Air cargo represents less than one percent of global trade by tonnage but amounts to $6 trillion worth of goods moved every year – more than 36 percent of global trade by value. Globally, half of that airfreight cargo has been carried on passenger jets rather than dedicated freighters. The rapid shutdown of passenger flights has eliminated passenger jet freight capacity, and air freight rates have responded, increasing significantly.
With the cascading passenger flight cancellations (and flight restrictions), air carriers are moving idle passenger planes to freight in high-demand routes, taking advantage of the very high air cargo market rates at a time when fuel prices have plummeted (American Airlines Group Inc. is flying its first scheduled cargo service since 1984 between Dallas and Frankfurt). As Asian manufacturing capacity comes back online, moving goods to the U.S. will further increase demand for airfreight. Equipment maker, John Deere & Co., is budgeting an extra $40 million in expedited freight cost for the second quarter to help ensure parts from Chinese suppliers can reach its facilities in Moline, Illinois.
Markets are telegraphing their uncertainty over how long the coronavirus will impact the domestic consumer activity which has driven our recent eleven-year bull market run. The sell-off that’s occurring is being amplified by a constant media blitz of event cancellations, corporate travel bans, ‘shelter in place,’ school closings, and election-year ‘coronavirus politics’. To stop the pandemic, we are forcing a recession. Near-term, the impact will reduce second-quarter economic growth. However, the politics of the fall election (and a $2 Trillion Stimulus package) will lead to a rebound in the second half.
While commercial passenger air travel has been turned on its head, U.S. rail freight continues to move the essential goods we need to survive. The slowing of the global and U.S. economies will delay domestic rail traffic improvement.
But, as the summer appears, and the virus abates, domestic manufacturers and retailers will need to play inventory catch-up. Companies will face such a need to restock there will be the potential for a significant freight traffic recovery in the second half of this year. Longer-term, rail equipment demand uncertainty has been created due to the industry’s adoption of precision scheduled railroading (“PSR”). PSR (and trade) are driving the market dynamics, impacting rail equipment values and lease rates.
Rail traffic (excluding coal and grain) is down year over year (still up from January lows). First-quarter container volumes through the Port of Los Angeles, the largest U.S. gateway for inbound seaborne container shipments from China, are expected to be down 15% year-over-year. Spring flooding will impact traffic along the Mississippi. Oil’s slide will negatively impact the demand for crude oil tank cars and the frac sand cars that serve the shale oil industry.
Air and Rail equipment values and lease rates are stressed. But consider what the markets allow. Volatility creates opportunities. Now is the time to look for those gaps, weaknesses, and areas of growth; ask “Where are the most productive assets available?”
Investor interest continues to demonstrate market confidence in Air and Rail transportation equipment. Increasing interest in these ‘alternative investment’ categories has created a challenging environment. Railtransportation is a high-volume low-value freight business while airis a high-value passenger and freight business. Even with interest rate cuts (three in the last year by the Fed), falling global traffic levels across both modes have created caution flags for near-term investment activity. Whether the cause is tariffs, or the coronavirus outbreak (COVID-19), equipment demand, lease rates, and equipment values are being impacted.
COVID-19 and Travel
China’s rise as the world’s second-busiest market has been a strong source of growth for the world’s major economies and airlines. The virus’ impact on supply chains and passenger traffic is complicated. Air travel is suffering as thousands of flights are being canceled. The International Air Transport Association has published an initial assessment that estimated global lost airline revenue is as high as $29 Billion (airlines in China would be the most impacted).
U.S. carriers completely halted flights to China in January. The US Department of State has issued a level-4 travel advisory, meaning the public is advised not to travel to China. In February, the CDC issued a Level 3 warning, recommending avoiding all nonessential travel to China. In China, Cathay Pacific Airways asked all staff to take three weeks unpaid leave, Hong Kong Airlines Ltd., terminated 400 workers and Asiana Airlines Inc. (South Korea) asked thousands of staff to take unpaid leave. The number of infections worldwide is approaching 80,000 (China’s official count of 74,576 infected, and 2,118 dead is being updated daily1). China is bearing the immediate brunt, but the virus clearly presents a risk to the global economy.
With the delay in returning the 737MAX to service (which is now impacting suppliers, e.g. GE LEAP engines), election-year politics, and the spread of the coronavirus beyond China, it’s difficult to assess the magnitude of impact.
Favorable U.S. Developments?
The leading economic index indicates continued growth, US consumer confidence remains high, labor markets are tight, and existing home sales (supported by lower mortgage rates) are at a two-year peak. The possibility of slower economic activity requires thorough analysis, a sound underlying investment strategy, and downside protection.
Risk is inseparable from the opportunity for profit, and whenever there is change, there is opportunity. Transportation equipment investment is no different. In every investment, risk is an exchange: the buyer holds the primary risk, while the seller has given up the chance that equipment values will go up. The biggest economic risk is buying at the wrong price, at the wrong time.
Market intelligence, equipment configuration, and equipment condition are all critical. Equipment ownership and long-term contracts that ensure predictable cash flows and equipment values in difficult markets are needed. Often existing, well-maintained equipment is a better choice than new. Investors should be financially (and psychologically) prepared for volatility. It’s time to review your portfolio and ensure it’s properly positioned to weather the storm that might lie ahead. In times of uncertainty, think long-term and strive to minimize risk.
We believe the current supply chain disruptions and turbulent global markets will lead to buy-side investment opportunities. Get ahead of today’s challenges. Call RESIDCO.
1 Wall Street Journal, “Coronavirus Wreaks Havoc on Airlines”, February 21, 2020.
https://residco.com/wp-content/uploads/2020/03/Residco-Turbulent-Markets-Lead-to-Opportunity.jpg8001200residcohttps://residco.com/wp-content/uploads/2016/12/RESIDCO_Logo_225x72.pngresidco2020-03-09 08:00:412020-03-10 14:28:55Turbulent Markets Lead to Opportunity
Strategic decisions are never simple. Despite the significant resources investment managers devote to the decision process, they often make judgments that go wrong because of human shortcomings. Behavioral economics teaches that human biases, such as over-optimism about the likelihood of success, often affect the decision process, and employee incentives may be misaligned with long-term investment results.
Most investment managers know about these pitfalls. Yet cognitive bias distorts the way managers collect and process information, and judgment often is colored by self-interest. Overoptimism and loss aversion (the human tendency to experience loss more acutely than gain) are the causes. All investment decisions have two essential components: the likelihood of the expected outcome, and the value placed on it. When investment probabilities are based on repeated events optimism may be less of a factor.
The Impact of Loss Aversion
But loss aversion also influences investment decisions. Consider Boeing’s design and marketing decisions for the 737MAX. Did Boeing sacrifice safety and airframe design principles to meet competitive pressures from the Airbus A320neo? Boeing and Airbus operate a ‘duopoly’ in the market for single-aisle jets (valued at over $3.5 trillion over the next 20 years). Neither can afford to fall behind. Boeing had considered the single-aisle market large enough to launch a new aircraft design (New Midsize Airplane, “NMA”). But in 2011, when American Airlines announced a record order for 460 single-aisle planes from Airbus (260 A320, 130 of which were the A320neo) and 200 737s from Boeing, Airbus had managed to break the longstanding monopoly Boeing had with American.
The Airbus order, “loss aversion’ and market forces forced Boeing to commit to revamp its best-selling 737 with new engines rather than develop an all-new NMA. Analysts had said that developing an all-new replacement for the 737 would have cost Boeing as much as $12 Billion. But with the 737MAX grounded world-wide since March 2019, Boeing has now booked $9.2 billion in charges. In the rush to meet market competition Boeing opted not to develop the new jet. Now, Boeing may still be required by regulators to re-approve the plane as a separate aircraft type from the 737 family.
As investment decisions are evaluated, a misalignment of time horizons frequently leads to the wrong decisions. Short term paybacks are favored over the impact decisions may have on longer investment horizons. Precision scheduled railroading (“PSR”) promises to improve operating ratios, train speeds, and yard through-put. But the Rail Industry is not addressing how to provide delivery precision to the final railway freight shippers’ docks. Boeing’s re-engined 737 and the Class One’s PSR implementation are examples of optimizing short-term performance at the expense of customer relationships and longer-term corporate health. Boeing feared the loss of market share and Class One’s fear of being left behind. This ‘loss aversion’ phenomenon can lead decision-makers astray.
Be reluctant to ‘bet the farm’ on these larger decisions. Minor decisions can be managed as part of a long-term diversified risk-mitigating strategy. The way to become better is by using tools and techniques that create a culture of constructive debate. Initial assessments should be supplemented with independent second opinions.
The economics of transportation equipment investment are complex. Take a fresh look and ensure the right questions are being asked and answered. When does it make sense to take risks? Call RESIDCO.
Residual value forecasting for transportation equipment often begins with an expected value curve that traces ‘value decay’ over an asset’s assumed useful life. Once the basic value curve is in place, value volatility must be considered and incorporated (value decay curves do not provide an accurate forecast since the value of transportation assets doesn’t always go down).
Overlaying volatility allows an estimate of the range of expected value at any point, given the impact of expected changes in market factors and customer needs on specific equipment types in the portfolio. The economics of an investment requires lessors initially measure their residual as the present value of the amount that they expect to derive from the underlying asset following the end of the lease term; This is a value that is not guaranteed by the lessee or any other third party unrelated to the lessor, discounted using the rate implicit in the lease. An investor’s individual risk tolerance affects residual values that eventually are incorporated in the economics of lease return calculations. At the same time, accounting recognizes book income during the life of a lease based on the assumption that residual values will be realized, unless ‘impaired.’
Aircraft values were impacted by the events of 9/11 and by the 2008 global financial crisis. Passenger and freight traffic tumbled, and airlines parked their jets by the hundreds and returned leased planes as lease contracts expired. Yet over the decade following 2008, the global airline industry logged ten consecutive years of profitability.
Effects of Equipment in Storage
Today, as CSX, Norfolk Southern, and the Union Pacific implemented Precision Scheduled Railroading, they are storing or returning locomotives and freight cars, idling yards, and laying off employees. On December 1, 396,200 railcars were in storage, almost 25% of the 1.7 Million car fleet (storage levels last peaked in 2016 at 425,000 cars). The future economics of these car types are complex. Of the railcars in storage, 35% are Covered Hoppers, 28% Tanks, and 12% Coal Gondolas.
Equipment in storage, whether a locomotive, railcar, or a 737MAX that is not flying, is worth less than if in service. Planes are built to fly. Once recertified, it will take 100 to 150 hours of additional work for each 737MAX to return to flight. Maintenance must spool the engines and boot up a flight computer and auxiliary power units every week. Exterior surfaces and cabin interiors must be protected. The longer in storage, the more maintenance needs to be done.
Are These Assets Impaired?
“Impairments” are recognized only if there is a “permanent” reduction in value (the amount of an impairment loss being the difference between an asset’s carrying amount and its current fair value). With a 30% decline in value, an investor who is leveraged 2:1 would experience a 60% decline in net worth if they were to take a write-down. Bank lessors, who are typically leveraged 10 to 1, will elect to store their equipment rather than sell into a down market. Next year’s equipment values will be impacted by the existing fleet, new equipment demand, the business cycle, and the always unpredictable ‘unexpected’ events. Strategic thinkers leverage experience, judgment, and proprietary data to manage residual risk and achieve investment goals. Call RESIDCO.
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  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 , the Class Ones remain insistent on maintaining pricing. It’s alienating shippers . 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.
 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.
 See Railway Age, October 23, 2019, “We Are in A Freight Recession”.
 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.
 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.
Article 1, Section 10, of the U.S. Constitution (the “Contract Clause”) contains a list of prohibitions concerning the role of the States in political, monetary, and economic affairs . The laws of some countries require damages that may be recovered for breach of contract or other obligations be limited to the level of damage or loss suffered. For example, in English law, any provision in a contract, such as a liquidated damages clause seeking to set damage levels, will be void if it exceeds what would be a genuine pre-estimate of damage. It would then be for the court to determine the appropriate level of damages.
When parties are sophisticated and deemed to be on equal footing, U.S. contract law is generally treated as a matter of private law. Yet U.S. Courts have adopted a distinction that Constitutional obligations mandated by the Constitution’s ‘Contract Clause’ preserve obligations under a contract but do not prevent the State from limiting remedies. This doctrine rests on the idea that enforcing a contract is a matter of ‘public law’ since delivering justice is a public affair, done at the public’s expense.
The market, the credit, the asset, and the transaction structure demand that documenting an equipment lease financing transaction requires a level of predictability. By importing public policy considerations into contract law, Lessors have found it increasing difficult to identify solutions Courts will allow when considering the enforceability of default remedies. We played a leadership role fighting to enforce validly formed contracts in the Southern District of New York (the Republic Airways  bankruptcy case). The facts there were uncomplicated. We acquired aircraft leases in the secondary market. They included stipulated loss values commonly found in equipment finance lease agreements. Those stipulated loss values were unconditionally guaranteed by the lessee’s parent. The original sale lease back had been renegotiated several times, but the stipulated loss tables had remained unchanged. On default and the subsequent bankruptcy of both lessee and the parent guarantor we sought to enforce the express terms of the agreements we considered part of the consideration in originally acquiring the transactions. Even in light of the specific provisions of Article 2A of the Uniform Commercial Code (“UCC”), and the sophistication of the parties involved, the Bankruptcy Court found the liquidated damages provisions (and ‘hell or high water’ guaranty) unenforceable under Article 2A-504 of UCC. Why? The Court found they “violated New York ‘public policy’ and constituted unenforceable penalties.” ‘Public policy’ bias explains, more than any amount of legal analysis might, the reception we received in New York.
As much as we disagree, Lessors must now review and revise liquidated damages and related default provisions to maximize the likelihood of withstanding judicial review. On default, if remarketing values go down, will the lessee still be bound by SLV agreements?
The sanctity of contracts require respect for the freedom of contract. Solutions require both legal and commercial judgement. We have that experience. Call RESIDCO.
 Art. 1, Section 10, the Constitution of the United States of America, “No State shall …pass any law impairing the Obligation of Contracts.
 In re Republic Airways Holdings Inc., 2019 WL 630336 (Bankr. S.D.N.Y. Feb. 14, 2019).
 In Exxon Corp. v. Eagerton, 462 U.C. 176(1983), the Supreme Court found that a ‘broad societal interest’ was sufficient to justify a decision to prevent a company from asserting its explicit contractual right to pass on any increased severance tax to its consumers.
 Also see ‘Republic Airways: Crash Landing for SLV Damages’, in Equipment Leasing and Finance, October 2019 by Stephen T. Whelan, ‘posted with permission from the Equipment Leasing and Finance Association’s Equipment Leasing & Finance magazine’.
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The 737MAX 8 was developed from the 737NG and certified by the FAA on March 8, 2017. The aircraft is powered by CFM LEAP-1B engines which are 12% more fuel efficient than the CFM56-7B engines used on the 737NG. The airframe has a length of 129 ft. 6 in. (39.47m), a wingspan of 117 ft. 10 in. (35.9m), and a maximum payload of 46,040 lbs. It includes a newly designed winglet (the 737 MAX AT Winglet) which maximizes the efficiency of the wing. The MAX 8 offers seating capacity of up to 210. Undiscounted sticker price? $121.6 million.
The 737 ‘Classic’ was originally designed in the 1960s and over time was revised to increase range and passenger capacity. In 1991 Boeing developed the 737 NG (“Next Generation”) to compete with the Airbus 320. Boeing has delivered 350 of the 737 MAX 8 since 2017 and has an order backlog for 5000 more. The more fuel efficient MAX 8 engines are larger and heavier. To accommodate their larger diameter they needed to be moved slightly forward under the wing and higher up to keep them out of the way of the landing gear (and for ground clearance). The repositioned engines changed the handling characteristics of the aircraft. As an aircraft takes off the angle of attack (“AoA”) of the wings is higher than at cruise. Because the engines had to be repositioned forward the nacelles that hold the new LEAP-1B engines are actually ahead of the aircraft’s center of gravity. This forward placement creates greater lift at higher angles of attack (the engine thrust on takeoff is downward which adds more lift forward of the center of gravity as the aircraft takes off). It’s this additional lift created by the engines that produce a pitch-up effect that further increases the angle of attack the moment the pilot releases pressure on the yoke. The result can send the aircraft into a stall. To compensate for this pitch up effect, Boeing introduced the Maneuvering Characteristics Augmentation System (“MCAS”) which causes the aircraft to tilt its nose downward. It is the aircraft design and engine placement that requires the installation of the MCAS to automatically trim against this extra lift effect. Why? So that the plane and pilot population could fly the aircraft without the time or investment needed for a new type certification and additional pilot training.
During manual flight, as in takeoff, if the angle of attack is too high (or if the AoA indicator is faulty) the MCAS will trim the aircraft stabilizer ‘nose down’ a maximum of 2.5° (for a maximum of 10 seconds). It can be interrupted by the flight crew by using the electric stabilizer trim which will stop the MCAS. However, after the MCAS has been stopped once, it will reactivate in 5 seconds and requires additional pilot manual trim commands. To prevent constant manual trim (‘runaway trim’) the stabilizer trim cutout switches must be moved to ‘cutout’ to resolve a false or a continuing high angle of attack indication. If the cutout switch is not used the MCAS will not reset the trim tabs from their current position and will continually pitch the nose down in additional increments of 2.5%, ultimately pitching the nose down as steeply as it can. Without adequate training a flight crew’s reaction would be to pull back on the yoke and increase engine thrust which would not act to overcome ‘runaway trim’ but would result in an accelerating nose down dive. Until the flying public regains confidence in Boeing’s correction of this MAX8 flight control issue other 737 models will experience a short term period of higher demand similar to what we witnessed with other widebody aircraft during the 787 Lithium ion battery issue a few years back. Most importantly the MAX8 tragedies remind the airline industry that safety never stops being job number one.
Until Hunter Harrison, there was a lack of focus on how efficiently rail assets could be employed. Customers demanded service and the railroads invested. More equipment was better. The result was a consistent inability of the roads to cover their cost of capital. Herb Kelleher founded Southwest Airlines as a low cost no-frills regional. It first took off in 1971 and changed the nature of air transportation for millions of Americans. Both Hunter and Herb focused on transforming operations. Hunter’s message? Here’s what really matters: “Precision Scheduled Railroading”. Sales and customer service focus on driving top line growth while operations and investment measures focus on asset turnover and margin improvement (e.g. lowering the ‘operating ratio’ for railroads). In both the Air and Rail industry the challenge is to design, invest in, and manage network capacity so that it best meets customer demands while managing pricing, maximizing profitability, and meeting society’s goals. As Matt Rose, the retiring Executive Chairman of the BNSF recently stated, “It’s a three legged stool”. Customers, Capital, People (and politics).
What’s the key metric? Return on invested capital (ROIC) is the one metric that captures both operating margins as well as the capital required to generate it. It tells us how much a firm earns for each dollar invested. When ROIC is greater than your weighted average cost of capital you are creating “investment” value. Identifying the components of ROIC and acting on those components is what creates value. But ROIC is a Wall Street investment analyst measure and discussions are generally confined to finance departments. The genius of both Hunter and Herb is that they understood the components of ROIC. They inspired, motivated, and challenged their people to focus on constantly improving performance. Net operating profit after tax (‘NOPAT’) as a percent of Invested Capital is used to generate ROIC. The main components of invested capital include equipment, spare parts inventory, operational facilities, and the ‘working’ capital needed to run operations. But the formula doesn’t identify how to influence the value drivers. The ‘DuPont’ analysis disaggregates ROIC into its key parts: return on sales (NOPAT/Sales) and asset turnover, or capital productivity (Sales/invested capital). Both return on sales and capital productivity measures can be further broken down. It’s these components that managers must act upon. Understanding this allows operations to identify the causes of differences in performance over time and among competitors. Activities can then be designed to increase both return on sales and capital productivity, thus maximizing value. Strategies that improve capital asset productivity are the focus of precision scheduling railroading. Eliminating excess equipment from the system and increasing the productivity of remaining equipment. For Southwest Airlines it’s a commitment to their people and to operating a single type of plane (the Boeing 737). The other component of capital productivity is sales. So, finding ways to expand offerings that drive revenue growth using existing equipment is key.
The BNSF’s focus is on long term investment results. Charlie Munger, Buffet’s right-hand man, says “We don’t have to make the last dollar”. And, as Southwest’s Herb Kelleher once said, “We have a strategic plan. It’s called doing things.” With a focus on the mechanics of Air and Rail equipment finance, industry conditions, competition, customers, investment returns required to deliver capacity, and the people and politics of service delivery, we’ve designed a platform for sustainable Aviation and Rail investment. If you are interested, call us. Call RESIDCO.
As we close out 2018, it’s time to look ahead. What’s in store for 2019? Equity markets and global political conditions are volatile while the fundamentals of the U.S. economy remain strong. Market turbulence can be caused by a number of factors; the impacts of some we can forecast, the impacts of others are not fully knowable. Everyone has opinions. Here are RESIDCO’s insights from our own analysis.
Unemployment and Wage Rates
Last week, the U.S. Bureau of Labor Statistics reported the unemployment rate unchanged at 3.7% (for the third month in a row). That’s a low not seen since 1969. Low unemployment tightens labor markets which lead to wage increases. Full employment elevates consumer confidence and drives consumer spending.
But rising wages pressure inflation and the Federal Reserve’s expected response will be to continue to raise interest rates which will create a moderately more challenging business environment.
Also announced last week, U.S. shale production turned America into a net oil exporter for the first time in 75 years. Crude oil and jet fuel pricing are moderating. Trump’s Tax Cut and Jobs Act and deregulatory agenda have driven domestic growth above trend.
GDP has expanded by 3% over the past year and the Federal Open Market Committee expects it will continue to grow above trend in 2019. Over the past thirty years, the average growth in revenue passenger kilometers (“RPK”) has exceeded global GDP growth by about 1.7 times each year. Applying this history to recent International Monetary Fund economic forecasts implies expected global passenger growth of ‘around’ 6.3% for 2019. Despite market turbulence, the outlook for 2019 remains positive. Commercial aircraft manufacturer order books certainly support this optimism.
Bracing for Turbulence
Prior to every flight, a pilot checks the weather. Flight risk is mitigated by adjusting routes to avoid thunderstorms and icing. The FAA defines Clear Air Turbulence (“CAT”)’ as sudden, severe turbulence occurring in cloudless skies that causes violent buffeting of an aircraft. It’s a recognized problem that affects all flight operations and is especially troublesome because it is often encountered unexpectedly and frequently without visual clues to warn pilots of the hazard. The first step in avoidance of hazards? Establish access to the best available information for planning flight operations.
Similarly, when heading into economic turbulence consider your investment horizon, goals, and risk tolerance. Different aircraft portfolios react to turbulence in different ways. The solution is to develop a set of protocols that deal with uncontrollable events. An example: earlier this month the yield curve flattened, producing its first ‘inversion’ in more than a decade. History shows inversions have preceded all nine U.S. recessions since 1955 (with lag times from six months to two years). The year ahead won’t bring the end of the current cycle. There is time to dodge market turbulence, secure the cabin, and adopt defensive investment strategies.
Late cycle investing for current income and capital appreciation? Call RESIDCO.
The commercial aviation fleet consists of large passenger jets with over 100-seating capacity and regional jet aircraft with up to 100-seats capacity. Regional jets fly routes that can’t be flown profitably with the larger aircraft. About 43% of all domestic major carrier U.S. flights use the smaller regional jets to bring passengers to their mainline hubs (travelers prefer the regional jet to turboprops, and American, Delta, and United are removing the last of their turboprops this year). From 2017 to 2032 it is expected the U.S. will account for 70% of the world’s regional jets.
The U.S. Regional Jet Market
Our domestic markets are competitive, and fares have fallen due to increasing capacity, the growth of domestic discount carriers and consolidation in the industry.
The major U.S. air carriers are focused on optimizing the profitability of both their mainline and regional networks. The current hub and spoke model of the major carriers allow larger aircraft to serve major population centers while the regional jets serve smaller communities that are too far for a turboprop, but not busy enough to make a larger aircraft profitable.
Profits are closely tied to carrier networks, their labor contracts, fuel cost, and the capital cost of aircraft. Mainline pilot union’s “scope” clauses limit the number and/or seating capacity of aircraft a major air carrier is allowed on a “regional” airline (to protect higher-priced union jobs from being outsourced to lower-priced regional pilots).
The Evolution of the Regional Jet
Bombardier stretched its Challenger business jet in 1989 into a small airliner seating 50, the CRJ100. They followed with the CRJ200 which also seated 50 but had more efficient engines. Brazil’s Embraer followed with its ERJ135 (37 seats) and ERJ145 (50 seats). Even as the OEMs move to larger regional jets this market is facing the same challenges as the larger aircraft markets. Increasing use of the latest materials and most efficient engines ensures the latest generation of regional jets will be as lightweight and efficient as the larger jets.
While larger jets will always beat out the smaller aircraft based on their economies of scale the reason the majors operate the smaller jet is to find the right size the aircraft to the mission. In markets that cannot exploit the larger aircraft, the regional jet flourishes. In these markets, the smaller jet offers better economics and flexibility. As an example, United is adding regional capacity to drive traffic to its hubs. And frequently the term “regional” is a misnomer when for example airlines will add smaller jets to beyond the “region” to enhance schedule availability. United’s 2018 fleet plan calls for an increase in its regional fleet by 36 aircraft, with 50-seat regional jets accounting for virtually the entire increase. The current availability of the 50-seat jets has made it a short to mid-term solution until United can reach a deal with its mainline pilot’s union.
Regional Jet Investment Opportunities
Regional jets have transformed the airline industry by facilitating much of its expansion. These jets allow increased profitability and flexibility in route planning. They’ve helped build the legacy carrier hubs and, as United is demonstrating, continue to do so. As oil drops, the 50 seaters offer immediate availability. The legacy network carrier and their pilot unions hold the key to weight and seat count restrictions on future deliveries of larger regional jets.
The coronavirus was the turning point. Schools and universities are being closed. Public activities are being canceled. Air travel and supply chains are being disrupted. Companies are telling employees to stay put. The virus constitutes a force majeure event. Even before the U.S. ban on travel from Europe, Air Carriers were reacting by trimming capacity, […]