Challenging the conventional wisdom: Is there an aircraft order bubble today?
When Chicago-based United Airlines inaugurated flights with the new Boeing 787 Dreamliner on November 4th of this year, it marked just the latest sign of positive momentum in deliveries of the beleaguered widebody programme after the aircraft was inducted into the fleets of Chile’s LAN Airlines, Air India, Ethiopian Airlines, United Airlines, LOT Polish Airlines and Qatar Airways this year. At press time, 39 Boeing 787 Dreamliners have already been delivered, including 36 in this year with several more poised to be delivered before the turn of the year, exceeding the company’s delivery goal of 35-42 examples this year.
In addition, a recent spate of orders for the 737 MAX, including an order for 17 737 MAX 8s, and 20 737 MAX 9s by Seattle-based Alaska Airlines aircraft lessor AFALCO’s one for 20 MAX 8, Aeromexico’s for 60 MAX 8s and MAX 9s and SilkAir’s for 31 MAX 8s, has swelled the number of firm orders of the 737 MAX programme to 969, and over 1,300 purchase orders and commitments from numerous carriers, including Icelandair’s for 12 737 MAX 8s and MAX 9s. Meanwhile, its transatlantic arch-rival Airbus has won 1,579 orders for its A320neo (new engine option) offering. These orders are in addition to the 1,810 current engine option A320s and 2,131 737 Next Generations currently in the backlogs of Airbus and Boeing.
In the past few months, growing aircraft backlogs have sparked concern amongst industry observers, concerned that the aircraft industry is in the midst of a dangerous bubble. In an era with unprecedentedly high fuel prices, rapid demand growth in developing markets such as Latin America, Asia, Africa, and the Middle East, and ageing fleets amongst Western airlines, there are certainly drivers behind the growth in new aircraft orders.
At the same time, there are several downside risks to the ever expanding backlogs of aircraft, for both the airlines and the original equipment manufacturers (OEMs).
On the airline side, the impetus for the recent slew of orders has been the persistently high fuel prices that have plagued the world economy since 2006. But the combination of over-exuberant expansion during the 2002-2007 period, and the shutdown of major airlines such as Mexicana, Spanair, Malev, and the struggling Kingfisher Airlines has combined to heavily depress valuations for the current generation of aircraft. The pricing of Airbus A318s and A319s, as well as 737-600/700s on the open market has collapsed, let alone the values of older types such as the 737 Classics and MD-80s. This creates a problem for airlines, which are now left with large fleets of aircraft that are rapidly depreciating. If prices for the current generation of narrowbodies decline as they are expected to as the world fleet of A320s and 737 NGs (Next-Generation) continues to grow and the timeline on the introduction of the re-engined products continue to shrink, the valuations of airline fleets around the world will precipitously drop. In turn, this will drive heavy losses in the mark-to-market value as depreciation and impairment on airlines’ profit and loss statements. One of the underappreciated factors in the recent bankruptcy of American Airlines was the heavy depreciation in the valuation of its large fleet of McDonnell Douglas MD-80 aircraft in the middle of this decade as fuel prices rose. While these losses on depreciation were certainly not the most important factor in American’s financial decline, American did accrue more than a billion dollars in depreciation every year between 2004-2007, coinciding with the increase in oil prices, contributing to its growing net debt which ultimately triggered the Chapter 11 filing in November last year. In an industry where the projected profit margin for 2012 is a tepid 0.6% according to projections from the International Air Transport Association (IATA), every dollar counts. The airlines in the United States and parts of Asia are likely to be robust enough to withstand this blow, but weaker airlines in Europe, India, Africa, and Oceania could be decimated by it.
And the implications for airlines extend beyond the valuation effects on airline profits and losses. If valuations decline on the 737s and A320s, the financial institutions which financed most of the deliveries of these aircraft types in the last decade, especially some of the riskier purchases by unknown low-cost carriers (LCCs) will be left with assets steadily declining in value even as their debtors are on the hook for much larger sums. It would be a situation akin to the position of mortgage lenders following the crash in US home prices, when homeowners were forced to make payments on a house much less valuable than the mortgage. Airlines could end up paying a tonne of extra money for their aircraft, thereby inflating their net debt levels.
Declining valuations will also affect the balance sheets of various aircraft lessors and make them less likely to accept newly purchased aircraft from airlines and then lease those aircraft back to the airlines. This sort of sale-and-leaseback tactic has been used by several LCCs and full service carriers around the world, most notably American Airlines, Jet Airways and IndiGo as a tool to raise cash during times of lean operating profits or losses. This is one of the most effective ways for an airline to raise cash in an environment where airlines are seen as risky investments, and the loss of this tool will have profound implications for years to come.
From a practical standpoint, one way to look at the recent slew of orders for the re-engined products is that they are effectively a massive hedge against higher future oil prices. The primary attraction of these re-engined airplanes is the 13%-15% lower fuel burn that is large enough to justify the massive investment of huge orders such as those placed by American Airlines, IndiGo or AirAsia. There are some maintenance savings from incremental technological improvements, but these alone cannot outweigh the financing costs, especially if the cost of such financing rises. Moreover, if one views these aircraft orders within the framework of fuel hedging it quickly becomes apparent that there is a nightmare scenario for airlines. Harken back to the global financial crisis of 2008-9. During that period, oil prices fell rapidly from US$148 per barrel to around US$40 and airlines that had hedged at the high fuel prices such as most of the US legacy carriers incurred billions of dollars worth of mark-to-market losses. The same pattern played out on a considerably lesser scale earlier this year when US airlines which had hedged at the peak of oil prices during the post-recession recovery, lost lots of money from hedging contracts that turned sour. So long as the price of oil stabilises at the current level of around US$90 per barrel or increases as in the case of most pessimistic predictions, the large orders make a lot of sense, even as fuel hedging does. But there is a very real risk that oil prices will go down, both in the near term, and due to longer run trends. In fact, due to the long-run expansion of the supply of crude oil thanks to the explosive growth in shale oil production as well as the continued decrease in costs as shale extraction technology moves up the steepening learning curve. In fact, a new report from Merrill Lynch analyst Sabine Schels and his colleagues suggests that oil prices will decline to US$50 per barrel within the next 24 months. While this is one of the more extreme projections, many of the long-term production trends, barring government intervention due to environmental concerns, do a favour a long-run drop in the price of oil thanks to increasing North American production and stabilising BRICS (Brazil, Russia, India, China and South Africa) demand – other investment banks including Credit Suisse, and Citi have made similar projections. If the price of oil declines to even US$60 per barrel, much of the business case for these new aircraft types arguably evaporates. At that point, coupled with rising credit costs, the large orders may become ticking-time bombs on airline profit and loss statements. The one caveat to this analysis is that if carbon taxation schemes such as the recently neutered emissions trading scheme (ETS) in the European Union are applied on a large scale around the world. This scenario would once again improve the cost savings from more fuel efficient aircraft.
From Boeing’s and Airbus’ perspective, the bubble bursting will not have an immediate effect on their near-term prospects. With a backlog of more than 3,700 aircraft at each of the two plane-makers, they can always find solid, creditworthy carriers to step into early delivery slots in the foreseeable future. But as the timeline moves further out, and credit for airliners starts to tighten, sustaining production levels, such as 84 narrowbodies of two generations simultaneously, will become increasingly difficult.
To understand why credit is likely to tighten, it is important to look at a macro-level analysis of the global economy over the past few years. Between the tepid recovery and increasing economic uncertainty especially in the West, the global economy has demonstrated an extraordinary appetite for safe assets in the past few years. This can be seen in the continuously falling yield of 10 year US Treasury bonds with falling bond yields are correlated with increasing demand,which has declined to just 1.5% as of November 30th. When combined with the increasingly easy monetary policy pursued by central banks around the world, especially by the Federal Reserve in the US, and increased cash holdings by large corporations, the last four years have witnessed a situation where banks were flush with cash, but lacked low-risk assets to purchase with that cash. In the near term, aircraft appeared to be a relatively safe investment, given the high demand for aircraft in light of rising fuel prices. Thus, without a better alternative, banks and investment firms around the world eagerly financed aircraft deliveries.
But the question then becomes, how safe are today’s aircraft backlogs? Obviously there are many individually safe, low-risk aircraft orders for banks to finance: United’s 737 MAXs and British Airways’ A380s to name a few. But en-masse? Logically, does it make sense that a global airline industry which cumulatively is projected to have made an industry-wide profit of just US$4.1 billion in 2012, equalling an anaemic 0.6% net profit margin, can sustain the purchase of 34,000 new airframes worth US$4.5 trillion over the next 20 years? Even if by some minor miracle the industry can meet that projection, banks and financiers will have long moved on to more profitable and rewarding investments. Aircraft deliveries may look relatively safe today, but this perception will not continue indefinitely. That naturally, will drive up the interest rate and thereby the cost for new aircraft deliveries, potentially crippling the tenuous orders of several airlines. Already, Indian low-cost carrier (LCC) SpiceJet is having trouble in securing financing to top up its fleet of Bombardier Q400s and this problem will likely spread in the coming months.
In the past, the US export-import (Ex-Im) bank could have provided some of the backstop financing for new Boeing deliveries (ditto for Airbus and the EU’s export-credit agency). Indeed, Ex-Im financing in the US over the past 3 years for Boeing hit US$27 billion, an all-time high. But given the fiscal concern in both the United States and the European Union over increasing government indebtedness and expenditures, it is not likely that the Ex-Im banks could entirely paper over the decreased financing from the private sector.
It is important to remember that the bursting of the bubble will not kill either Airbus or Boeing. Both original equipment manufacturers, (OEMs) are likely to maintain profitability, though not at their current historically high margins. The 737 and A320 programmes, will still be profitable, even in the A320neo and 737 MAX iterations. But as Boeing attempts to work out the kinks in the 787 programme, launch the 787-10X and 777X while Airbus races to bring the Airbus A350 to market, increase the competitiveness of the A330-300, and consolidate gains on the A380 programme, any loss of margin on the narrowbody programmes simply increases the financial pressure on the widebody developments.
The implications of the bubble bursting extend beyond the internal financial turmoil. Today, Airbus and Boeing enjoy a duopoly, really hegemony over the global large airliner market, the recent burst of negative advertising notwithstanding. But if the bubble for narrowbodies burst, then all of a sudden that gets thrown into doubt. Today, their newly revitalised rivals in China and Russia such as Commercial Aircraft Corporation of China (Comac) and Sukhoi cannot match the product reliability or reputation enjoyed by Boeing and Airbus. But as credit tightens for the latter two OEMs, the former two can leverage their state credit arms to offer attractive financing. While this will not be enough to make a serious dent on Boeing and Airbus, it will affect some customers at the margins, especially the emerging market low-cost carriers (LCCs) that have questionable business cases – some of whom will pan out and drive them to buy Comac or Russian. Then if those customers have good experiences, Comac and the Russians will go into the next round of aircraft purchases with heightened credibility and maybe win even more customers at the margin. Over time, this will allow emerging market manufacturers to slowly narrow the gap between them and the dominant OEMs – threatening sales and margins at Boeing and Airbus. A similar opportunity exists for Bombardier and Embraer who are trying to blaze a new trail into larger aircraft segments.
In conclusion, the risks to Boeing and Airbus of an aircraft bubble bursting are diverse and powerful. It is Aspire Aviation’s view that the potent combination of cheap credit and the image of perpetually high oil prices has created a bubble for narrowbody aircraft. Given the long-term trend in oil prices and a likely tightening of credit for airliners, that bubble is likely to burst within the next 2-4 years, albeit there is going to be sufficient financing at US$104 billion in 2013, according to Chicago-based aircraft manufacturer Boeing. While this may not be a popular view, neither was claiming that the housing market in the US was going to fall apart back in mid-2006. Of course, there is always the chance that this analysis is wrong and for the sake of Airbus and Boeing we do hope that narrowbody demand, and the willingness to finance such purchases remains robust. But it is at least time to consider the possibility that the narrowbody bubble can burst, and for smart and sensible players, that shift in the market will offer opportunities to profit.
Categories: Airbus, Airbus Group, Boeing Tags: 737 MAX, 737 MAX 8, 737 MAX 9, 737 NG, 777X, 787-10, A320, A320neo, A330-300, A350 XWB, A380, AirAsia, Airbus, Alaska Airlines, American Airlines, Boeing, Bombardier, Embraer, EU Emissions Trading Scheme (ETS), IndiGo, Kingfisher Airlines, SilkAir, SpiceJet, United Airlines
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