residual value, etc.
Note: The comparison changes in favour buying against leasing for ‘tax paying lessee’ NPV comparison. With 35% tax credit and with accelerated tax allowances, purchases outright would be a better option.
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Reference case: SIA has successfully use this method to depreciate the aircraft for sale in young fleet and profit from sale proceeds of fully paid assets.
Figure 1 Example of NPV Comparison vs. Discount Rates for project selection
Note that any NPV calculation is highly contingent upon the discount rate, study period and forecast of assumptions (e.g. taxation, depreciation policies, etc.) within. Thus, we can develop a ‘scenario building’ simulations ranging between ‘optimistic’ scenario to ‘pessimistic’ scenario, combining some probabilistic s simulations to generate a set of NPV results for comparison.
Note that having run through the NPV exercises and ‘scenario building’ simulations, it is always a good practice to reflect on the following elements before jumping into the projects with the highest NPV ranking:
1. Optimal timing of investment 2. Deciding when to replace the equipment: Taking into consideration the cash flows projection between the remaining useful life of the old and new equipment and the loss of residual value of old equipment over time. 3. Fluctuating load factors, especially during uncertainty periods whereby demand volatility is a key concern: Would it be beneficial to push out some of the new equipment delivery and take a progressively approach to replace only some of the equipment. However, do be wary whether there is any penalty involved in delaying the delivery schedule. 4. Investment risks: a. Inflation risk: Inflation risk is also known as the purchasing power risk because the ability to purchase different quantities of goods and services is dependent upon the changing levels of prices of all items in the economy. b. Interest rate risk: Any unexpected change in the general levels of interest rates will unexpectedly affect the values of all asset classes. c. Market risk: When an unexpected change in values due to events such as possibilities of war, natural catastrophes, etc. which is systematic and affect all the goods and services to the whole market, the risk is termed as market or systematic risk.
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d. Business risk: The risk associated with the changes in a firm’s abilities to measure up to expectations is known as business risk or unsystematic risk. Business risk can be further segregated into operating risk and financial risk (a.k.a. credit risk). The risk that a business may not be able to meet its fixed operating costs, such as rent, management salaries, etc. is known as operating risk, The risk that the company may not be able to meet its fixed financial obligations, such as paying interest on its debt or lease payment is known as financial risk. e. Liquidity risk: Liquidity is concerned with the ability to convert the value of an asset into cash. Any event or condition that affects this ability is termed as liquidity risk. f. Political risk: Due to cross-border’s operations, airline operators with foreign operations may face the danger of political upheaval which overthrows the political party in power which may lead to change in rules, tax regime and regulations, etc. g. Exchange rate risk
4.2 Sources of Aircraft Financing
There are four primary sources of aircraft finance:
A. Commercial bank debt B. Lessors C. U.S. capital market, and D. Export credit agencies.
Rocked by the US financial crisis in 2008, commercial banks in the United States and Europe are being more circumspect about lending due to the credit crunch and mistrusts between banks as even major global mainstream banks and institutions like Citigroup, BoA, AIG, etc, faced imminent bankruptcy threats and needed to be bailed out by US government. Vigorous capital markets are emerging in the fast-growing economies of Asia-Pacific and the Middle East.
Over the past two decades, European banks were the primary providers of commercial aircraft debt. Aircraft portfolios of these institutions are performing exceptionally well through the current downturn. However, most European banks that own those portfolios is not in good shape. The current financial crisis has hit European banks hard and is severely limiting their ability to continue doing business even in the sectors where they are doing well, like aircraft finance. These pressures will result in realignment of the global commercial aircraft bank debt landscape.
North American banks were the primary financiers of worldwide aircraft
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deliveries during the 1960s and 1970s. Japanese banks assumed the major role in the 1980s, to be succeeded by European banks when Japan’s economy faltered in the early 1990s.
Originally encouraged to enter airplane financing by European governments interested in facilitating the sale of Airbus products, European banks soon recognized the excellent performance of their airplane portfolios and diversified into the broader airplane financing market, becoming dominant players.
Many European banks will continue to play a leading role in airplane financing. However, the current challenges to world banking institutions are extending the opportunity for regional banks to strengthen their airplane portfolios. As a result, airplane financing is becoming much more geographically diverse, mirroring the increased diversity of the airplane market itself.
4. 2.1 Impact of Operating Lease
Figure 2 Trends of operating lease between 1985 – 2005
Operating Lease Trends (1985-2005)
1995 2005 1985 21% 31% 7%
Owned Leased 2005 1985 1995 69% 93% 79%
Airline operators rarely use its own funds to acquire entire fleet of aircraft. It is common practice to obtain financing in the form of a secured debt using the aircraft as collateral: Asset Financing. Nowadays, it is very command for airline to lease the aircraft by a simple rental or by a long-term lease with a right to purchase.
By 1995, about half of US scheduled airlines’ fleets were leased. Through leasing, airlines conserve their its own capital position but loses the residue value of the aircraft when the aircrafts are returned to lessor, unless an option to purchase has been included in the lease. Airlines uses operating leasing to adapt for the flexibility between demand peaks and supply constraints.
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Disadvantage to leasing is its effects on cash flow. When an aircraft is leased, the airline does not lay out cash out-front when the aircraft is acquired. Instead, cash is laid out throughout the lifetime of the aircraft. When an airline owns an aircraft, it allocates a portion of its revenue to an account that covers the depreciation of the aircraft. Depreciation is an accounting charge and does not require an actual outlay of cash.
As a result of increasing adoption of leasing by airlines, airlines are experiencing annual cash outlays equal to their cash inflows and may run into cash flow problems leading to bankruptcy in adverse economic conditions or crisis.
Major aircraft leasing and financing companies: GECAS (GE), ILFC (AIG), ACS (Pacific Life), AWAS, etc.
Air Transport World and Aviation Week and Space published Aircraft Costs data in trade publication which show cost experience of each airline with each type of aircraft. It is possible to make comparisons between types of aircraft.
Advances in airframe (composites), engine technology (twin engines, increased on- wing reliability, fuel efficiency) and longer-term routine maintenance overhauls, shorter maintenance down-time at hangar/on ground checks. Advancing technology has managed to achieve lower seat-mile costs and with new aircraft model introduction, TIC break-in costs in training’ learning curve in servicing new models.
Boeing attempt on developing Sonic Cruiser supersonic transport aircrafts (SSTs) like Concorde (operated by Air France/British Airways) was abandoned . Concorde flight was only made economically feasible with the operating economics by reducing the Drag Coefficient by 0.5 and was eventually scrapped as the fleet retired due to age, technical and maintenance feasibility although there was actual demand for the trans-pacific routes for busy executives.
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4.3 Aircraft Leasing
4.3.1 Accounting for Finance (Capital) & Operating Leases
There are various aircraft lease classification guidelines and accounting treatment differences between US, UK, EU and Japanese.
4.3.2 Aircraft financing spectrum
Aircraft Financing Spectrum
In The Past Today In The Future
Figure 3 Illustration of the trend in aircraft financing (Source: Boeing, Airbus and other leasing companies)
Focus shift from relying on airline credit rating to aircraft assets value but may take a step back in current turbulence economic environment (i.e. credit crunch, bankruptcy, etc.) whereby some airline operator business models, survival and ratings are in questions.
4.3.3 The world of Lessor versus Lessee
An aircraft lease is a contract between a lessor (bank, leasing company or high tax- paying individual to reduce tax payments like PAL, Kingsfisher, Cebu Pacific, etc.) and a lessee by defining these parameters:
1. Select the aircraft specifications (usually by the first user) 2. Make specific payments to the lessor for an agreed period 3. The lessee is granted the exclusive use of the aircraft for the specified period 4. Ownership of the aircraft belongs to the lessor. Lessee may negotiate for option to acquire the leased aircraft or share in the proceeds of the sale of the aircraft at end of lease term. Or the lease may be extended at the end of the initial lease term.
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Figure 4 Past trends of number of airlines owning and leasing aircraft for comparison
Total % Finance Lease % Operating Lease Singapore Airlines (2006) 118 4 21 Cathay Pacific (2005) 96 56 13 Air Asia (2005) 26 NA 85 RyanAir (2005) 87 0 15 EasyJet (2005) 109 0 83 British Airways (2006) 284 0 27 AirFrance-KLM (2006) 397 17 37 Continental Airlines (2005) 630 1 76 United Airlines (2005) 460 12 38 JetBlue (2005) 92 0 34
Operating leases account for 35.3 per cent of the world fleet. The above shows that LCC: easyJet, AirAsia, JetBlue , Iberia, Continental and Air New Zealand are main users of operating lease.
4.3.4 Finance Lease
Finance lease account for about 30 per cent of new aircraft financing in 1997, half of which are financing for US airlines but has declined significantly due to the withdrawal of Japanese Leveraged Lease (JLL) and US tax lease. As the leases are non-cancellable or cancellable at a heavy penalty, thus lessor expects a healthy profit on the asset through rental fees, tax benefits and conservative residual value assumptions. Risks, benefits of ownership, repair and maintenance responsibility, risk of obsolescence and insurance of the aircraft is with the lessee as the lease period is for major part of aircraft’s life although the airline is not the legal owner of the aircraft.
There are various leasing scheme which evolved over the years:
a. Japanese Leveraged Lease (JLL)
b. US Leveraged Lease
c. European Leveraged Lease
d. Extendible Operating Lease
Operating Lease characteristics : 1. offers flexibility to airlines to respond rapidly to changes in market conditions
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2. Short term on average of five years and can be return to lessor at short notices with major penalty 3. Lessee cannot choose the aircraft configurations. 4. Lessee gains exclusive use of the aircraft without high upfront capital and costs to purchase the assets 5. Lessor expects to make profit from either selling or re-leasing the aircraft 6. Lessee is responsible for maintenance of the aircraft and pay lessor a maintenance reserve for big ticket items (like engines overhaul)
e. Japan Operating Lease (JOL) as a replacement of JLL
f. Wet Lease
g. Sale and Leaseback
h. Equipment Trust Certificates (ETC) – a form of securitisation
i. Enhance Equipment Trust Certificates (EETC)
The role of capital markets in airplane finance mushroomed in 1994 with the advent in the U.S. of the Enhanced Equipment Trust Certificate (EETC). EETCs provide a greater degree of certainty to airplane financiers by clarifying the rights of lenders in case of a bankruptcy or default under section 1110 of the U.S. Bankruptcy Code. This clarification facilitated the issuance of nearly $10 billion per year in airplane financing during the late 90s and early years of this decade.
The market has not approached that peak since, because the U.S. Bankruptcy Code covers only U.S. airlines and U.S. airlines have not taken a large number of deliveries since 2001. However, the performance of EETC bonds as investment instruments has proven exceptional. Since 1995, more than 99.9 percent of A- tranche EETCs have performed flawlessly.
Principal and interest were paid in a timely manner, even by airlines that filed for bankruptcy. Of the $12.5 billion of A-tranches that went through bankruptcy – in some instances multiple times – the recovery rate for principle and interest has been 99.7 percent, an extraordinary performance for a fixed-income instrument.
In one of the major development in 2009, we saw airplanes guaranteed by the U.S. Ex-Im Bank were funded in the U.S. capital market. Previously, airlines relied on commercial banks to finance Ex-Im guaranteed airplanes. Now the U.S. capital markets have greatly expanded the liquidity of export credit guaranteed financing, helping bring down the cost of funding of all Ex-Im guaranteed airplane transactions.
In 2009, we also witnessed the first Islamic bond (sukuk) secured by aircraft. About $500 million worth of bonds were issued, secured by 16 airplanes. This is a very important development in expanding globally aircraft capital markets.
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Boeing is working closely with the Aviation Working Group to establish structures similar to the U.S. EETC, with its well-defined creditor protections, in the global airplane market. The Cape Town Treaty is a significant step toward that end. As the number of treaty signatories continues to increase around the world, airplane financing through global capital markets is the next frontier.
First among the emerging entrants to the airplane finance market, China’s banks began financing airplane deliveries into China in 2001. In 2009, they finance $4–$6 billion worth of airplane deliveries per year. Chinese banks have recently branched into the world market, providing financing for deliveries to airlines in the Republic of Korea, Germany, France, the United Kingdom, the United States, and Australia.
Japan’s banks continue to dominate finance for deliveries into Japan and play a significant, though less dominant role in the global market.
Australian banks have also started to expand beyond financing for Australian airplane deliveries. Westpac and ANZ, for example, have financed deliveries to the Asia-Pacific region as Macquarie has also entered the global market.
Banks in the Middle East, after successfully financing deliveries within the region, have started to partner with Western aircraft financiers. Recent partnerships are: Partnerships of ACG/CAIF and DVB with the National Bank of Abu Dhabi
In addition, a multitude of regional banks around the world-including Russia, India, and South Africa-are providing financing to their own regional airlines. In aggregate these regional developments are establishing a new, globally diversified commercial bank debt market for aircraft.
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4.3.5 Comparison of profitability between Major Aircraft Lessor (ILFC & GECAS) versus major Airlines
30%
25% Aircraft Lessor 20% Profit Margin
15% Major Airlines 10% Average Profit 5% Margin
0% 1994 1996 1998 2000 2002 2004 2006 2008 -5%
Figure 5 Trends of profitability of aircraft lessors compared to major airlines (Source: Estimated figures of IATA and Leasing companies annual reports)
4.3.6 Parked Aircraft
Most of aircraft that were park at the Modavi desert were either broken up for spares or scrapped. Number of parked aircraft increased doubled to 1,000 in year following the Gulf War, as air travel demand decline and aircraft deliveries accelerated. By 1995, there are still 730 aircraft parked which comprises of 45 Stage 1 and 230 Stage 2 aircraft. By 2005 after 9/11, 668 aircraft = 6 per cent of total IATA member airline fleet . Average parked age was 23.6 years (B727s & early B737s Classic).
Depending on the airline strategies and market segments, apart from the engine performance, intended service range for routes, the investment appraisal will have to take into consideration whether the intended service life of the aircraft for each airline as some aircraft will incorporate unique IFE system and cabin interior configurations (i.e. number of seats, toilets and seating configurations – A380 can be co figured for 488 or 840 passenger’s seating configuration by Air Austral!), flexibility of gallery re-configurations (e.g. Bucher reconfigurable gallery system which is popular with aircraft leasing company as it can be easily reconfigure and swap configurations by ordering and installing the kits set.
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4.4 Aircraft Residual Value
International Society of Transport Aircraft Trading (ISTAT) is a professional organisation giving an arm’s length, independent advice on aircraft trading. Appraiser’s opinion defines the base value based on historical trends and assuming the aircraft underlying value in an open, unrestricted, stable market environment with a reasonable balance of supply and demand and its useful values in the absence of duress.
Unfortunately, many of the transactions do take place with some degree of duress.
4.4.1 Factors influencing Residual Value:
1. Age is by far the most reliable and critical indicator with price disparity of similarly aged aircraft due to difference in modification status, maintenance level and number of aircraft involved. 2. Early aircraft off production of a new type maybe affected by the ‘dash one-hundred virus’ whereby some aircraft are produced and carry the stigma of lower design weights. 3. Once a new model is launched and introduced in the markets, the residual value of older models will drop significantly. Thus, it is a good barometer to check the ordering patterns and backlog of the an aircraft variant and production life cycle. The very last aircraft off the production line cannot be expected to hold their initial value for a long time. 4. Real economic conditions determine the fair market value of the aircraft while keeping inflation in consideration. 5. Demand of new or/and second-hand aircraft is very much dependent on the economic conditions and geographical demand. During the Asian crisis in late 1990s, wide-bodied aircraft values were affected whereas value of single-aisle aircraft fluctuation was not significantly affected. 6. New aircraft prices set the ceiling price on market value especially if there are no supply shortage and price stability. 7. Price of second-hand aircraft values rise with higher interest rates which alleviate the higher costs of financing or leasing incurred. 8. Efficient and fuel-efficient aircraft outweigh older aircraft in aircraft values as the efficiency will contribute long-term savings. 9. Aircraft in impeccable maintenance history which incorporate all the relevant airworthiness directives and service bulletins and operate in a stable and favourable condition up held its aircraft values (vs. aircraft operating in the desert or sea-bound conditions).
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10. Aircraft with common technology will preserve better value rather than an odd child. 11. Aircraft which can easily reconfigured and deployed in other regions is attractive with the options and flexibility. Larger aircraft normally find it harder to find new homes for the right match of level of traffic. 12. Any major airline re-equipment or replacement programme will result in market being saddled with depressed underlying values of specific aircraft types. 13. Manufacturer stability is a major concern for the life cycle support of the aircraft, e.g. Fokker went bust and terminated the production lines. 14. Depreciation, base value and loan payments 15. Why residual value is important in fleet planning?
4.4.2 Key model inputs for residual value forecast:
1. Expected replacement cost 2. Remaining economic life 3. Future earning power 4. Relative operating costs versus current and future competing aircraft types 5. Expected market conditions
Appraiser will agree that the forecast is more of an art than a science.
A obvious trend that developed in the freighter markets when Fedex or UPS decided to select a specific type of aircraft for freight conversion as their main fleet, we will see an immediate interests and appreciation of these specific type of aged aircraft which otherwise would have a lower residual value as a passenger aircraft towards the end of their life.
Based on my experiences, it is rather difficult to appraise the resale or fair market value of aircraft of similarly aged aircraft operating in emerging markets due to the maintenance practices, documentation practices and b-to-b traceability of the components, for example, in China, India and Africa continental and others given the local maintenance record practices and language.
Investment Trends and Consideration
As the aviation industry is a high capital investment, high risks industry, despite the mushrooming of LCCs and new airlines across Europe, Asia and USA we have also witnessed a large number of LCCs and new airlines bankruptcy, alliances synergy, merger and consolidations across the industry.
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Most recent emerging trends of Jetstar (Qantas LCC) alliance with KLM-Air France in search of expanding the network externality and reach is an interesting development for main stream carriers to rethink their business strategies and investment plans. If these new activities are structure and develop in servicing/growing new market routes/segments, it will be beneficial to the overall industry in growing the overall market pie serving untapped markets instead of competing for market shares in the same pie on similar routes or city pairs.
In an effort to defend the local turf, main carriers, e.g. Qantas, SIA, BA, UA, Delta, etc. have all set up their ‘equivalent versions’ of LCC subsidiaries to compete for market shares and defend potential entry into lucrative routes by new LCC comers (e.g. Singapore – KL routes which was dominated by SIA and MAS through bilateral agreement before it was opened up to LCCs a few years ago). The morphing from a traditional carrier business model to adapt and absorb the LCC subsidiary operation modes also have significant impacts on the aircraft investment strategies and planning. For example, SIA has a dedicate task of juggling between 3-tier of service segments as it also owns SilkAir (Premium Regional Airlines) and Tiger Airways (LCC). Although it can leverage on its brand equity and deliver seamless customer experiences on network multiplier effects, the airlines have a challenging task to differentiate between the services, products and targeted customer segments both internally and externally in response to competition. For example, Jetstar has recently introduced the iPad trial in Australia in May 2010 as their onboard IFE services menu, if Tiger Airways or/and SilkAir were to follow suits with similar offerings, will SIA have to up the ante for their premium customers as they already have in-seat IFE system depending on customer’s preferences to read the article from a fixed screen (eye-sight constraints) or read it from a portable, large screen iPad device?
Case review: Timing of SIA A345 Singapore – USA routes all-business class cabin reconfiguration.
Case review: Indonesia national flag carrier, Garuda, has initiated an aggressive campaign and re-branding exercises to market its new five-star airlines image with new young fleet of B737-800 and A330 new aircraft with in-seat IFE entertainment to woo the market shares. Garuda has also resume the flights to Europe segments after EU ban its flight access a few years ago due to previous poor safety records.
READ:
Principles of Corporate Finance by Brealey Myers, McGraw-Hill publisher
Chapter 2.1, page 16 on Introduction to Present Value Chapter 6, page 121 on Making Investment Decisions with Net Present Value Rule Chapter 23, page 669 on Valuing Debt
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Chapter 19, page 541 on Financing and Valuation Chapter 25, page 735 on Leasing
READ:
Magic Numbers by Peter Temple, Wiley publisher
Chapter 9, page 53 on Margins Chapter 16, page 97 on Gearing Chapter 19, page 114 on Return on Capital Employed Chapter 23, page 143 on Free Cash Flow Chapter 29, page 180 on Weighted Average Cost of Capital (WACC)
READ: Airline Fleet Management, March-April 2010, Issue 66, Page 39 – Page 41 AFM Interview with Kostya Zolotusky, MD, Capital Market Development, Boeing Capital Corporation, USA.
REFERENCE
Latest developments: Article review of AFM Interview with Kostya Zolotusky, MD, Capital Market Development, Boeing Capital Corporation, USA.
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STUDY UNIT 5
EAS431 STUDY UNIT 5
OVERVIEW
Having reviewed the aircraft economics, airline operating economics, investment appraisal, it is timely to review the global MRO businesses and how it is affecting the airline MRO practices in general, highlighting the difference of in-house practices versus outsourcing to independent third party shops.
This unit will also review the external factors of regulatory guidelines, environment consideration, currency exchange risks and fuel price which are beyond the airline’s management control.
LEARNING OUTCOMES
At the end of this unit, you are expected to:
Explain the global MRO Business outlook for 2010 Explain the roles and impacts of regulatory framework, guidelines and its compliance effects on airline investment and operating costs (noise, environment CO2 emission – carbon taxes, handicap seating compliance by regulatory bodies) which put substantial and additional burdens to the airline’s woes Explain the foreign currency effects on airline operational revenues and profitability
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CHAPTER 5: OVERVIEW OF THE MRO BUSINESSES & EXTERNAL FACTORS AFFECTING THE AIRLINE INDUSTRY
5.1 Global MRO Market Outlook in 2010
The global downturn of aviation demand, especially in the premium class segments, due to global financial crisis since 2008 has been devastating for major airline operators like SIA, Qantas, BA, Cathay Pacific, etc. which had a knock-on effect on the MRO shops as airline industry is deferring and completely eliminating maintenance on a large portion of the global fleet. Most airlines took the opportunity to pull some of the older aircraft from service and to expedite the aircraft retirement and fleet renewal program (e.g. SIA and Cathay Pacific have both parked and looking to sell portion of their B747 fleet in 2010 and UA retired 100s of their old A320 fleet in 2009). Thus, these parked aircraft will effectively reducing the amount of available MRO work in the global market. To make things worst, 26 airlines ceased operations in 2009 resulting in the supply flood of parked aircraft that were salvaged for their parts as replacement instead of repair or overhaul. Given the shrinking pie and excess capacity, we will expect major consolidation as the weaker MROs will be acquired or forced out of businesses by competition.
Light at the end of the tunnel with some optimism in 2010:
1. Air travel demand will bottom out by 2010 and global economic stability will see the return of travel demand as it is becoming more affordable through various promotion and discounted packages. Air travel in China, India and emerging economies in Asia that seems to hold up relatively well during the financial crisis period are showing very healthy growth trends.
2. Due to the limited aircraft delivery supply and order books, some airlines are postponing their investment in fleet renewal, canceling their purchase options or pushing out their aircraft delivery schedule. Hence, they will continue to operate the aged aircraft for a longer period which will need maintenance to sustain the maintenance practices and safety compliances.
3. Airline operators are looking to reduce the cost base and find a reliable and cost-effective MRO partner to outsource their maintenance needs.
4. MRO market growth is still in a positive trend as more recent aircraft are coming out of their ‘newbie’ status and requires heavy checks and heavy maintenance.
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According to the research firm Frost & Sullivan, global MRO growth from 2009 to 2014 is expected to increase at a compound annual growth rate (CAGR) of 2.3 per cent, with 2009-2011 expected to be relatively flat. Beyond 2011, the CAGR is expected to grow by 2.9 per cent.
Figure 1 Chart of Global MRO Market Share (2009) (Source: ICAO, IATA and other OEM manufacturers)
Global MRO Market Share 2009
15% North America 5% 35% Western Europe Eastern Europe 15% Asia Pacific
China 4% Others 26%
Figure 2 Projected Trends Of Captive versus Outsourced MRO businesses Estimated US$45 Billions in 2007, estimated US$60 Billions by 2017 (Source: ICAO, IATA and other OEM manufacturers) Captive versus Outsourced MRO Trends
25 20
15 Captive 10 Inhouse
US$Billions 5 Outsourced 0
Engine 2007 Engine 2017 Engine Maintenance Maintenance Component Component Maintenance Maintenance
Airframe Airframe
2007 2017
Line Line
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Figure 3 Projected growth in various market segments (Source: ICAO, IATA, Boeing and Airbus) Projected Growth of Fleet Size 2007-2017
10000 8000 Emerging 6000 Market 2 4000 Emerging Market 1 2000 Main
America America Pacific Pacific Europe Europe Others Others 0
Asia Asia
2017 2007 2017 2007
North North
Figure 4 Projected global fleet distribution (Source: ICAO, IATA, Boeing and Airbus)
Projected Global Fleet Distribution in 2017
100% 80% Future 60% New 40% Mature Old 20% 0%
America Europe
Pacific Others
Asia
North
25% 16%
27%
32%
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Figure 5 2008 Estimated Total Airframe (excluding Engine, Component, LM and others) Man-hours by Corporate entity inclusive of subsidiaries with majority share-holding ownership (Source: Annual Reports from various companies) : Airframe Manhours Revenue (US$) 1. ST Aerospace 8.5 M* (3rd Party) $1.34 B 2. Lufthansa Technik AG 5.4 M $5.24 B 3. HAECO/TAECO/STAECO 5.36 M $632.28 M 4. SIA Engineering Co. 4.8 M $723.83 M 5. IAI / Bedek Aviation Group 3.7 M* $3.59 B 6. TIMCO Aviation Services 3.7 M* $330 M 7. AAR Corp. 3.33 M* $1.38 B 8. Aveos Fleet Management 3.15 M* $753.47 M 9. Aviation Technical Services 2.6 M* 10. SR Technics 2.51 M* $2.49 B 11. Abu Dhabu Aircraft Technologies 2.02 M 12. Sebena Technics 1.5 M 13. TAP Maintenance & Engineering 1.47 M 14. PEMCO World Air Services 1.4 M 15. Japan Airlines 1.38 M
Note: (A) Airline/OEM affiliated MRO shops: LHT, SIAEC, GAMECO, HAECO/TAECO, AMECO, etc. (B) Independent 3rd Party MRO shops: ST Aerospace, SR Technics, TIMCO Inc., etc.
5.2 International Regulatory Bodies
5.2.1 Federal Aviation Administration (FAA) is part of the US, Department of Transportation whose mission is to provide the safest, most efficient aerospace system in the world and set the regulatory guidelines for the below subjects of carriers operating in North America:
a. Air Carriers & Operators
Certification: Air Carriers and Commercial Operators
Hazardous Materials Regulations and Dangerous Goods Advisory Bulletins
Part 298 Exemptions for Part 135 Operators
Operating Requirements: Domestic, Flag and Supplemental Operations
Operating Requirements: Commuter and On Demand Operations and Rules Governing Persons On Board Such Aircraft
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Overflight Fees b. Pilots, Flight & Ground Instructors
General Operating and Flight Rules (14 CFR Part 91)
Certification: Pilots, Flight Instructors, and Ground Instructors (14 CFR Part 61)
Pilot Schools (14 CFR Part 141)
Aeronautical Experience Checklist c. Commercial Space Transportation
Regulations
Advisory Circulars
Guidelines
Commercial Space Transportation Regulations d. Policy & Guidance Acquisition Guidance
Aeronautical Information Manual
Aircraft Continued Operational Safety
Aviation and International Affairs Policy – Domestic, International
Benefit-Cost Analysis
Enforcement Information Reports
Environmental
Hazardous Materials on Aircraft
International Flight Information Manual
Investment Criteria
Outdoor Laser Operations
Policy Statements
Privacy Policy
Safety Risk Management
Space Transportation
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Voluntary Safety Programs e. Airworthiness Directives
Emergency (Last 30 Days)
New (Last 60 Days)
AD Notices of Proposed Rulemaking (NPRMs) f. Licenses & Certificates
Airmen
Airmen Certification: Airmen Certification FAQs, Integrated Airmen Certification and/or Rating Application (IACRA), Become a Pilot, Become a Mechanic
Airmen Practical Test Standards (PTS) g. Aircraft
Airworthiness Certification: Aircraft Registration, Airworthiness Requirements, N-Numbers, Aircraft Records
Type Certificates: Supplemental Type Certificates (STC), Type Certificate Data Sheets (TCDS)
Flight Standards District Offices (FSDO)
Aircraft Certification Information h. Medical
Medical Certificate
Locate an Aviation Medical Examiner i. Airline Certification
14 CFR Part 121 Air Carrier Certification
14 CFR Part 135 Certification Information j. Airport Certification
Airport Certification Requirements (Part 139)
Form 5280-1, Application for Certificate
CertAlerts
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Airport Advisory Circulars k. Commercial Space Transportation
Launch or Reentry Vehicles
Experimental Permits for Reusable Suborbital Rockets
Launch Site Pre-Application Consultation
Commercial Space Transportation
Aircraft Registration Inquiry The Aircraft Registration Inquiry database provides aircraft registration information through eight different queries:
N-Number Inquiry
Name Inquiry
Engine Reference Inquiry
Document Index Inquiry
Serial Number Inquiry
Make/Model Inquiry
Dealer Inquiry
State & County Inquiry
Territory & Country Inquiry
N-Number Availability
These queries provide information about current registered owners, documents filed, aircraft dealers, and more.
5.2.2 European Aviation Safety Agency (EASA)
EASA promotes the highest common standards of safety and environmental protection in civil aviation. EASA is the centrepiece of a new, cost-efficient regulatory system in Europe and a reliable partner for its counterpart authorities throughout the world.
5.2.3 Japan Civil Aviation Bureau (JCAB)
5.2.4 Other local regulatory bodies: Civil Aviation Administration of China (CAAC), Civil Aviation Administration of
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Singapore (CAAS), Thai Department of Aviation (DOA), India Directorate General of Civil Aviation (DGCA), etc.
5.2.5 Association of Asia Pacific Airlines (AAPA)
The AAPA is the trade association of major scheduled international airlines based in the Asia-Pacific region. The AAPA permanent secretariat is headquartered in Kuala Lumpur, Malaysia with international representation in Brussels and Washington, D.C. Collectively, the 17 AAPA member airlines carry 285 million passengers and 10 million tonnes of cargo representing approximately one-fifth of global passenger traffic and one-third of global air cargo traffic respectively, and thus play a critically important role in the ongoing development of global aviation.
We need a global approach to security, and look to ICAO for leadership in establishing harmonised standards. Effective security measures need to be based on objective assessments of risk and threat levels, and must balance costs and perceived benefits, with governments accepting their full share of the resultant costs imposed on society. Furthermore, maintaining public understanding and support is an essential ingredient of any secure and sustainable security regime.
In January 2008, AAPA hosted the first ever high level Security Forum jointly organised with the United States Transportation Security Administration (TSA). Topics provoking discussion included the need to create sustainable partnerships; balancing security and facilitation; enhancing cargo security; the deployment of technology and the benefits of sharing internationally agreed best practices in aviation security.
Source : http://www.aapairlines.org/resource_centre/AAPA_PR_Issue03- AvsecForum08-29Jan08.pdf
When US DOT enforced the FAR 382.61 regulatory rules of the need for movable aisle armrests to be provided proportionately in all classes of service in the cabin for all new seating after May 2009, AAPA members complaint and raised objections against the ruling as it will result in substantial escalation in new design costs or replacement costs, implementation time frame which affect aircraft refurbishment programme. However, this regulatory ruling only apply to aircraft flying into the North America regions. Till date, there is no similar regulatory enforcement by EASA in EU regions.
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Subpart E—Accessibility of Aircraft FAR 382.61 What are the requirements for movable aisle armrests?
(a) As a carrier, you must ensure that aircraft with 30 or more passenger seats on which passenger aisle seats have armrests are equipped with movable aisle armrests on at least one-half of the aisle seats in rows in which passengers with mobility impairments are permitted to sit under FAA or applicable foreign government safety rules.
(b) You are not required to provide movable armrests on aisle seats of rows which a passenger with a mobility impairment is precluded from using by an FAA safety rule.
(c) You must ensure that these movable aisle armrests are provided proportionately in all classes of service in the cabin. For example, if 80 percent of the aisle seats in which passengers with mobility impairments may sit are in coach, and 20 percent are in first class, then 80 percent of the movable aisle armrests must be in coach, with 20 percent in first class.
(d) For aircraft equipped with movable aisle armrests, you must configure cabins, or establish administrative systems, to ensure that passengers with mobility impairments or other passengers with a disability can readily identify and obtain seating in rows with movable aisle armrests. You must provide this information by specific seat and row number.
(e) You are not required to retrofit cabin interiors of existing aircraft to comply with the requirements of this section. However, if you replace any of an aircraft's aisle seats with newly manufactured seats, the new seats must include movable aisle armrests as required by this section. However, an aircraft is never required to have movable aisle armrests on more than one half of the aisle seats.
(f) As a foreign carrier, you must comply with the requirements of paragraphs (a) through (d) of this section with respect to new aircraft you operate that were initially ordered after May 13, 2009 or which are delivered after May 13, 2010. As a U.S. carrier, the requirements of paragraphs (a), (b), (d), and (e) of this section applies to you with respect to new aircraft you operate that were initially ordered after April 5, 1990, or which are delivered after April 5, 1992. As a U.S. carrier, paragraph (c) of this section applies to you with respect to new aircraft you operate that were initially ordered after May 13, 2009 or which were delivered after May 13, 2010.
(g) As a foreign carrier, you must comply with the requirements of paragraph (e) of this section with respect to seats ordered after May 13, 2009.
Source:
http://ecfr.gpoaccess.gov/cgi/t/text/text- idx?c=ecfr;rgn=div5;view=text;node=14%3A4.0.1.4.62;idno=14;cc=ecfr
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Reference Case in USA: Rowley v. American Airlines, (1995) 875 F.Supp. 708 Plaintiff brought action against airline alleging violation of ACAA and intentional and negligent infliction of emotional distress. In her complaint, Plaintiff alleged that she had a disability and required an aisle chair, a special wheelchair that can be rolled down the aisle of an airplane; that she was not assisted to or from her seat; that her seat did not have a movable armrest; and that she was left unattended at a baggage claim area for more than an hour in a chair from which she was not independently mobile. The District Court denied Defendant’s motion for summary judgment holding that: (1) emotional distress claims under Texas and Oregon law were too tenuously related to Defendant’s services to be preempted by ADA; (2) emotional distress claims were not impliedly preempted by ACAA; (3) Department of Transportation did not have primary jurisdiction over disabled passenger's claim against airlines for injunctive relief under ACAA; and (4) issues of fact precluded summary judgment on claim that airline violated a regulation pertaining to disassembly of wheelchairs or other assistive devices. (Source website: http://www.suetheairlines.org/07_relevantcases.htm )
5.2.6 Trends and Effects of Market Deregulations
At the Chicago Convention in 1944, 52 state members established the International Aviation Organisation Convention (ICAO), an inter-government agency, responsible for the coordination of worldwide technical and operation standards in four main areas:
1. Airfares 2. Capacity and Flight Frequency 3. Application of traffic rights or ‘air traffic freedom’ 4. Freight levels
These four regulatory elements have been the main barrier to entry for new carriers, the pricing freedom, production level and severely limited any form of price or network competition.
History of Market Deregulations
In 1978, the US domestic market began to liberalise followed by the international markets in 1980s and 1990s. Since then, there were noticeable trends as follows:
1. New market entry of LCC players 2. Wave of mergers among main carriers 3. Rapid growth of air travelers 4. General decline of air fares due to price war
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5. Increased variability in fares across the market 6. Emergence of the hub-and-spoke system by main carriers in contrast to point-to-point approach by LCC
As for Europe, the market fully deregulated to permit free competitions in pricing, capacity and access in 1997. In late 1990s, the emergence and rise of the international airlines’ alliances due to demand-related (i.e. the economic globalization has created demand for the intercontinental flights) and supply – related (i.e. long intercontinental flights need one or more stop and require the interline journey provided by different airlines). Most European carriers still operates in the hub-and-spoke system using their home country as their main hub.
The third effect was the growth of Ryan Air and easyjet LCCs. They experienced fast growth after 1999 and compete with main carriers on the same routes and for coincident segments igniting a price war on some segments and margins erosion.
Another major development is the EU-US open-skies agreement and eventually touch on the limitation of foreign ownership and control of the airlines.
In June 9, 2010, the International Air Transport Association (IATA) reacted sharply to the announcement made by the German government of a EURO 1 billion annual burden on aviation with a new departure tax in Germany. The tax is branded as an environmental (green) initiative.
Case review: US DOT grounding of the DC10 in 2008.
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5.3 Effects of Currency Exchange Rate
Currency volatility has serious impact on an airline’s reported profitability. In Oct 2006, SIA reported that its results for the first half of the financial year had been hit by both the higher fuel prices and the strong Singapore dollar. The depreciation of key revenue earning currencies such as Yen and DM contribute to a 6.7 per cent decline in yield expressed in Singapore dollars.
Most of the airlines are short in US dollars, a common position for many airlines stemming from the fact that capital costs, fuel, airport charges, US station and sale costs are all in US dollars.
Qantas uses a estimation tool below to show the impact of currency changes on Qantas after-tax profit for 1995/1996. Qantas estimated the sensitivity of their profit forecasts with respect to the key currencies in which it trades, namely US dollars, Yen and UK British Pounds. They examined the effect of a 5 per cent movement in exchange rates of these currencies and their impacts.
Figure 6 Illustration of different currency movements Depreciation Appreciation 5 per cent movement in A$ against: (A) Movement of A$ against US$ -22% 20% (B) Movement of A$ against Yen 3% -3% (C) Movement of A$ against GBP 3% -3%
Notably the Asian financial crisis of 1997 and 1998, resulted in the rapid depreciation of many Asian currencies. Many airlines short of US dollars found that they have to buy US dollars at a very high cost! Thus, the Asian airlines was badly affected by the local currency depreciation against US dollars. A coke which used to cost US$1.00 costs US$1.50 in Thailand!
International ‘Exporter’ airlines with 60% revenue in foreign currency and 60% of expense in local currency is a sample reflection, e.g. Effect of exchange rate depreciation on profits on exporter airline.
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Figure 7 Illustration of profitability affected by currency exchange rates
Revenue Expenses Difference Local currency (US$) 40 60 -20 Foreign currency in S$ 120 80 40 Foreign currency in US$ (At exchange rate of S$2.00 per US$) 60 40 20 Total (US$) 100 100 0 Profit in US$ 0 Foreign currency in US$ (At exchange rate of S$1.50 per US$) 80 53 27 Local currency (US$) 40 60 -20 Total (US$) 120 113 7 Change in profit (US$) 7
Garuda (Indonesia) and Malaysian Airlines (Malaysia) have large domestic markets generating negligible foreign currency revenues, unlike Singapore totally reliance on foreign currencies markets. Thai experienced a 50 per cent drop in depreciation, Thai Airways shaved 4 per cent points off their operating ratio. Asiana with a 30 per cent drop in local currency reduced its operating ratio by almost 10 per cent points.
Airline will try to reduce foreign exchange exposure or risk of loss by matching revenues and payments, as well as assets and liabilities, in each currency, a.k.a. a natural hedge. Where surplus are made, you can either sold it on a spot market or on a forward market.
When there is liability in foreign currency, e.g. purchase of a $100 million aircraft to be paid in US dollars over a two year period, there are three possible strategies:
1. Do nothing and wait until delivery date and buy the required US dollars amount on Spot market 2. Hedge the risk of an adverse movement in the US$/S$ exchange rate by buying the required US dollars amount forward. Forward market prices are quoted for major currencies for 3, 6,9 and 12 months ahead. 3. Hedge the risk of an adverse movement in the US$/S$ exchange rate by buying a ‘call option’ the required US dollars amount in two years time at the current forward rate. An option gives the holder the right but not the obligation to exchange a certain amount of currency at a certain rate, at a future date. A ‘sunken’ premium have to be paid for buying the option to purchase currency (a ‘put option’) or sell currency (a ‘call option’). The holder can either exercise the option if the subsequent trend in the spot rate is unfavourable, or throw away the option if the spot market favourable. A
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European option remains with the buyer until the exercise date. An American option can be traded in the intervening period as there will be a market price for buying and selling options.
Case review: Lufthansa dilemma case in 1985.
US Dollars down trends as US 3 Trillions Debt due to collapse of US housing mortgages market and bank and financial institutions financial crisis leading to the collapse of Lehman Brothers, AIG, Citigroup, BoA bailouts while US government continue to keep printing green notes to finance the debts and obligations.
Euro is in trouble and EU unity is in questions due to collapse of Greek Debts (April 2010), Spain Debts (May 2010), Portugal , etc. which mirrored the US financial woes. Cheaper to finance the aircraft acquisitions through US dollars, Euro or Yen carry trade? Most of the aircraft financing are based on US dollars dominated currency just as oil trade. However, as the Middle East and other oil producing countries are contemplating the value and stability of US dollars in long run, some countries are switching to a mixed basket of Euro and US dollars trades.
Most currency traders predicted that the US Dollars is on a long-term down trends as US has accumulated close to 3 trillions USD debt due to the collapse of US housing mortgages market, banking and financial institutions financial crisis leading to the collapse of Lehman Brothers, AIG, Citigroup, BoA bailouts while US government continue to keep printing green notes to finance the debts and obligations.
Recently, the Euro has got into trouble too and EU unity is in questions due to collapse of Greek Debts (April 2010), Spain Debts (May 2010), Portugal , etc. which mirrored the US financial woes.
Thus, is it cheaper to finance the aircraft acquisitions through US dollars, Euro or Yen carry trade? Most of the aircraft financing are based on US dollars dominated currency just as oil trade. However, as the Middle East and other oil producing countries are contemplating the value and stability of US dollars in the long run, some countries are switching to a mixed basket of Euro and US dollars trades.
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5.4 SUMMARY
Given the current woes in the airline industry struggling to get out of the economic crisis, these external factors can put substantial pressures on the cash flow and generate huge fluctuations in the airlines profitability. In the event of a ‘perfect storm’ crisis, it will also threaten the survival of the weaker airlines which may not have the deep pockets or open credit lines to tie through the difficult times, especially for those LLCs that operate on a shoe-string budget and cash flow position.
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EAS431 Aviation Finance
STUDY UNIT 6
EAS431 STUDY UNIT 6
OVERVIEW
The aviation industry has experienced various external shocks throughout the decades, this section analyses and differentiates the degree of external influence between the certainty factors and uncertainty elements in order to address and manage the risks and impact of these uncertainties which are beyond the airline’s control and aviation industry limits.
LEARNING OUTCOMES
At the end of this unit, you are expected to:
Explain the importance of the fuel price and nature catastrophe effects on the profitability of the airline operators State the bankruptcy laws in US and other regions and its impact and influences with regard to fair competition and capacity supply in the aviation industry Explain the emerging trends and development of the aviation industry in the near future
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CHAPTER 6: OVERVIEW OF THE EXTERNAL SHOCK FACTORS
6.1 Price of Jet Fuel
The key question at the back of everyone’s mind: Where will Oil go next?
Figure 1 Correlation and divergence between Jet Fuel and Cruel Oil (Brent) Prices (Source: Estimated figures from OPEC, IATA, ICAO)
Jet Fuel versus Crude Oil (Brent) Prices Per Barrel US$
120 Jet Fuel 100 Price 80 60 40 Crude Oil (Brent) 20 Price 0
Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 US Cost of Domestic Travel
Attempting to predict and hedge the fuel prices is like reading a crystal ball as oil is a commodity and oil trading industry is a global business community regulated by OPEC, by some degree as an inter-governmental organization dedicated to the stability and prosperity of the petroleum market) by itself.
Airlines regularly highlight and report the fluctuation of airline’s profitability and provisioning due to fuel hedging portfolio and risks in its annual reports.
Fuel is a growing larger component of the airlines operating costs, up to over 30% and over takes labour costs as the leading cost parameter. Thus, airlines maybe reluctant but have exhibit the need and means to fuel hedging due to the significant exposure to the uncertainty and volatile high fuel prices.
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Figure 2 Europe Crude Oil (Brent) Spot Price FOB in US$ per Barrel (Source: OPEC and European oil trader reports)
120
100
80 Crude Oil 60 (Brent) Price 40
20
0
1995 1997 1999 2001 2003 2005 2007
The sharp rise in oil and jet fuel prices since 2003 has added greater urgency to the need of fuel-efficient aircraft in order to stay cost effective and competitive. The average cruel oil has increased from $31 per barrel in 2003 to $60 per barrel in 2006 and an expected average of $106 in 2008. In May 2008, it hit $120 per barrel and Goldman Sachs leading oil analysts forecast that it will reach $200 level by 2010 (speculative buyers/investors) due to pent up demands from large emerging economies like China and India. It did not happen as we are going through a dramatic global economic recession since then.
Figure 3 Volatility and changes in fuel prices, US$ per Barrel (2004-2008) (Source: OPEC and oil trader reports)
Dec 2004 Dec 2005 Dec 2006 Dec 2007 Dec 2008 % % Change Change in last 2 in last 3 years years Global 51 73 74 113 52 55 122 Asia Pacific 49 73 74 111 51 52 126 North 52 70 75 115 53 65 122 America Europe 47 67 71 110 54 63 132 Middle East 52 77 74 114 54 48 119 Latin 51 76 75 113 52 49 120 America
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For example, refueling in India is very expensive so SIA carries extra fuel (extra load) for turnaround of Singapore –India routes. Kingfisher CEO once commented that the high fuel prices make India international uncompetitive to other international airline operators.
There are certain measures that airlines may adopt to deal with fluctuating fuel prices: 1. Increase fuel efficiency of operation and aircraft 2. Pass cost increases as fuel-charges to passengers 3. Hedge fuel costs using physical or derivative markets
Fuel is a commodity and airlines can avail themselves of similar derivative contracts similar to the foreign exchange markets.
Fuel price risks can be managed in three ways: 1. Forward contracts 2. Future contracts 3. Derivatives such as option, collars and swaps
Oil Futures Trade Oil futures are financial instruments and carry with them legally binding obligations. Buyer and seller have the obligation to take or make delivery of an underlying instrument at a specified settlement date in the future. Oil futures are part of the derivatives family of financial products as their value ‘derives’ from the underlying instrument. These contracts are standardised in terms of quality, quantity and settlement dates.
Aviation fuel can only be hedged through over-the-counter arrangement with the additional counter-party risks (i.e. either airline or supplier goes bankrupt before the deal is closed). Heading oil on the NYMEX or SIMEX exchanges eliminates the counter-party risks.
Figure 4 Examples of hedging position by Asia and European airlines (2003-2004) (Source: Airline annual reports and others) % Hedge Product Instruments Value US$M Iberia 54 Jet Swaps & NA Options Lufthansa 72 Crude/Heating NA 72 Oil British 41 NA Swaps & 53 Airways Options Singapore NA NA Swaps & 59 Airlines Options Cathay Pacific 25 NA Various NA Emirates 19 NA Options & NA Futures
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Figure 5 Examples of hedging position by US based airlines (2004) (Source: Airline annual reports and others)
% Hedge Product Instruments Value US$M Delta 32 Crude & NA 97 Heating Oil American 12 Crude & Jet Swaps & 54 Options US Airways 30 Crude & Swaps & 38 Heating Oil Options Southwest 82 Crude & Swaps & 251 Heating Oil Options
To alleviate part of the problems, airline operators began to impose a ‘fuel charges’ on top of the air ticket and airport tax charges, similar to the air cargo practices, to the passengers. BA regularly published a ‘fuel charges’ table on periodic period to inform the passengers the ‘expected’ charges due to uncertain and fluctuating fuel prices as part of the travel costs.
Recent update: The Mexico Gulf BP’s oil extraction platform oil incidents has prompt the US president Obama, who was a proponent of off shore oil exploration, to extend a ban on new deepwater permits and exploration by Royal Dutch Shell Plc in the Alaskan Arctic for six months, putting off limits as much as 23.2 billion barrels of potential resources in the short term due to the major outcry of the oil leak wide-spread damages to both the businesses and ecological environment. Market analysts are predicting that the oil market is signaling that oil prices have nowhere to go but up as the biggest spill in U.S. history curbs drilling and makes it more expensive to develop new fields.
6.2 Nature Catastrophes
Recent nature catastrophe incident from Iceland volcanic ash disrupting air travel resulted in the grounding of European flights which cost global airlines 1.7 billion dollars in lost sales alone. Given the size of lost revenues, some of the European airlines are at the brink of bankruptcy urging calls for "urgent" government aid and relaxation of the European aviation control agency Eurocontrol ruling of ‘no flight zones’. In 1982, a British Airways jet lost power in all four engines after flying through an ash cloud above the Indian Ocean.
As a benchmark, in the aftermath of the attacks on the United States on September 11, 2001, the US government provided 5 billion dollars to compensate airlines for the costs of grounding the fleet for three days.
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At its height of crisis, from April 17-19, the disruptions affected 29 percent of global aviation and affected 1.2 million passengers a day. British travel agents' association ABTA estimated 150,000 Britons were stranded abroad while 40,000 Americans stuck in Britain. The scale of the crisis eclipsed 9/11 when US airspace was closed for three days.
6.2.1 AIRLINE LOSSES
Some European airlines had conducted numerous test flights problem-free for a couple of days but experts were divided over how to measure the ash and who should decide it is safe to fly.
European airlines were losing $250 million in revenue a day, an EU deal was reached under pressure from the airline industry to relax from the blanket closure of airports and permitted flights in a wider zone with a lower concentration of ash, subject to local safety assessments and scientific advice.
6.2.2 TRAVEL AND INDUSTRY MISERY
Firms dependent on fast air freight with perishable goods were feeling the strain. Fresh stock exporters said they were already losing millions a day due to perishable stocks as imports into the European Union came to a halt. One freight forwarder that was based in Hong Kong claimed that they have 4,000 tonnes of backlog in Hong Kong alone.
Millions of people have had travel disrupted or been stranded and forced to make long, expensive attempts to reach home by road, rail and sea, as well as missing days at work and school at the end of the busy Easter holiday season.
Businesses have had to find alternative ways of operating. Communications provider Cisco Systems said companies were turning to videoconferencing to connect executives.
HOW LONG WILL THE DISRUPTION LAST?
This depends on how long the volcano under Iceland's Eyjafjallajokull glacier keeps erupting, whether it continues spewing ash, and whether winds carry the ash toward Europe or other regions.
The volcano's previous eruption lasted over a year, but changes in wind and weather patterns could disperse the ash; many experts think the cloud will not linger over Europe for more than a few days at a time.
If the volcano does continue to erupt, occasional disruption will be possible over six months or more, experts say. Much will depend on whether
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Eyjafjallajokull triggers a new eruption from the nearby and larger Katla volcano, which has happened in the past. That could magnify the impact.
Countries are proving able to resume flights quite quickly and reopened its airspace when local conditions improve.
OVERALL ECONOMIC, MARKET IMPACT
Unless the cloud disrupts flights continuously for weeks, threatening factories' supply chains, economists do not think it will significantly slow Europe's shaky recovery from recession or affect second-quarter gross domestic product figures.
If extended disruption to air travel hits supply chains, factories will be able to reduce the damage by using sea, river or road cargo, or changing procurement plans.
IMPACT ON AIRLINES
Around 17,000 flights were expected to be cancelled on Friday, with airspace closed across much of Europe.
Shares in Lufthansa, British Airways, Air Berlin, Air France-KLM, Iberia, Ryanair and SAS fell between 2 and 4 percent. The disruption is costing airlines more than USD$200 million a day, air industry body IATA estimated.
Airport operator in Frankfurt estimated that their revenue lost and costs will be between EUR€2.5 million and EUR€3 million euros per day.
Iceland's location across international flight path highlighted the risks that the eruption could prompt wider disruption to international flights.
ALTERNATIVE TRANSPORT
Eurostar, which runs trains between London and the European continent, said trains were operating at full capacity and it might lay on additional trains if necessary.
London taxi firm Addison Lee said it had taken requests for journeys to Paris, Milan, Zurich and Salzburg in Austria.
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AIR CARGO
Grounded air cargo flights have halted delivery of items such as microchips, flowers and mail. Europe's largest mail and express delivery company Deutsche Post said it was switching to road transport where possible.
Switching to sea cargo might be an option for longer deliveries, although not for perishables such as flowers or fresh food but shipping analysts suggested that rebooking by sea would only happen in the event of a prolong disruption.
Pharmaceutical supplies in particular were often transported by air, but experts said there were sufficient stocks but may face shortages if prolong air disruption continues for weeks into months.
ENERGY
An energy's simulation model projection for European jet fuel consumption puts daily consumption at 1.17 million barrels a day, so assuming an estimated 80 percent of Europe's airports are shut for 48 hours, the disruption had reduced 1.87 million barrels of demand. Some demand will simply disappear since some scheduled flights did not take place.
European jet fuel price spot differentials to the ICE-traded gas oil contract fell to USD$48 a metric tonne on Friday from USD$50.50 at one time. But analysts said the long-term price impact would be minimal once flights resumed; much airline buying was secured through long-term contracts.
European oil, gas and electricity production is not expected to suffer. Some helicopter flights to and from oil rigs in the Norwegian Sea had resumed; the effect on solar power plants was unlikely to be greater than the impact from any other passing cloud, while wind power industry sources said cold volcanic dust on wind turbines should not cause any problems.
INSURANCE IMPACT
Airlines were expected to have little recourse to insurance firms. Most airlines were neither insured against cancellations nor business disruption at airports.
Source: http://news.airwise.com
AIRFRAME INTEGRITY Although there have been concerns that aircraft fuselage and cabin windows may experienced some chemical corrosive deterioration due to long term exposure to the volcanic acidic clouds, there has not been any major reported damages till date.
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6.3 Bankruptcy Laws
Insolvency is the inability of a company to meet or service its debts as they become due. Creditors may extend or restructure the debt payment schedules or force the company to liquidate its assets to meet its debt repayment obligation. Normally, the creditors will take a ‘hair-cut’ as in successfully recovering only partial portion of the debts. This process of liquidation is normally known as bankruptcy.
Note that in most of the bankruptcy cases, most of the airlines’ assets are probably been mortgaged or used for security for loans. Hence, it is unlike to sell these assets to raise cash to fund the on-going activities. Moreover, most aircraft lessors or secured creditors prefers to keep the aircraft flying to generate earning for payments, rather than to re-possess the aircraft and do a ‘fire’ or ‘distress sale’ in the weak market if these aircraft cannot be re-marketed to other operators in other regions. Note that bankruptcy laws also differ by country.
6.3.1 US Bankruptcy code
Chapter 7 means liquidation of the businesses and stopping the entire business operations which would lead to grounding of aircraft, shutting down of services, employee layoffs leading to unemployment and in worst cases lost of pensions.
Chapter 11 (normally known with the industry as the ‘back-door’ and easy way of ‘resetting’ the financial health of US airlines) is designed to avoid the adverse effects of liquidation by giving the company time to come up with a credible business plan for profitability on a on-going concerns and protection from creditors during this period. The airline management has to appear before a judiciary judge to account for the various decisions on any cash payments or investment plans. Airlines could defer the principal and interest payments as a relief from creditors but are obliged to put right any arrears in rental or related payments and continue paying them or return the aircraft assets to the rightful owners.
The Air Transport Association of America (ATA) published the list of all US airlines that went into bankruptcy since 1978, notably with 144 airlines filed for Chapter 11 (by 2004) and only 14 filed for Chapter 7.
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Figure 6 Entry and exit history of US airline Chapter 11 bankruptcy (Source: Airline annual reports and others)
Entered Emerged Months Continental Airlines (1) 1983 1986 36 Continental Airlines (2) 1990 1993 28 United Airlines 2002 2006 37 US Airways (1) 2002 2003 7 US Airways (2) 2004 2005 12 TWA 1992 1993 21 Pan American 1991 1991 11
Various studies have been done to investigate the role of Chapter 11 in unfair cost advantages (due to relief from creditors by limits protection from interest and rental payments on secured financing, leaving only some financing and capital charges; and labour concessions and suspended pension contributions) which resulted in lowering fare for price war, thus, destroying industry values in a prolong tug of war depending on which airlines have a deeper pocket to out last the others. The Chapter 11 airlines did however faced uphill struggle in losing brand image, service credibility, fear of loss of frequent flyer miles and experienced difficulties in negotiating for long-term deals with corporate and travel agencies.
One major criticism of Chapter 11 was on the expensive profession fees of legal, aircraft, lease and management consultants that were hired to help restructure and revive the airlines’ businesses.
One interesting development was the establishment of the Air Transport Safety and System Stabilization Act introduced on September 22, 2001, to bring some stability and to restore confidence in the US airline industry following the 9/11 terrorist attacks. The Board was empowered to implement its programme of compensation and loan guarantees which comes with onerous covenants, including security of all unencumbered assets, satisfactory debt ratio, fixed charge coverage ratio and adequate liquidity. A total of US$4.6 billion was paid to 427 airlines as compensation for those suffered loses as a direct result of 9/11 event, including of increased insurance premium.
Canada has a close equivalent to US’s Chapter 11 known as the Companies’ Creditors Arrangement Act (CCAA). Air Canada file for CCAA’s protection in April 2003 and emerged from bankruptcy protection at end 2004 as a subsidiary of ACE Aviation Holdings.
In Europe, a Chapter 11 equivalent does not exist. In France, a court appoints officials to help the management of the bankrupt company draw up a rationalisation plan but limit the process to 18 months, beyond which liquidation takes place.
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Most of flag carrier in Asia are still majority owned by their national governments and are unlikely to be allowed to go bankrupt. Most Asian countries do not have adequate procedures for restructuring ailing airlines and creditors tend to have limited rights. Creditors with lien over aircraft have a better chance of re-possessing the aircraft if the aircraft is operating on international routes where legal enforcement of rights and recourse is easier.
All bankruptcies lead to significant dilution of the interests of the existing equity holders. Secured debtors usually chose to keep the aircraft in service to continue to generate revenue and rental payments, rather than incurring the risks and costs of re-possession, or ‘fire’ sale of assets or re-leasing to another airline operator.
Unsecured creditors are probably supplier of airport service providers, ATC, fuel services, pre-paid passengers or shippers, etc. Airport and ATC often force settlement of outstanding debt by blocking the aircraft and prevent it from take off. To the lost of most passengers, it would also mean that they would not be able to secure the frequent flyer accrued mileages which has not been redeemed.
6.4 Boeing & Airbus 20 Years Forecast Reports
Boeing and Airbus both issue their 20 years forecast reports on a regular basis to highlight their insights and prediction of aviation trends. Most tends to be based on simple economic models which relate traffic growth to growth in world GDP, normally forecast by Global Insight, Standard & Poor’s, the World Bank.
IATA does provide a 5 years forecast build up from individual airline members forecasts with measurement in passenger-kms or in passengers. Table 13.3 identify two major sectors (Within Asia/Pacific and Europe-MiddleEast due to high growth in China and India as Increased start-up of airlines in MiddleEast.
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Figure 7 A sample of 20 years forecast by Boeing (2004-2023) (Source: Boeing)
Regions No. of Aircraft Value US$ Average Billions Value/AC in US$M Asia Pacific 7160 770 110 North America 8800 590 65 Europe 6700 530 80 Middles East 870 120 130 Latin America 1750 100 55 Africa 430 35 80 Total (Est.) 25700 2130 85
Note that nearly 90 per cent of capital expenditure by world’s airlines historically gone towards aircraft. Future aircraft needs are based on accuracy of traffic forecast with key assumptions on load factors, flight frequencies, aircraft utilisation and aircraft retirements (uncertainties in high fuel prices and maintenance costs, new regulatory compliance/requirement on noise and carbon emission standards – most B727s and B737s classic were phased out by 2002). Degree of hubbing and future of hub development and congestions is a key consideration but Asia cities exhibits high concentration of population in major hub with few secondary airports.
Airbus and Boeing also have different views of speed and balance of aircraft delivery and retirement. One of the key differences in the last downturn is the increased dependence of the manufacturer on the Operating Lessors. In Q1 2001, 38.8 per cent of Airbus’s 1,016 backlog was accounted for by operating lessor (& 31 per cent unplaced with airlines); for Boeing, 30.6 per cent of 1,084 backlog with 22 per cent unplaced.
If Boeing and Airbus forecast turns out to be accurate, there will be a need for between US$1.9 trillion (Airbus) and US$2.1 trillion (Boeing) to finance the cost of the aircraft over the next 20 years assuming at 2004 pricing. This is around $100 billion a year which looks out of sync with the 2004 cash flow generated by the overall world airlines’ from internal sources of only $16 billion.
Despite the withdrawal of the JLL ($12 billion/year) and JOL ($2-3 billion/year) from the financing markets; new entrants have no difficulties raising equity and funding from VCs and other private equity players. Public debt using EETCs is popular in the US whereas Operating Lease is more popular for the rest of the world. Export credit with bank lending plays a significant part of $10-$15 billion/year.
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Future development in foreign ownership restrictions, international merger and acquisitions for consolidation of capacity and network reach, growth of operating lessors may drive future aircraft orders and demand. Most importantly, aircraft order will adjust to a level where the cost of financing an aircraft allows a reasonable profit return to the aircraft owner. Given the over-ordered aircraft situation, it maybe a painful adjustment for some lessors and airlines.
6.5 Emerging Trends and Development
From the OEM perspectives
Intensify competitions drive the aircraft manufacturers, engine manufactures and other OEMs to be innovative and more creative in developing and adopting new technologies to up the ante as a ‘game-changer’.
Technology advancement of new aircraft model: Example of B747-8
Boeing is quoted as saying that the ‘Operating economics of B747-8 will offer a significant improvement over the A380. The B747-8 is more than 10 per cent lighter per seat than the A380 and will consume 11 per cent less fuel per passenger than the 555-seat airplane. That translates into a trip-cost reduction of 21 per cent and a seat- mile cost reduction of more than 6 per cent, compared to the A380.’
The unique features of the B747-8 (Source: Boeing website) are as follows:
a. Quiet GE’s GEnx engine which produces lower emissions, achieve better fuel efficiency and reduce noise during takeoff as it meets the stringent noise standards for takeoff and landing set at Heathrow airport as it is 11.6 decibels quieter than the Stage 4/Chapter 4 noise limit set by ICAO.
b. The B747-8 flys as fast as any commercial aircraft flying today with a cruising speed of Mach 0.86.
c. The B747-8 can takeoff or land at existing airport infrastructure and use existing ground support equipment at most airport worldwide without the need for modifications.
d. The B747-F version empty weight is 80 tonnes lighter than the A380F, resulting in a 24 per cent lower fuel burn per ton, 21 per cent lower trip costs and 23 per cent lower ton-mile costs than the A380F. One highlighted major advantage is that it enables operators o choose between carrying greater revenue payload – up to additional 20 tonnes or flying up to 1,400 nmi farther in markets where cargo density demand is lower.
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e. B747-8 draws heavily from the technologies introduced in the B787 Dreamliner. The aircraft will feature fly-by-wire spoilers and outboard ailerons, and a 100 per cent digitally integrated system with commonality of similar flight deck features of B777/B787 thus enable operators to use the same pilot pools with same ratings and simulator for B747-400.
f. The B747-8 incorporated extensive new generation aluminium alloys, same as those on B777, and graphite composite in the flaps, spoilers, nacelles and rubber which are more durable and resistant to corrosion and damages. New lightweight composite materials are also introduced in new airframe while the landing gear features new materials, wheel, brakes and tires.
So far, there have been encouraging trend of 76 (out of 108) order for the B747-8F freighter version by Cargolux, Nippon Cargo Airlines, AirBridgeCargo Airlines, Atlas Air, Cathay Pacific, Dubai Aerospace Enterprise, Emirates SkyCargo, Guggenheim and Korean Air. However, noted that the B747-8 is an extended stretched version of the original B747 design which was designed in the late 1960s, 40 years old technology.
Composite Technology Adoption
Composite material technology which has been widely used in military aircraft is finding its ways into commercial aircraft production offering significant weight savings and reduction in fuel consumption.
Composites, mainly carbon fibre-reinforced plastic (CRFP), have an unprecedented 53 per cent share in the material breakdown of the A350, compared to 50 per cent of carbon parts of B787, 25 per cent of A380 and 5 per cent of A310-300.
A350’s first flight is planned for early 2012 and entry into service (EIS) with Qatar Airlines (launch customer of 20 x -800, 40 x -900, 20 x -1000) for mid 2013.
Airline perspectives
Emerging trends: Consolidation within the industry has led to the formation of ‘mega airlines’ or ‘mega alliance’ whereby size, network reach and strategic hubs are becoming key elements in the next decade. British Airways and Iberia (Spain) merger followed by alliance with United Airlines which merged with Continental Airline (UA merger with CA created one of the world’s largest airlines in scale with a combined 1,000 planes). Virgin Airways (49% owned by SIA) is considering merger with Qantas (which was in merger discussion with BA in 2008 but failed to agree to split ownership, a combined carrier of US$24 billion in sale and 500 planes); American Airlines alliance with Japan Airlines to access into Japan and Asia region. Potential effects of the mega mergers and alliances for consumers: reduce capacity, dominant market position, less choices, pricing power, poorer service quality, stifle competitions, etc.
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6.6 SUMMARY
Having identified and diagnosed the various contributing factors that affect the aviation industry financial health, the key questions are:
6.6.1 Where does the industry go from here?
6.6.2 Would it be sunshine after the financial markets and economic recession storms?
6.6.3 Or further dark clouds ahead in near future in a danger of a ‘double-dip’ economy in US and EU?
There are no silver bullets solution to reshape the complex aviation/airline businesses and its performance for profitability due to its highly cyclical nature, high operational and financial gearing leading to severe cash reserve management in anticipation of future investment capital needs or in anticipation of unanticipated prolonged downturns (in a tight situation like the ‘sitting ducks’ as selling capital assets in duress, i.e. aircraft, may not be a good or viable option or retrenching the labour workforce for scale-down operation, etc.).
Moving forward, we need to take into consideration the dynamic changing environment which may exert further constraints or open up new opportunities in the aviation industry:
i) EU regulatory enforcement of aircraft engine carbon emissions (e.g. new German taxes)
ii) Deregulation movement of US-Europe open sky agreement or ASEAN open sky agreements
Under the Asean proposed open skies of a single unified aviation market, Asean carriers would be allow to fly freely over the region, transporting passengers and cargo from one airport to another. Latest Indonesia decision to delay the development of a single Asian aviation market by limiting the access to only five key airports in Indonesia will hurt travellers, member countries and the bloc as a whole since foreign carriers will not be allowed to ply domestic routes.
Liberation of air space brings advantages of free market competition between airlines, better choice and prices for consumers, the ‘knock-on’ and multiplier effects for tourism, social community development and other sectors of the economy.
iii) Airlines consolidation and alliance to rationalise and leverage on the economic of scale in the capacity and network reach
SU6-16 EAS431 STUDY UNIT 6 iv) new technology in light weight composites, fuel efficient engines for SST routes, bio-fuel feasibility as alternative fuel, etc. v) Airlines are allow to charge for Ancillary Fees as new source of revenue streams for ‘extra leg room’, ‘extra checked baggage’, ‘use of toilet facility’, etc.
US Department of Transportation (DOT) reported that US airline’s captured $7.8 billion revenue from ancillary fees in 2009, up 42 percent compared with 2008 since the year baggage fees were introduced when oil prices soared to a record high $147 per barrel. The biggest chunk of the revenue came from checked baggage. Besides checked bags, other ancillary fees include reservation changes, pets, seating assignments, food and drink sales, pillows and blankets and mileage sales.
Food for thoughts:
1. During ICAO’s meeting in May 1997, Dr. Kotaite suggested the Virtual Airline concept as such:
6.6.4 The Virtual Airline owns no aircraft – the aircraft are leased
6.6.5 The virtual Airlines employs no cockpit or cabin crew – they are on contractual hire
6.6.6 The Virtual Airline has no engineering facility – the maintenance is contracted out
6.6.7 The Virtual Airline has no ground handling – the ground handling is contracted out
6.6.8 The accounting and reservation systems are also outsourced
Basically the Virtual Airline outsourced all the non-core activities and focus on its core businesses of transporting people from Point A to Point B most cost- effectively for a profit.
Lessons learnt from LCCs :
6.6.9 Challenge the regulatory for licences and open sky agreements
6.6.10 Challenge regulatory efficiency in addressing compliance issues
6.6.11 Lobby the aircraft manufacturers for better financing terms and production turnaround, flexibility in delivery schedules/options, pricings, guarantee residue values, etc.
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6.6.12 Lobby for airport/ATC and infra-structure (airport terminals) development for economic stimulations in new or existing markets.
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References
1. Competitive Strategy (1980) by Harvard Business School Michael Porter’s Five Forces Industry Analysis
2. Kellogg on Strategy by David Dranove & Sonia Marciano, Wiley publisher Industry Analysis- Page 16 – 17 on Porter’s Five Forces Framework
3. Kellogg On Strategy by David Dranove and Sonia Marciano, Wiley publisher Chapter 9, page 203 on Examples In Action : Southwest Airlines
4. Long Range Planning by Thomas C. Lawton, Elsevier Science publisher Volume 32, Number 6 on ‘The limit of price leadership : needs-based positioning strategy and the long-term competitiveness of Europe’s low fare airlines’, page 573 – 586, 1999.
5. The Journal of Air Transportation World Wide by Thomas C. Lawton Volume 5, Number 1 on ‘Flying Lessons: learning from Ryanair’s cost reduction’, page 89 – 106, 2000.
6. Buying The Big Jet by Paul Clark, 2nd Edition, Ashgate publisher Chapter 6, page 171 on Aircraft Economics
7. Magic Numbers by Peter Temple, Wiley publisher Chapter 9, page 53 on Margins Chapter 16, page 97 on Gearing Chapter 19, page 114 on Return on Capital Employed Chapter 23, page 143 on Free Cash Flow Chapter 29, page 180 on Weighted Average Cost of Capital (WACC)
8. Airline Fleet Management, March-April 2010, Issue 66, Page 39 – Page 41 AFM Interview with Kostya Zolotusky, MD, Capital Market Development, Boeing Capital Corporation, USA.
9. www.boeing.com (Source: Boeing) 10. www.airbus.com (Source: Airbus) 11. www.iata.org (Source: International Air Transport Association) 12. www.icao.int (Source : International Civil Aviation Organisation) 13. en.wikipedia/wiki/Airbus_A380 (Source : wikipedia) 14. en.wikipedia/wiki/Boeing_B787 (Source: wikipedia)
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