What Value Now?

Call me old fashioned, but at Cathay Pacific we never buy a plane without knowing exactly how we are going to use it.” Judging by the surge of large orders for new aircraft in the latter half of 2011, it’s hard to believe that all airlines share the philosophy of CX CEO John Slosar.

Speaking at the Association of Asia Pacific Airlines annual meeting in Seoul in November, Slosar was commenting on the rational of such large orders – especially by Middle East carriers – in highly uncertain times and when IATA is predicting airline profits will fall to $4.9 billion in 2012, meaning a paltry 0.8% margin. “These very large orders, I think, are sometimes about a general idea of growth, but not about something specific. There’s also the idea that they can lease them out if it doesn’t work.”

As everyone scratches their heads and admits that it’s almost impossible to know where the economy is heading and what lies in store for airlines next year, the apparent confidence behind these 50- or even 100-unit orders seems contradictory. Whether the buyers ultimately prove to be wise or foolhardy, there are immediate questions about the impact of prices on existing aircraft. And in particular, in sales involving the new, re-engined Airbus A320neos and Boeing 737 Max aircraft, what will be the effect on values of current A320 and 737 family aircraft?

There are also concerns that financing practices may be feeding the new-aircraft spending splurge. While many banks are no longer interested in funding aircraft, government funds have become much more available, but only for new aircraft. That may be pushing a trend of buying more new aircraft than are needed.

From the manufacturers’ perspective, not surprisingly, their forecasts support the check-signing. Airbus has forecast demand for 27,800 new commercial aircraft over the next 20 years, including 26,900 passenger aircraft (with more than 100 seats) and 900 freighters, valued at $3.5 trillion. In its latest global market forecast, “the aviation sector is expected to remain resilient to cyclical economic conditions as in the past.” The forecast represents a 6.9% increase over the manufacturer’s projection last year of demand for 26,000 aircraft over two decades.

Boeing, meanwhile, predicts a demand for 33,500 new commercial aircraft worth $4 trillion through 2030, though it includes regional aircraft in its analysis while Airbus does not.

Airbus predicts that global passenger traffic, as measured in RPKs, will grow 4.8% per year on average, leading to a doubling of traffic between now and 2030. That will lead to a doubling of the world’s passenger aircraft fleet from 15,000 currently to 31,500 by 2030, according to Airbus. (Boeing in June projected an annual passenger traffic growth rate of 5.1% over 20 years.)

“Factors driving demand for new aircraft include population growth with increasing wealth, dynamic growth in emerging economies, strong continued growth in North America and  European markets, greater urbanization and a more than doubling in the number of mega cities by 2030,” Airbus stated. “Drivers also include the ongoing expansion of low-cost carriers, and the need to replace older less efficient aircraft with new eco-efficient models in established markets.”

The bulk of the demand, according to Airbus COO-customers John Leahy, will be made up of nearly 19,200 single-aisle aircraft with 100-210 seats valued at $1.4 trillion, he said. That supports the strong interest in large new narrowbody orders, such as American Airlines’ history-making decision to acquire 460 single-aisle aircraft from the 737 and A320 families beginning in 2013 through 2022; Spirit Airlines’ order, announced at the Dubai Airshow in November, for   75 A320s, comprising 45 A320neos and 30 A320s; and Qatar Airways’ order for 50 Airbus A320neos.

But it’s not just the narrowbodies that are selling fast. Emirates Airline has set a new record for Boeing, in dollar value, with its $18 billion order for 50 777-300ERs; and Air France KLM now has on order 50 firm aircraft plus 60 options, an even split between  Airbus A350s and Boeing 787s.

If there’s a common theme here, it’s probably the now-urgent quest to bring onboard new-generation, fuel efficient aircraft and dump jet kerosene-hungry aircraft as rapidly as possible. Oil prices, combined no doubt with some aggressive new-aircraft pricing, now outstrip many carriers’ personnel costs, so the rush to greater fuel efficiency makes fiscal sense.

Aviation Capital Group (ACG) CEO Stephen Hannahs confirmed that view when the lessor signed a firm order for 30 A320neos at the Dubai Airshow, bringing its total A320 order book to 98 aircraft. “Faced with increasing fuel prices and tough competition, we are seeing a stronger than ever demand from our customers for modern fuel-efficient aircraft such as the A320neo,” Hannahs said, noting that the neo would cut fuel burn by 15%.

“Outside of the economy, fuel prices have had a split effect. First, they’ve killed or seriously damaged older aircraft values. And second, they’ve stimulated demand for new- generation, fuel-efficient aircraft and, in particular, development of the neo and Max,” said Aviation Specialists Group president Fred Klein.

In their Commercial Aviation Industry Outlook report, released last month, lessor CIT and Forbes Insights also point to technologically-advanced, fuel-efficient aircraft being in high demand.

CIT Transportation Finance president C. Jeffrey Knittel plays down the impact of the neo and Max on current aircraft values. “The interest in the current A320 and 737NG fleets remains strong. Since Airbus launched the neo last year, they’ve had quite a bit of success with their sales efforts, resulting in large orders, and we are seeing the same level of interest in the 737 Max,” he said. “However, these new aircraft won’t be available in substantial numbers until the end of the decade and continued traffic growth will need to be accommodated by current standard models.”

Avitas senior VP Adam Pilarski holds a similar view. “The installed base of 737NGs and A320s is quite big and so you when you look at values, you have to consider the secondary market and how many customers you have for them. From that point of view, it’s hard to believe that the neo and the Max will crash the market. The technical term is that there’s no need to freak out,” he said.

Pilarski also points out that when the NGs were introduced, their impact on classic 737s was not immediate. “The gap that eventually developed happened during a downturn. I think the effect with the neo and Max will be similar; there will be no big impact now, but down the road and in the next downturn, that’s when it will be exposed,” he said.

With the entry into service dates of these aircraft not starting before 2015 at the earliest, and more years beyond that needed for them to establish their heritage and performance levels, Pilarski believes the impact will not truly be felt until around 2020. “At that point, it will be the beginning of the end for the old planes and they will see a reduction in value. But it’s a very big market,” he said.

ASG’s Klein agrees that there remains a lot of interest in 737NGs and A320s. “The economic uncertainty is still everywhere, but if you look at passenger traffic, it’s holding up. The order books are real big for all the popular stuff and there’s demand for all the new stuff,” he said. But he thinks it’s a stretch to say the neo and Max won’t affect current inventory values.

“When you look at the general depreciation curve of the A320, it has a certain shape. It may be that the new generation aircraft won’t change the shape of that curve, but the curve itself could shift down. It depends how the new aircraft are priced. If both Airbus and Boeing are doing hard discounting of the new generations to get their order books built up, then the gap closes between the prices for them and those of current aircraft.

“We are all scratching our heads and I don’t think anyone knows what will happen, but the true effect won’t be known for five years,” he said.

Concerns remain, however. Pilarski sums it up this way, “We have been in a period of uncertainty for quite some time, but passenger traffic is not doing bad. However, freight is in negative figures and that’s the bellweather indicator for declines in traffic.

“The macro picture, I think, is that we are in a big bubble environment. When you look at demand and supply, there are a lot of airplanes available and everyone is buying new airplanes, especially airlines like Emirates and Qatar. And the fact is that there’s some double counting going on. Airlines in the Middle East believe they will carry the traffic, while airlines in Europe and Asia believe they will take the traffic. If I was a betting man, I would bet on the Lufthansas and ANAs etc, but the Middle East is not seeing it that way,” he said.

On top of that, he points out, new leasing companies have sprung up while the traditional lessors are still in business “All this means there will be too much supply and not enough demand, which is actually getting weaker. Europe may drop in the ocean for all we know and China is definitely slowing down,” Pilarski said.