The rise of Chinese aircraft lessors

There is an age-old saying in the transport business, “If it flies or floats, you should rent it.” Traditionally, airlines have bought their planes outright, even if a significant portion of these deals were arranged as “finance leases”, with the installments spruced up as rent payments in order to make them more tax-friendly. Back in the 1980s, there were next to no aircraft under lease. However, airlines are increasingly turning to aircraft leasing. As of 2015, nearly 40% of the world’s airline fleet is rented.

This growth in the leasing sector can be attributed to airlines becoming more risk-averse and their desire to shift the depreciation and residual value risks associated with ownership to the leasing firm in an operating lease, albeit at the expense of depreciation tax shields. Deals in which airlines sell part of their existing fleet to a lessor and rent it back, known as “sale-and-leaseback” (SLB), are becoming more common. Cathay Pacific, for example, has 6 of its Boeing 777-300ERs financed this way via a deal agreed in 2009 with Singapore-based BOC Aviation. Leasing also offers airlines greater flexibility to ramp up or tune down seat capacity at short notice.

Peter Barrett, chief executive of SMBC Aviation Capital, notes that the aviation industry is shifting towards the model adopted by the hotel hospitality business; with one side specialising in owning the asset, while the other side operates it. One interesting difference is that aircraft leasing firms can easily take back their aircraft should the lessee default, a luxury that hotel owners do not have, which in a way makes aircraft leasing less risky.

The most dramatic sale to date must be that of International Lease Finance Corporation (ILFC) to AerCap Holdings NV in 2013. Steven Udvar-Hazy founded ILFC in 1973 with two fellow Hungarian partners. ILFC went public in 1983, with a market value of around US$100 million. In 1990, it was bought by insurance giant American International Group (AIG) for US$1.3 billion. The business arm experienced robust growth throughout the 1990s and soon was regarded as the crown jewels in the AIG portfolio. By September 2013, ILFC owned 913 aircraft that it leases out to over 150 customers. In December 2013, AIG announced plans to sell off their flagship aircraft leasing arm; to both raise much-needed cash after AIG’s taxpayer funded bailout in 2008 and to allow it to focus on their core insurance business. The buyer was Amsterdam based lessor, AerCap Holdings NV. The US$7.6 billion deal was finalised in May 2014; in the process creating one of the largest independent jet leasing firm. After the takeover, the aircraft portfolio of AerCap stands at 1,300 rivalling that of industry leader, General Electric’s Capital Aviation Services (GECAS), which currently leases out over 1,800 fixed-wing aircraft.

Image Courtesy of Boeing

Image Courtesy of Boeing

The leasing market has been especially active recently, with an influx of Asian investors becoming increasing drawn to this lucrative sector. This started last year with Hong Kong-based Cheung Kong, which has made a dramatic entry into the arena, with deals totalling US$1.9 billion. Cheung Kong Group, headed by Hong Kong billionaire, Li Ka-shing, entered into a US$714 million deal with GECAS to buy 18 aircraft; with BOC Aviation in a US$491 million deal for 10 aircraft and with Jackson Square Aviation a US$584 million deal to buy 14 aircraft.

The most recent development has being the sale of Irish leasing firm Avolon to Bohai Leasing. Dublin-based Avolon, owned or managed 152 aircraft and had more than 100 on order as of June 2015. Bohai Leasing, an aviation arm of Chinese-backed HNA Group, the largest privately-owned air transport company in China, agreed to pay US$31 per share in the deal, with a total enterprise value of US$7.6 billion. Bohai Leasing’s purchase of Avolon for US$2.6 billion is not only the largest aviation deal in China so far, but it also marks the first time a Chinese lessor has succeeded in taking over a Western one. In 2012, a Chinese backed consortium failed to take over then world’s largest lessor, ILFC. AerCap subsequently took over ILFC in 2014. “In the future, Chinese lessors will account for a larger share of the global leasing market… how we differ from other Chinese lessors is, firstly, specialisation, and secondly, internationalisation,”said Ren Weidong, Bohai Leasing’s chief operating officer (COO). Upon completion of the takeover next year, Bohai Leasing’s total aircraft under management would reach 525 aircraft worth 129.5 billion yuan; making it the world’s third-largest aircraft leasing company by fleet size.

Going forward, the emergency of new entrants will place downward pressure on the net interest margin (NIM), generated between the aircraft yield where aircraft yield = lease rate/current market value (CMV) and the lessor’s cost of funds. This is especially true when the US Federal Reserve is poised to raise overnight cash rate in December for the first time since the 2007-2009 global financial crisis (GFC), after which the exit of many banks has enabled the remaining players to enjoy historically high NIM.

The trend for airlines to increasingly look at leasing as their preferred option is set to continue. The especially frantic pace at which Chinese lessors are expanding means they are keenly looking for aircraft management talent. In the past, most Chinese lessors have had to do very little in the management of an aircraft after it is delivered to a lessee. However, all this is set to change, and they are racing to master the sophisticated trade of aircraft leasing, with many having to deal with aircraft coming out of lease contracts for the first time.

Another key risk facing these Chinese lessors dovetails the residual value of current-generation aircraft, with the imminent entry into service (EIS) of the re-engined Airbus A320neo (new engine option). Investment bank UBS found that the current market values (CMVs) of A320ceos (current engine options) and 737 NG (next-generation) aircraft have been declining at almost one-third of the 737 Classics aircraft’s rate at the same lifecycle, at 6% against 15%. Possible explanations include sustained high fuel prices over the past decade and strong air traffic demand growth in emerging economies helping to keep aircraft values firm.

With both Airbus and Boeing hiking outputs, to 60 A320 family aircraft per month by mid-2019 and 52 737s per month by 2018, the medium-term availability of the current-generation examples is expected to improve significantly. Despite a plateauing oil price for an extended period of time, thus leading to a reduced net present value (NPV) of the passed-on fuel saving of leasing or purchasing these replacement aircraft, usually at 50% of the touted 15% block fuel burn reduction, airlines would still be inclined to prefer the A320neo and 737 MAX for reduced fuel and maintenance expenses.

The need to sell or lease out surplus aircraft, most likely the A320ceo and 737 NG, is further necessitated by the economic slowdown in several emerging markets, which prompted the International Air Transport Association (IATA) to slash its 20-year passenger forecast to 7.0 billion at a compounded annual growth rate (CAGR) of 3.8% instead of the original 7.4 billion and 4.1% projections, respectively. While the long-term outlook remains robust, with 3 of the 5 largest additions of new passengers being in Asia, namely China whose passenger total would grow 173.1% to 1.196 billion in 2034 from 438 million at present; a 267.0% growth in India from 103 million passengers to 378 million and a 151.7% growth in Indonesia from 87 million passengers to 219 million in 20 years’ time – the transitory soft patch currently plaguing the world’s second-largest economy, which has posted the worst purchasing managers’ index (PMI) reading since August 2012, will exacerbate the downward pressure on CMVs of the A320ceo and 737 NG in the next few years from the demand side.

When this happens, the time for consolidation among the Chinese lessors, especially the smaller players such as Bank of Communications Leasing and Changjiang Leasing, would be rife. It is also safe to assume that a mega Chinese global lessor will emerge by then, as combining Bohai Leasing with Hong Kong Aviation Capital would only yield a US$8,475 million fleet value, placing the firm a distant ninth by fleet value, against AerCap’s US$33,099 million and GECAS’s US$32,507, according to the Ascend database.

Image Courtesy of UBS

Image Courtesy of UBS

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