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.

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 [1].  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 [2] 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 policybias 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[3]? 

The sanctity of contracts require respect for the freedom of contract.  Solutions require both legal and commercial judgement[4].  We have that experience.  Call RESIDCO.  

[1]  Art. 1, Section 10, the Constitution of the United States of America, “No State shall …pass any law impairing the Obligation of Contracts.

[2]  In re Republic Airways Holdings Inc., 2019 WL 630336 (Bankr. S.D.N.Y. Feb. 14, 2019).

[3]  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.

[4]  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’.

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.

Domestic Growth

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.

What is a regional jet?

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.

Exploring regional jet investment opportunities? Call RESIDCO.

U.S. Economic Expansion

Revenues among the leading airline groups rose more than 10% last year and operating profits remain at historic highs. The economic indicators that make up the Conference Board Leading Economic Index were up .2% in May suggesting we may be approaching a ‘late growth stage’ of the current cycle. Most U.S. economic expansions have lasted more than three years, while recessions typically no more than 18 months. The current expansion started in June 2009 and will become the longest on record in July 2019 based on National Bureau of Economic Research figures that go back to the 1850s.

Growth in Aviation

The Aviation business continues to enjoy global traffic growth with 7% growth in RPK this year (well above the 20-year average of 5.5%) and cargo growth of 4%. We are in an expansionary period. But headwinds have begun to appear as inflation is near the Fed’s 2% target (expect a continued and gradual rising interest rate environment). Tariffs and trade negotiations are generating turbulence. The Asian markets are significant (Boeing has said China will need 5,730 single-aisle planes during the next two decades). Labor pressures, rising interest rates and jet fuel price volatility are all squeezing operating margins. And, on the horizon is a looming pilot shortage.

As we approach late stage growth in the current business cycle, industry operations have stabilized amid continuing strong passenger demand and the unbundling of ancillary ‘service’ revenues. Both have allowed carriers to cover climbing unit cost.

Aircraft Investment

In this environment investing in aircraft is a good business, even when financing aircraft to less than stellar credits, and even if we’re headed into what appears to be risky jurisdictions. Buffet’s Berkshire Hathaway manages a $200 Billion portfolio; he returned to investing in the aviation industry in 2016. Recently he has been increasing his investment in SWA and Delta, operators that have the best return on invested capital. Return on invested capital (profit margins multiplied by asset turns) measures how efficiently aircraft are used. While ROA is not the same as returns to shareholder/owners due to factors such as debt, accounting policies and taxes, operators who produce a good return on assets create value. Southwest is a good example. By flying just one type of aircraft (737s), built by a single manufacturer (Boeing), they control pilot and mechanic training and cut down overall cost.

With solid U.S. growth, few economists expect a recession in the near term. Interest rates remain low and inflation is just now touching the Fed’s 2% target. As fuel, labor, and interest rates rise, IATA is forecasting profits of the world’s biggest airlines will dip. Despite cost pressures, the airlines’ return on invested capital will top their cost of capital for the fourth consecutive year. Markets are global and a focus on network planning and efficient aircraft utilization is key.

Historic high returns (over 9% annually) and low volatility. Understand aviation investment’s key performance drivers. Want answers? Call RESIDCO.

Transportation plays a fundamental role in global market integration. The traffic flows of trading nations affect the structure and location of manufacturing facilities, the frequency of trips, distances travelled, transport modes, and equipment selected.

Aviation Traffic

Global air cargo traffic is up. The heads of air cargo surveyed by IATA remain positive in their outlook for air freight and expect continued growth in volume. They are especially bullish on the outlook for cargo yields. Despite increasing trade tensions, global trade is expected to accelerate in the third quarter of 2018. The DHL Global Trade Barometer, a new and unique indicator, confirms this robustness. Growth dynamics are primarily coming from global air.

Airbus and Boeing support these growth conclusions, each having released their 20-year market forecasts at the Farnborough Air Show on July 17th. The demand numbers for single aisles, widebodies, and freighters are all up, based on passenger traffic growth and driven by expected aircraft retirements. The industry’s demand cycle shows no sign of slowing.

Rail Traffic

Rail traffic is up. Traffic on U.S. Class One carriers for the week ended July 7th totaled 485,193 carloads and intermodal units, up 8.6% from the same week in 2017. Carloads were up 5.4% while intermodal volume was up 12%. Nine of the ten carload commodity groups posted year over year increases, led by petroleum (21.4%), grain (17.7%), and nonmetallic minerals, including frac sand (up 7.1%).

Global Trade

Global trade remains potent even in the face of rising interest rates, oil prices, and potential tariff disruption. Second-quarter GDP increased 4.1% boosted by consumer spending and business investment. Investors and Nations pursue their own best interest and prosperity. Recent U.S. steel tariffs are an example[2]. Steel plays a critical role in building infrastructure and in national defense.

Chinese state-owned enterprises have willingly paid the price of economic inefficiency to accomplish political goals. In free market economies, private industry needs long-term confidence to invest. China’s government subsidies have led to global excess steel capacity, increased exports, depressed world prices and hollowed out other countries’ steel producing industrial bases. As long as it continues China is happy. When America no longer has the productive capacity, China will have won the war without firing a shot.

Some Americans are shocked the U.S. is moving to protect American productive capacity (or that the Administration does not believe in infinite American power). European leaders are shocked their free ride might come to an end. And China is shocked that the apparent self-liquidating superpower of the West might not be so self-liquidating after all.

The advantage lies with knowledgeable players who probe for opportunities, build on successful forays, and have an ability to shift flexibly as circumstances dictate. Success comes with leverage, market position, resources, and understanding. Traffic is robust. Contact RESIDCO today.

Farnborough Airshow 2018

The 2018 Farnborough Airshow is an aviation industry networking hub connecting over 1,500 exhibiting companies and 73,000 trade visitors. Held every two years, this year the Farnborough Airshow takes place between Monday, July 16, through Sunday, July 22.

As global GDP has grown, the demand for passenger and air cargo traffic has followed. Faster transit times for passenger and high-value cargo, higher density city pairs, global connectivity needs and rising affluence among the global middle class are all driving above-trend growth in load and utilization rates.


Airbus agreed to acquire a majority stake in Bombardier Inc.’s C Series October last year and has rebranded the aircraft as Airbus 220. Just last Tuesday they announced an order for 60 A220-300s aircraft with JetBlue.

The A220 comes in two sizes (with a single type rating for pilots) and serves the 100 to 150 seat market segment. It’s primarily a composite airframe with flight control managed by an electronic interface (fly-by-wire, not mechanical), using Pratt & Whitney’s PW1500G, a geared turbofan engine (bypass ratio of 12:1), which delivers lower fuel burn per seat (The A220 offers 29% lower direct operating cost per seat compared to the E190, with fuel cost 40% lower and non-fuel cost 22% lower). It’s able to fly both high-frequency short missions and longer trips that include trans-continental U.S. flights.


Boeing enjoyed $134.8 billion in net orders in 2017 from 71 customers and extended its backlog to a record 5,864 planes (approximately equal to 7 years of production).

Last week, Boeing announced a strategic partnership with Embraer to counter Airbus’ A220. Boeing is expected to take an 80% share in Embraer’s commercial airplane and services business, with Embraer owning the remaining 20%. The venture, which is subject to Brazilian lawmaker review, will position Boeing to serve the smaller single-aisle aircraft while giving Embraer access to Boeing’s sales network and ability to negotiate lower prices from suppliers.


Traffic varies by region, and according to the latest edition of IATA’s 20-year air passenger forecast, Asia-Pacific will be the biggest driver of growth with more than half of new passenger growth coming from the region. China is expected to overtake the US as the world’s largest aviation market around 2024. Boeing currently delivers approximately 70% of its aircraft to non-U.S. customers (with China accounting for 20% of Boeing’s order book).

Politically, China is a ‘collectivist’ society and dependent on central government management. President Xi Jinping envisions a globally competitive aerospace industry and reduced dependence on foreign aircraft makers. China’s two state-owned aircraft manufacturing groups (COMAC, and AVIC) have accelerated development through acquisitions of U.S. aircraft and avionics companies and partnerships with US companies. The price for access to Chinese markets has been required sharing of advanced technologies. This eliminates the need for Chinese investment and speeds their entry into global markets.

The size and future attractiveness of the Chinese market have led western business to invest in China. That investment is working to create a country competitor. Who will have leverage in U.S.-China trade disputes? Most of the planes targeted by recent Chinese tariffs appear to be older versions of the 737.

Yet if China were to cancel orders for newer Boeing aircraft it would be forced to turn to the second-hand market for aircraft (Airbus is booked and struggling to deliver). The result? Expect existing aircraft values to benefit.

Identifying competitive challenges and coping with political uncertainty. For competitive insights and Aviation economic analysis- Call RESIDCO.

Demand in Aviation

Global passenger traffic is growing faster than expected. The International Air Transport Association (IATA) expects 6.0% revenue passenger kilometer (“RPK”) growth for the year, above the 5.5% long-term trend.

This level of RPK growth is indicative of the robust demand in the aviation sector. Rising fares coupled with continuing (but still relatively) low fuel cost and low-interest rates are expected. With tax reform, most agree this cyclical expansion will continue.

The industry’s net profit is expected to be $38.4 billion in 2018, an increase of 11% over record profits of 2017. With rising demand, carriers expect to grow capacity 3.4% in North America. It’s record profits, tax law changes and capital availability [1] that are allowing carriers to consider adding more efficient aircraft in important traffic lanes.

Operational Economics

While fuel remains relatively inexpensive (Brent crude is expected to average $62 a barrel this year, while West Texas Intermediate [the U.S. Standard] should average close to $59), newer technology aircraft are more fuel efficient. A transcontinental trip from New York to Los Angeles is 2,451 miles. Comparative fuel cost on that same trip? 757: $12,000, 737-800: $9,100, and 737MAX: $7,800.

Air carriers are balancing the economics of overhauling lower cost older aircraft (and refreshing interiors) while they wait for delivery of newer technology (better fuel, higher capacity, and distance) but more expensive units. It’s operational economics in competitive traffic lanes that drive aircraft selection. The aircraft finance market for new deliveries is more than $100 billion per year. The Boeing 737-700 has a list price of $75 million, the GE-90 engine that powers the Boeing 777 lists at $24 million each, while the A380 has a list price of almost $390 million U.S.

While improving financials are allowing North American carriers to consider fleet replacement, air carriers continue to operate units for their full life (25 to 30 years). United Airlines is mulling adding narrow-body jets to upgrade capacity on routes currently served by regional carriers (changes are pending an agreement with pilots’ unions).

New orders and the size of manufacturer’s backlogs are driving production rate increases. 2017 commercial jet aircraft deliveries were up 3% at 1617 units. Gross orders in 2017 increased to over 2,500 units (83% of which were for the Boeing 737 family and A320/1). These single-aisle aircraft have coast to coast non-stop range, are the industry workhorses, and are expected to remain so. The world’s commercial fleet which currently estimated at approximately 25,000 in-service aircraft is forecast to expand to 35,000 over the next decade.

The Future of Aviation Leasing and Investment

Operating lessor investors are providing the fleeting flexibility air carriers demand. The number of leasing companies is growing. In 2015 there were approximately 33 such companies with assets more than $1 billion and five with assets worth $10 billion. Today there are over 50 companies with assets in excess of $10 billion. Aviation investment is high profile and high reward, with attractive and stable returns. Nine years of a bull market, still growing and attracting new investment.

The future? Rising interest rates, higher fuel and operating cost, more competition, and more capacity. Investment success is based on aircraft type selection and an understanding of the strength of the user base. Lenders take credit risk, lessors residual risk.

While macro trends are important investing in aviation requires insight into aircraft type residual values and a team of aircraft finance and remarketing professionals. And, investors must ultimately be able to analyze and enforce contractual rights under transaction documents. Global economic growth continues. The air carrier industry is profitable.

With global economic growth continuing, aircraft type investment requires a long view of transaction analytics, including tax, accounting, legal, economic transaction pricing, and future residual values. For profit insight, call RESIDCO.


[1]: In 2017, nine ABS transactions were closed, the most since before the financial crisis.