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Aviation Industry Leaders Report 2019

Tackling Headwinds

Tackling Headwinds

Our Aviation Industry Leaders Report 2019: Tackling Headwinds examines the current state of the aviation market, including financing trends, new aircraft production and entry-into-service issues as well as the impact of new technologies.

This executive summary provides a snapshot of the broader report, highlighting the critical issues and challenges facing the industry over the next 12 months.

About this report

Over the past decade, alongside the general improvement in the global economy, airlines have grown in profitability, matured in terms of employing better capacity management and cost controls, and have benefitted from the explosion in demand for passenger air travel. Airframe and engine manufacturers have booked orders and reported record deliveries, with plans potentially to further push production to historically high levels. Leasing companies are busier than ever as demand for lift continues, which is attracting many new entrants – backed by new investors – into all sectors of the leasing market, from brand new aircraft to mid-to-late-life equipment. Banks too are eager to lend despite impending constraints from new EU capital regulations; commercial debt finance is more popular than ever despite the lower yields, while structured capital markets transactions are becoming more standardised and tradable as investors pile into the sector.

Despite this positive picture, pressure is building as the industry tackles geopolitical, macroeconomic and industry headwinds as it moves away from peak growth and profitability.

This annual Aviation Industry Global Leaders Report examines the current state of the aviation market, including financing trends, new aircraft production and entry-into-service issues as well as the impact of new technologies.

State of the industry

Airlines, lessors and banks are operating within a global environment where a multitude of exogenous factors are colliding at once, presenting numerous challenges.

Geopolitical threats are building, notably the ongoing US-China trade dispute and the impending departure of the UK from the European Union (EU).

Interest rates are rising globally but particularly in the US, although as of the latest US Federal statement, rate hikes may slow down. This impacts currencies as a higher US dollar exchange rate pressures airlines with revenues in non-dollar currencies, slicing margins.

The US Federal Reserve and other central banks have been shifting away from supporting the markets, through a withdrawal from quantitative easing (QE) and interest rate rises, which will eventually result in the end of the era of cheap money.

Oil prices increased significantly in 2018 peaking at US$86/bbl (Brent Crude) in October before falling back down to US$55.63/bbl in late December 2018. While the drop in the oil price during the fourth quarter of 2018 gave airlines a slight reprieve, there is concern that they will rise again.

Labour costs are becoming a more significant issue for airlines, specifically in relation to pilots and skilled technicians. Maintenance costs are also rising due to more expensive labour and rising interest rates, which is pushing up prices for airlines and aircraft owners.

Passenger travel continues to grow above the long-term ten-year average of 5.5%. However, the latest data from the International Air Transport Association (IATA) shows a slight cooling in passenger growth over 2018, with profits, while still positive, also reducing for most airlines as they grapple with higher costs.

M&A activity

While the IATA figures remain a growth story for 2019, the cooling in industry-wide RPK growth ties in with the increasing number and strength of macroeconomic headwinds that are beginning to affect carriers around the world, putting pressure on margins. Airlines are particularly impacted by rising interest rates in terms of debt finance costs as well as escalation on aircraft orders.

As passenger numbers continue to rise, airlines have demanded more lift from aircraft leasing companies, which have grown in scale and number. In 2018, the leased aircraft portfolio increased by 629 aircraft to 8,109 aircraft, according to analysis from FlightAscend Consultancy, which also has identified that over the past decade, 100 new names have entered the commercial operating lease sector.

The wall of liquidity in the leasing space has continued throughout 2018, with more new leasing companies forming. Merger and acquisition (M&A) activity also increased across the leasing spectrum. Most market players agree that this M&A activity will continue through 2019.

Financing

In this ultra-competitive leasing environment, with its high OEM backlog and crammed delivery slots, lessors seeking to build new technology aircraft portfolios are forced into the already crowded sale-leaseback market pushing down lease rate factors in some deals to sub-0.5 levels and relaxing maintenance reserves requirements and return conditions. A downward turn in the industry cycle is predicted to help curb such excess and force more meaningful valuations over the next 24 months.

An emerging trend is for airlines to push for shorter leases on aircraft from 12 to eight, or even six years. This would have a positive impact on the airlines balance sheet under IFRS 16.

Aided by new investors piling into the sector, aviation financing has become much more mainstream and therefore much more attractive. Commercial banks are reporting high demand for debt products, while the increased volume of aviation capital market deals has fuelled significant investor interest, specifically for leasing companies issuing secured and unsecured bonds, and asset back securitisation (ABS) deals. Airlines have benefited too issuing more, and more-competitively priced, enhanced equipment trust certificates (EETCs) – with some from non-US issuers.

While the low interest rate environment has helped airlines and lessors raise competitively priced funds, it has also impacted banking margins with pricing remaining at very low levels. Most bankers therefore welcome the upward trend in interest rates, which may eventually lead to a contraction in the level of market competition.

Banks are preparing for the impact of more restrictive regulations that could lead to a reduced balance sheet. Basel IV could require banks to hold more capital reserves against certain loans they issue. This would likely be the case for unsecured loans but secured loans might qualify as specialised financing which could enable them to continue to be assessed under current Foundation and Advanced Internal Ratings based approaches, i.e. no change. Where Basel IV requires more capital allocation, it should cause banks to increase pricing; however, the competitive marketplace makes it very difficult for them to execute such a strategy currently.

There is a general acceptance that a slow moderation/correction in the industry cycle has begun. Many support the notion that the market will continue to experience a gradual moderation as opposed to a sharp fall, with growth likely to have peaked. However, the building headwinds are expected to worsen and most banks consider the current macroeconomic environment to be the sign that the cycle has turned.

Regional outlook

Respondents were once again asked to rate their levels of optimism for the industry over the next 12 months in the various regions of the world.

Overall, the concerns were concentrated on certain pockets of the world – excessive growth in China and South East Asia, while positive, also evoked concern over the ability of certain carriers to cope with building macroeconomic headwinds. India was the region where confidence was falling the most compared to last year in the wake of the continued troubles experienced by the main carriers.

North America was viewed with the most optimism as all market players are confident that the major US carriers are on a more secure financial footing. There was an overall sense that South American countries may be coming out of a prolonged slump, despite the significant political change in the region and the signs of stress for some of the main carriers, Avianca Brazil the most recent casualty.

Though still regarded as a strong market, Europe presented a very mixed picture for many, with the economy slowing down and a lack of clarity on Brexit and other political issues. The Middle East was a concern, due in part to the geopolitical issues, but mostly due to the big three Gulf carriers all vying for the same traffic and their business models showing signs of stress. The African airline market has much, albeit still unrealised, potential, but the ongoing challenges continue to drive low levels of optimism.

Financing trends

Airlines and lessors have been capitalising on the general availability of diverse sources of funding. Sale-leaseback transactions are being used more and more frequently by airlines due to the competitive pricing. Airlines are also utilising their purchasing power to push for more attractive terms on other forms of commercial bank debt, including pre-delivering payment (PDP) financing. Providing PDP financing is almost a must to win certain business, which is now being provided by lessors more than ever before.

Supported sources of financing from export credit agencies continue to be well below historical levels due to the health of the primary market but also because both major aircraft manufacturers still do not have full access to their domestic ECAs. This funding gap is being partially filled, at present by insurance-backed sources from the Aviation Finance Insurance Consortium and shortly with a new product from Marsh and Airbus, dubbed Project Balthazar. However, there are concerns that these will not be enough to serve as a replacement for the US Export-Import Bank, UKEF and Coface if there was a severe downturn.

Japanese investors continue to ramp up their investment in the sector with a significant uptick in Japanese Operating Lease (JOL) and Japanese Operating Leases with Call Option (JOLCO) transactions.

The capital markets remain very active and innovative, accounting for almost 28% of financing for new deliveries. The market saw 14 aircraft asset backed securitisations (ABS) totalling approximately $7.6bn in 2018, with strides being made to transform the ABS product to a more transparent and tradable product on both the debt and the equity side. Most expect the ABS market to remain active in 2019.

Sidecars also continued to be an investment channel in 2018 with CALC and Avolon closing deals.

Aircraft

New technology aircraft are largely well into the delivery phase but this has been hampered by entry-into-service issues affecting the new engine types, which has impacted airline operations around the world. Although confidence is high that these issues will be addressed, the longer a solution takes, the more difficult it will be for airlines to manage capacity issues.

Despite high development costs, the majority of leaders believe that Boeing will likely launch a new middle-of-the-market (MoM)/ new midsize aircraft (NMA), aircraft in due course, although they are divided on how successful this aircraft will be and the extent to which it will cannibalise other existing aircraft types.

Production rates are a concern for most lessors, particularly those who worry about supply chain issues and/or a change to the delicate market equilibrium (where capacity growth slightly lags passenger growth) should rates rise further. Production rate rises that result in much more capacity coming online than there is demand for would have a depreciatory effect on aircraft values and lease rates. Maintenance capacity and availability, as gluts of new technology aircraft enter the checking phase, are also a concern for airline operators and owners.

Technology

The aviation leasing industry is widely agreed to be a follower rather than an innovator of technology. However, in order to solve a pressing industry problem, the leasing community are pushing ahead with a very modern solution to the issue of novations. The Aviation Working Group’s Global Aircraft Trading System (GATS) aims to digitise the transfer of leased aircraft ownership using an electronic ledger to record the transfers. KPMG is delighted to be involved in the design of GATS. The system, which is poised to launch in the first quarter of 2019 and to be fully active by the end of the year, has been greeted favourably by all of the lessors who participated in this report, although they all recognise that it is still early days.

Final thoughts

Industry growth has begun to moderate. Airline profitability is coming down from its peak. Macroeconomic headwinds are continuing to build and are challenging weaker airlines to maintain growth and profitability. Further bankruptcies and consolidation in the airline market is expected, while M&A activity is predicted to increase among leasing companies. Growth in passenger demand, however, remains strong, so those airlines and lessors with strong balance sheets and experienced teams could see these headwinds as a tailwind to further growth.

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Joe O'Mara

Joe O'Mara

Head of Aviation Finance & Leasing

KPMG in Ireland

+353 1 700 4205

joe.omara@kpmg.ie