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Managing the Components of Risk

With more volatility likely, what’s the maximum level of risk you are willing to take in next year’s markets?  The answer requires knowledge of the impact changing traffic levels will have on the values of specific equipment types and portfolio credits. Values that will be driven by the economic, financial, and political environment over the next election cycle. A 2020 Roadmap? Maximum returns, minimum risk. With long economic lives, air and rail equipment values, risks, and returns change over time. Investment in transportation equipment requires an evaluation of lessee credit, specific equipment configuration, transaction structures, book and tax accounting treatment, deal economics, and the governing law of the jurisdiction where the equipment operates. 

Equipment values are intertwined with the financial condition of operators, the markets, and your perception of the future. Traffic demand drives all three. Recent interest rate cuts by the Federal Reserve and continuing trade relations discussions have bolstered expectations for continued economic growth. Unemployment is at its lowest level in 50 years and the services sector has continued to expand. Since predictions are always risky, what is important is to understand the components of risk, know what you want more of, what you want to keep, and what you would like to sell.

If you choose to sell you should satisfy two criteria. First, the proceeds from the sale should be greater than the proceeds from continuing to hold, and second, the reported accounting treatment should result in a book gain. If you’re selling, consider effective marginal tax rates, not just for yourself but for all participants. Understanding this concept is important since it directly influences prices at which assets are traded. A detailed transaction analysis will help understand why you are making money (interest rates, equipment values, taxes, the equipment markets, etc.), and ensure you are choosing the right thing to do, e.g. good economics and good accounting. The remaining question, where to reinvest the proceeds? 

When you made your first investment you made judgments about the lessee credit, future equipment values, and tax rate stability. When you reinvest, you make the same judgments. Diversification of lessees, equipment types, maturities, and the ability to use tax benefits allow you to reduce the overall risk of your portfolio investment.  That risk depends on how your lessee credits and equipment (aircraft and railcars) values correlate with one another. A portfolio that contains a lease of a 737 and a lease of railcars creates diversification which reduces risk and which will reduce the amount of capital needed to maintain your investment. The factors that influence the financial health of railroads and railroad shippers are different than the factors that impact the financial health of air carriers. Extending that analysis to companies in the same industry, there are differences in markets served, and equipment types used. The value of diversification depends on how portfolio investments react to changes in macro variables (freight, passenger traffic, interest rates, GDP) and which exposures impact returns the most.  Consider your lessees’ ability to manage through economic up and down cycles. Over the next ten years, equipment prices may rise, fall, and then rise and fall again. Manage maturities so not all will face the same equipment value market. 

Risk management requires developing a set of expected events and related action decisions that incorporate the probabilities of possible outcomes. Maximize the value of your action decisions by industry, credit, and equipment type. Best case, worst case, most likely. Maintain diversification. 

Managing the components of risk requires working with a better investment manager. Call RESIDCO.

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Adapting To Declining Traffic

Weak international trade is hurting international airfreight. Global airfreight volume has fallen for 10 consecutive months year over year (the longest losing streak since 2008). In the three months ended August, North American airlines’ U.S. dollar revenue from air-cargo between China and the U.S. fell 26% relative to the same period in 2018. While transportation equipment investors cope with the ongoing economic and trade uncertainties, no catalyst for growth has appeared. The International Monetary Fund (“IMF”) has said the world’s three largest economies, the U.S., China, and Japan are likely to slow further. Even so, the U.S. economy, which is growing slowly, is performing better [1] than the eurozone, the U.K., and Japan (the S&P 500 closed at an all-time high October 28, 2019, the 103rd record close since the 2016 Presidential Election). 

Your equipment investment portfolio’s balance sheet is configured based on the thousands of past investment decisions you’ve made. You can change direction, but results won’t appear overnight. As transportation equipment investors see the continued softening of air and rail freight, business strategies are being adjusted. A typical response is to cut variable expenses and reduce capital expenditures. Others manage fixed costs down to develop an adequate ‘margin of safety’. Southwest Airlines updates its revenue forecast daily and its fuel forecast weekly. The Class 1 railroads are implementing Precision Scheduled Railroading (“PSR”), running faster, longer trains, more efficiently. Greenbrier has acquired ARI. Trinity Industries has shifted a portion of its new railcar production from 2019 into the first half of 2020 to facilitate the transition to lower railcar production next year. With a focus on lowering their cost of capital and streamlining manufacturing operations, their lease fleet’s remaining lease term provides the cash flow to bridge current economic uncertainties and declining new car orders.  With PSR, rail shipping times are becoming more reliable, but the oversupply of truck capacity is preventing the Class Ones from growing modal market share.  

Running an organization ‘by the numbers’ is not enough. Boeing’s 737MAX design challenges are an example of misplaced strategic decision making. Emphasis on cost-cutting and hitting financial targets have resulted in the grounding of the 737 MAX.  Even with volume weakening [2], the Class Ones remain insistent on maintaining pricing. It’s alienating shippers [3]. Their focus on operating ratio improvement risks Shippers shifting their business to other modes.  In a world where global economic growth is its slowest since 2009, operations management should create opportunities, use different time horizons for different investment decisions, risk adjust expected cash flows,  develop alternatives where the additional value generated is commensurate with the risk undertaken, and maintain a ‘Margin of Safety’ and an on-going evaluation of the effectiveness of choices. Cost structures with higher levels of fixed costs are riskier, just as firms with higher levels of debt in their capital structure are risky.  With the ten year Treasury yielding 1.77%, Central Banks have only managed to drive asset prices up and investment yields down. The risk remains, and the longer your investment horizon the greater the risk.  

Adapting to declining traffic requires understanding customer needs, identifying current opportunities, and managing transaction structure.  We have solutions at RESIDCO.

[1] The National Association for Business Economics expects the U.S. economy will slow to 2.3% growth this year from 2.9% in 2018.  The OECD downgraded its global economic outlook for 2019 to 2.9% (its weakest since the financial crises). Third Quarter growth was 1.9% as business investment fell.

[2] See Railway Age, October 23, 2019, “We Are in A Freight Recession”.

[3] The Surface Transportation Board has requested the Union Pacific establish weekly calls with the Board’s Rail Customer and Public Assistance office, during their implementation of operating changes, September 28, 2018.

[4] Legacy carriers began offering super low fares as a way to fend off increasing competition from low-cost carriers.  Lower cost fills seats and keeps load factors high.

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