Liquidity buffers, loans, restructuring operations, cost savings. As the pandemic lingers it continues to depress economic activity.
The drop in passenger traffic is driving air carriers to constantly adjust network flight schedules and evaluate equipment needs and workforce reductions. United is exploring the possibility of a fall workforce reduction and American is considering similar plans. The major carriers are moving forward signing letters of intent lining up U.S. Treasury Department loans as their net bookings drop. Twin aisle and aircraft with higher operating costs are being parked. Newer more fuel-efficient single-aisle jets that can be filled with passengers more easily would be preferred.
But with demand down and list prices near $120 million, financing is challenging. United’s CEO, Scott Kerby, earlier told an investor conference “We won’t be taking delivery of a single aircraft unless it is fully financed.” American’s CFO has told Boeing it will not take delivery unless aircraft are financed under terms similar to those it enjoyed prior to the pandemic; “No financing, no 737 Max deliveries.” Delta said it will not take delivery of any new jets this year. Of Boeing’s 737 MAX on the ground inventory, 41 units are currently unclaimed (about 10% of the total parked). By year-end, as many as 155 may be without takers.
Airbus has reduced production rates of its A320 by one-third. Its CEO, Guillaume Faury, said in late April, “we’re facing the gravest crisis this industry has ever experienced”. The engines that power these aircraft are sold at a loss in order to secure long term service revenues. Ninety percent of Rolls-Royce Trent engines operate under service agreements that require airlines to make payments based on flight time. General Electric and its joint venture partner Safran (SAF, France) manufacture the Leap engines which power the MAX. They operate under similar long-term service agreements. The demand downturn is forcing Rolls-Royce to reduce production. It has resulted in a 17% workforce reduction (9,000 jobs out of its global workforce of 52,000). GE Aviation is implementing similar workforce reductions.
But discount carriers sense an opportunity as the legacy airlines retrench. Low-cost Allegiant Travel, CEO Maurice Gallagher Jr.: “I expect we will thrive in this changed environment.” Jets at bargain prices will be available as the legacy carriers retrench and sell aircraft.
In Rail, U.S. Rail carloads improved slightly in June but are still down 22.4% from 2019. Carload declines continue across the board with declines in coal, crushed stone, sand, gravel, motor vehicles and parts and chemicals. Coal continues to lose its share of U.S. electrical generation. Despite declining U.S. rail volumes Class Ones are improving their operating ratios (operating expenses as a percentage of revenues) as they focus on equipment and workforce efficiencies driven by Precision Scheduled Railroading. A third of the North American rail fleet remains in storage. But lower operating ratios make more cash available. With nonfarm payrolls rising by 4.8 million in June the unemployment rate fell to 11.1%. As Glassdoor economist Daniel Zhao puts it: “It’s fair to say the recovery has started, but that’s not a guarantee that the recovery will continue uninterrupted.” Its timing and path will depend on a Covid-19 solution.
As business models are being disrupted market realities are transforming transportation investment management. Identify and capitalize on current opportunities. Call RESIDCO.
Aviation and rail equipment lease rates and equipment values are stressed as operators adjust equipment capacity to meet current levels of demand (and adjust to the Class One Roads implementation of Precision-scheduled railroading “PSR”). In the near term, lessees are focused on ensuring the sustainability of their business by attempting to defer new delivery commitments and restructure existing lease terms. OEMs are doing the same as they adjust production schedules in recognition market demand will be lower until the virus clears.
The unknown duration of the path back to where the economy was before the pandemic adds complexity to evaluating equipment opportunities, whether under lease or currently stored. Secondary market values are often impacted by new equipment pricing and specific lease maintenance and return conditions if under a lease.
Technical factors also impact values. Standard configurations and deep markets mean units are easier to place. Special features can help equipment retain value. An example: a higher maximum takeoff weight enhances an aircraft’s utility and consequently its value. If it’s part of a family (e.g. A320/A321, or B737-800/900/MAX) equipment will retain value as operators benefit from lower investment in parts, equipment, and pilot training. Lower fuel prices improve demand for older aircraft. If fuel prices advance, demand for older units will be depressed, shifting operators’ preferences toward newer, more efficient aircraft. Lease rates for the single-aisle Boeing 737-800, the 900ER, and Airbus A321s remain “relatively unscathed” with fleet weighted average declines of around 5% or less since January 30th. And data shows the more fuel-efficient A320neos are being favored over the older A320ceos (54% of the A320ceo remain in storage, compared to only 30% of the A320neo).
Older equipment may appear less attractive due to operating economics or functional obsolescence. But a lot of planes parked in the desert could offer better returns than new equipment. Fifteen percent fuel savings on new aircraft may not justify their capital cost. As demand reappears some of these surplus units might be economically leased to second or third-tier operators or sold to another lessor or operator.
For Air, more than half of the world’s passenger jets are now in service. In Rail, the combination of lower rail freight volumes and the Class Ones’ implementation of PSR has placed 31% of the 1.67 million-unit North American rail freight fleet in storage (520,729 freight cars). Maintaining customer relationships is the key to today’s markets. Rail ‘relationships’ are being tested as rail shippers are being required to transition their operations to comply with the Class One’s PSR schedules. Rail modal share will grow only if the Roads better integrate intermodal and trucking to give rail shippers an ‘end-to-end’ solution.
The U.S. entered the recession as the strongest world economy. Now, “The big picture is the economy is on the road to recovery and we have passed the worst”. With fall elections approaching and an expectation of additional government spending on infrastructure, the recovery will continue. A return to moderate growth means the outlook is becoming brighter. Identifying opportunities is constant in portfolio management. Call RESIDCO.
As the U.S. economy began to reopen, investors looked past the pandemic and optimism drove financial markets to within 4.5% of their all-time high. Lockdowns eased and a stronger than expected jobs report (2.5 million new jobs added in May) indicated the U.S. economy was impatient to reopen. American and Delta reported progress in summer demand, shoppers are returning to stores, and Europe and Asia have restarted portions of their economies. After the Fed announced plans to keep interest rates near zero for an extended period (at least through 2022 indicating they are expecting an extended recovery) the markets retreated.
The virus remains a reality and there are concerns over a possible recurrence of COVID restrictions. But a vaccine is expected to be available within a year (perhaps as early as this fall) and a June Wall Street Journal survey reports 69% of economists expect a recovery in the third quarter. The uncertainty that is driving daily volatility is dictating a ‘bumpy’ recovery.
The nature of the passenger aviation industry is such that flight operations will have to deal with a slower recovery than the wider economy. S&P Global Ratings expects global air passenger numbers to drop 50% to 55% in 2020 compared with 2019, and travel demand to remain below 2019 levels until 2023. Idle U.S. passenger aircraft peaked in mid-May. United is reinstating flights at over 150 of its U.S. and Canadian destinations in July to 30% capacity. American announced it will increase domestic flights in July, to 55% of its July 2019 schedule. Recovery of global passenger travel will take additional time and require the implementation of agreed international safety procedures and removal of quarantine restrictions.
The lack of passenger revenues is driving temporary conversions of passenger aircraft to freighters and increasing sale-leaseback financing activity (since March 1st lessors have closed multiple transactions with Delta, Southwest, American, and United). Virgin Atlantic increased its cargo-only flights by more than one-third to nearly 600 in June, breaking its record for freight carried in May. British Airways began operating two 777-200s as cargo-only flights with cargo on seats. China Eastern Airlines is using 13 reconfigured A330-200s in temporary cargo service. Emirates has converted 85 of its Boeing 777-300ERs as stand-in freighters (in addition to their 11 777Fs). Some carriers are considering repurposing 737NGs as freighters and then arranging to replace them with MAX sale-leaseback financing. Older A380s can be moved to second lives as freighters. A ‘shared space’ 747-400M, in service with KLM since 1989 continues to fly. It has capacity for 268 passengers with a locked bulkhead on the main deck separating the cargo area from the forward passenger cabin.
Rail volumes remain stressed. U.S. rail freight carloads fell 27.7% in May from the same period in 2019. That is the largest year over year decline for any month on record. May was also the worst month for U.S. coal carloads in history. Cars in storage increased to 520,729 units. But consumer confidence rose, and both the Purchasing Managers and Non-Manufacturing Indexes rose. ‘All indications are that we’re starting to bottom out”.
To update your evaluation of the duration and volatility of factors influencing aviation and rail asset values, call RESIDCO. It’s key to setting the stage for tomorrow’s portfolio growth.
The past aviation super cycle was driven by growing demand from Asia’s emerging middle class (China) as well as the expansion of no-frills carriers. With much of the world now subject to air travel restrictions more than two-thirds of the world’s passenger aircraft are parked. The reality is that most of these aircraft will be parked for the remainder of 2020.
Boeing expects air traffic may not return to 2019 levels for two or three years (David Calhoun at a recent investor presentation announced, “we will be a smaller company for a while.”) Airbus, the European plane maker, is cutting jetliner production initially by a third, and embarking on a plan to ‘right-size’ its business. In a ‘Best Case’ scenario traffic will return to ‘normal’ mid-2021. While both are optimistic air traffic will eventually revert to its long-term growth path, the reality is they just do not know when.
‘Lockdowns’ are causing businesses to lay off workers where face-to-face interaction is unavoidable. Over the past six weeks, the Labor Department’s initial jobless claims have totaled over 30 Million (unemployment is forecast at 20%, the highest since it reached 25% during the Great Depression). With the U.S. economy shrinking at a seasonally adjusted annual rate of 4.8% in the First Quarter and a further decline expected in the Second Quarter, we are entering a recession.
Conservative ‘Worst Case’ estimates expect a ‘U’ shaped recovery – two to three years for air traffic to return to trend line growth; Domestic narrow body smaller aircraft traffic first, International traffic later. Airline executives are now leaning toward smaller aircraft that can be more easily filled in a time of depressed demand. Delta is keeping all 31 of its fleet of A220s flying, despite grounding more than half of its fleet (it has firm orders for an additional 64). Boeing terminated discussions with Embraer SA (which produces a rival to the A220) and will now rely on returning its 737MAX to service. Will cabins be configured to allow social distancing while we wait for herd immunity, require everyone to wear a face mask, take temperatures at the gate, or a vaccine appears? Ultimately, how quickly global traffic recovers will depend on how well the current outbreak is contained and how the global community chooses to work together to limit future outbreaks.
The trend toward younger fleets started after 9/11. Markets were surprised when many U.S. carriers decided not to bring back the 737 Classic. Similarly, the COVID crisis is creating a dynamic that is forcing Carriers to ‘right-size’ existing fleets, retaining newer models, taking delivery of aircraft in the current production inventory (e.g. Boeing’s 737MAX — with financing supplied by the added liquidity the Fed is providing), and retiring older units[1]. Air travel is not going away. Look closely, the pandemic is likely to create asset investment opportunities. But, be prepared for a ‘choppy sluggish’ recovery even after the virus is contained. To navigate to tomorrow’s fleet environment, call RESIDCO.
[1] With oil’s collapse, economics (and load factors) will ultimately decide whether existing equipment remains attractive.
As the coronavirus spread across the world, the recession we were unable to predict arrived. Over 140 countries have instituted air travel restrictions, shelter in place orders, and border closures. More timely global communication and a coordinated approach may have been able to limit the virus’ spread and protect the world’s people and economies. Justin Leverenz of Invesco described the virus as “truly a black swan in the sense of being both unpredictable and an event of massive consequence.”
It’s impacted passenger air transport in an unprecedented manner. In the last two weeks of March, commercial air traffic declined 41% as compared to 2019 levels (the decrease was 55% in the final week of March and is expected to continue). More recent data indicates flights are down 70% since February. Anecdotally, the TSA is reporting 95,000 people were screened on a recent April day, down from 2.3 Million screened the same day last year. The International Air Transport Association (IATA) reports 10,500 aircraft, representing 40% of the global fleet, have been grounded (and it’s expecting the number to increase). Ninety-eight percent of revenue earning routes across the world are now subject to ‘severe’ travel restrictions.
American is cutting 80-90% of its international schedule (and 60 to 70% of its domestic schedule). United’s April schedule has been cut 60%. Delta is set to ground 600 aircraft out of its total fleet of 900. As aircraft are parked, the drop in air travel demand appears to be accelerating the retirement of older aircraft. American has decided to retire their 767s, A330-300s as well as their 757s, El90s and some 737s. Delta is accelerating the retirement of its MD88/90s and some 767s. “People have been asked to put their lives and livelihoods on hold,” said Federal Reserve Chairman Jerome Powell in a Brookings webcast, “at significant economic and personal cost.”
Expectations drive investment, and global recovery will be extended due to the staggered timing of the outbreak in different regions. In the U.S., expect a ‘rolling’ return to an open economy. With the fall elections seven months away, Washington’s fiscal stimulus and the Fed’s monetary actions are equal to more than a quarter of GDP (longer term, these actions will also work to dampen economic recovery). Once a vaccine is developed and global populations immunized, air travel will return to pre-crisis levels. As this year unfolds, we’ll be witnessing reduced consumer spending and lower corporate earnings. Fall elections may determine if we face increasing levels of taxation and government regulation. As economies reopen, the world will work together to prioritize the health, safety, and wellbeing of air travelers.
Transportation asset investment successes come from staying invested across multiple business cycles, and from identifying and investing in themes that continue across those cycles. Economics will dictate whether ‘decommissioned’ units will be replaced with newer more fuel-efficient models (the current absence of the 737MAX is a plus). Every part of a decommissioned aircraft has value (engines are highest in demand).
Today’s dynamic, the non-linear global environment has shown analytical problem solving is not always able to identify the unexpected. It’s the experience across multiple business cycles that provides an ability to identify opportunities and avoid pitfalls. Start thinking about tomorrow. Call RESIDCO.
Freight Demand Sustains Transportation Equipment Investment
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?”
We have some answers. Call RESIDCO.
Air and Rail Investments
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. Rail transportation is a high-volume low-value freight business while air is 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.
Minimize Risk
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.
Prepare Now
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.The Foundation of Investment Decisions
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.
Mitigating Risk
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.
Value Forecasting
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 [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.
RESIDCO’s size and wholesale capability is a competitive advantage. We respond quickly and creatively to ever-changing market conditions.
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