Rail freight transportation has grown over time with the expansion of the population and economic activity in the U.S. The markets are dynamic. Freight demand is driven primarily by the geographic distribution of the population and the level of economic activity (consumer spending and online ordering have made UPS the largest single rail customer). The U.S. freight rail system owns and operates more than 138,000 track miles and is the dominant mode by tons and ton-miles for shipments moved between 750 to 2,000 miles. Major categories of rail freight flow include:
Intermodal
Rail intermodal volume in 2017 was a record 13.7 million containers and trailers, accounting for 24% of total revenue for major U.S. railroads (and up 7% in the second quarter of this year compared to the same period last year). Intermodal has become the largest single source of U.S. freight rail revenue. Exports and imports count for about half of the U.S. intermodal traffic. Chicago and Los Angeles/Long Beach are the top U.S. metropolitan areas for intermodal volume. In these long-haul markets, double-stack trains are more cost-efficient and environmentally friendly than transportation by truck.
Coal
Coal volume has declined in recent years, but coal remains a crucial commodity for U.S. energy production (and for the railroads). In 2017 coal accounted for 32.2% of originated tonnage for the Class Ones, far more than any other commodity; 522.5 million tons of coal were loaded, up from 491.7 million tons in 2016 (coal shipments accounted for 14.8% of rail revenues in 2017, behind only intermodal).
Most coal is consumed at power plants with 70% delivered by rail. Different fuels dominate electric generation in different states; for example, in Indiana coal accounts for 72% of electrical power generation, while in California coal accounts for virtually none. The key to coal’s future lies in the demand for electricity. If natural gas exports result in an increase in gas prices, expect coal-based generation to be more competitive.
Crude Oil
Historically, pipelines transported the most crude oil. But crude oil production outpaced growth in pipeline capacity and railroads filled the gap. As crude oil output surged, so did crude oil carloads on U.S. railroads. Rail can serve nearly every refinery in the U.S. giving market participants the flexibility to shift product to different places in response to market needs and pricing opportunities. And, rail infrastructure can be expanded more quickly than pipelines.
Grain
The U.S. is the world’s largest grain producer (an average of 569 million tons per year from 2008 to 2017). As of the end of 2017, the North American grain car fleet consisted of nearly 283,000 railcars. Class One’s originated 1.46 million carloads (5.1% of all carloads, 144.1 million tons, or 8.9% of tonnage). The grain markets are complex and are influenced by weather, soil, consumer demand (both in the U.S. and for export), crop yields, competing grain exporting countries, exchange rates, government policy (think ethanol) and ocean freight rates.
Chemicals
Rail originated 2.1 million carloads of chemicals (7.4% of total carloads, third behind coal and intermodal). The vast majority of chemical traffic includes industrial chemicals, plastics, fertilizers, and other agricultural chemicals. The highest volume chemical carried by U.S. railroads is ethanol. Historically only coal and intermodal have provided more revenue to railroads than chemicals.
Investment in transportation equipment is made when earnings are robust enough to attract the capital needed to pay for it. With multiple opportunities available, you need to be alert to the risks and rewards of your decisions. To do that you’ll need the experience to evaluate current transportation facts.
Identifying alternatives, coping with uncertainty. For Rail Investment Opportunities Call RESIDCO.
Farnborough Airshow 2018 Showcases Robust Commercial Aircraft Demand
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
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
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.
China
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.
Transportation equipment investment is a long-term play. While the Conference Board’s index of leading economic indicators suggests the U.S. economy will enjoy solid growth through the end of this year, there are areas where headwinds and complexity exist.
China and America’s Trade
The Trump Administration imposed 25% tariffs on $50 billion of Chinese goods “that contain industrially significant technologies.” The purpose is to stop the forced transfer of U.S. technology (and mandatory joint ventures as a condition for doing business in China). China’s theft of intellectual property and their refusal to let American companies compete freely threatens millions of future American jobs.
China’s “Made in China 2025” plan is to make a China-dominated Eurasia an economic rival to the American dominated transatlantic trading area. The plan prioritizes ten sectors including Advanced Information Technology, Aerospace, Aeronautical Equipment, and Rail transport. But without a free domestic market, China’s production bears no relation to demand and is export driven. Its state-owned company contracts are simply the beginning of negotiations, and cyber warfare and technology theft are embedded in their state-controlled business model.
Evaluating the risk of engaging in a serious ‘Trade War’ and measuring its unintended impact on global economic activity, supply chains, and Air and Rail transportation equipment is critical.
Energy
Oil prices have risen 50% compared to last year. Given the difficult to predict political factors at play, the near-term outlook remains clouded [1]. The Saudis and Russians have indicated a willingness to increase output in response to the geopolitical risk to supply from Iran and Venezuela. Higher oil prices will help American shale producers and increase crude by rail shipments. More oil production means more natural gas. As a result, lower gas prices are expected to reduce domestic coal consumption 2% (to 756 short tons in 2018) as gas-fired plants increase generation of electricity (up to 34% while coal-fired generation falls to 28%).
Aircraft Engines
Spare engine values continue to increase to a point where engines could represent 90% of total aircraft value at 10 years of age if current inflation trends continue. With more than 30,000 in service with over 500 different air carriers, the CFM56-7B engine is the most popular high-bypass turbofan engine in the world. The Federal Aviation Administration has mandated ultrasonic inspection of its fan blade population due to the recent Southwest incident where a fan blade fractured in-flight. Similar problems with the Rolls-Royce Trent 1000 engine (which power Boeing’s 787 Dreamliner) are forcing air carriers to idle equipment.
Rail Investment
Improving economic activity is driving rail carload traffic. It is up 4.2% for the week ended June 9th from the same week a year ago. For the first 23 weeks, carloads are up 1.3% and intermodal units up 3.6%. Rail is continuing to benefit from tight trucking capacity. The percentage of the fleet in storage fell to 18.6% (306,500 railcars, of which tanks comprise 34% of total empty stored railcars).
Over the next four years, the Canadian Pacific (“CP”) is replacing its grain fleet with 6,000 new high capacity grain hopper cars (using National Steel’s shorter and lighter car design with a 15% greater cubic volume). The CP said it will be able to fit 147 of the new cars in an 8,500-foot train, a 44% increase in capacity. CSX has removed its boxcars from the nationwide Boxcar Pool (25,000 remain in the national pool managed by TTX). This has improved CSX service levels but has put an added strain on the shrinking fleet of boxcars which now total about 122,000 cars, down from 660,000 in 1971.
Reality is noisy. To extract transportation investment signals from the noise, get smart. Call RESIDCO.
A Growing American Economy
The U.S. economy is heading into the second half of 2018 with strong momentum. Nonfarm payrolls are beating expectations. Manufacturing and construction indexes are accelerating. Economists are expecting growth through the end of the year between 3.6% and 4.8%. Economic activity, passenger, and both domestic and global air and rail freight traffic flows are growing.
The expected value of our economy is in the direction of its activities, the processes and politics that enable those activities, and the ensuing progress in technology and productive efficiency of its participants. It’s driven by expectations of the future.
While there are many software programs that take into account cost, accounting, tax, and cash flow considerations, these programs may not say anything about the future ‘risk’ of current investment. Risk tools allow originators, investors, and portfolio managers to adjust investment and portfolio structure by testing transaction exposure under different scenarios. Enterprise business intelligence tools keep investment strategy on course and allow it to react to changes.
Recognizing that market volatility often will limit any plan’s short-term usefulness it is important to take a long-term view and look to the underlying direction of economic activity, inflation, and political policy backdrop. The goal is to transform current investment opportunities into revenues that contribute the most to your long-term bottom line.
Risks To Global Growth
Over the past year, global growth has been supported by still relatively low-interest rates, central bank balance sheets, and larger government deficits. But the trend toward nationalism (and economic protectionism) increases the risk of trade tensions, deglobalization, and moderating growth.
Some risks are judged acceptable because of their returns (others may be judged too large to be compensated for). An example: credit risk is the uncertainty about the lessee’s ability to make rental payments. Such risk might be managed with structured rent streams (front-loaded, back-loaded, or level payments).
To manage credit risk, you need four pieces of information: the ‘probability of default’, how that probability changes over your investment horizon, the expected recovery in the event of a default, and an estimate of the variability of each of the previous three. Although you seldom can time the market successfully you can improve your returns by knowing where you are in the business cycle. Given that we are nine years into the current expansion we might suggest there is a relationship between the state of the business cycle and credit risk.
Analytics in Investment
Understanding investment behavior with better information allows you to prepare for success. Advanced analytics are keeping planes flying more than 16 hours a day, helping to spread operating cost. Aircraft manufacturers like Bombardier, Boeing and Airbus are using “AI” (Artificial Intelligence) to scan reams of data in order to monitor their planes in flight. So-called health monitoring on planes such as Bombardier’s C Series allows data to be analyzed more quickly and accurately, enabling preventative actions to be immediately conveyed to airlines.
AI could eventually be used on all systems of aircraft, including brakes, generators, valves, engines, and avionics to extend the life of parts, minimize maintenance disruptions and offer huge savings to operators.
Best results are created with access to a wide range of perspectives. Bill Gates once said, “Once you embrace unpleasant news not as a negative, but as evidence of a need for change, you aren’t defeated by it, you’re learning from it.” Predictive analytics monitors trends and prioritizes investment using data, experience, research, and insight. True value lies in your ability to make reliable predictions.
Leverage our insight in translating raw data into meaningful and useful investment alternatives.
Call RESDICO.
Global Economic Forecast
Investment forecasts are driven by models built on expected levels of economic activity. Shifting international dynamics and the impact of the U.S. Administration’s economic policies are driving changes.
While oil prices remained below $50 for most of 2017, recent volatility reminds us there is uncertainty as to their future direction. OPEC has raised its oil supply forecast based on US output growth. The U.S. is expected to be producing a record 10.5 million barrels a day according to preliminary weekly data from the Energy Information Administration (quickly approaching top producer Russia, which pumps about 11 million barrels daily).
Apart from the U.S., global economic growth is open to impacts from U.S. trade policy and sanctions on Russia and Iran. OPEC, along with Russia has been limiting output since January 2017, in order to drain a glut of oil that caused a historic price crash. The decision to exit the Iranian nuclear deal will mean the U.S. will restore wide-ranging sanctions on Iran, OPEC’s third-largest producer.
This and the movement of the U.S. Embassy to Jerusalem are likely to cause turmoil in the Middle East which will act to support crude pricing. Brent crude oil spot prices averaged $72 per barrel in April, an increase from March, and the first time monthly Brent crude has averaged more than $70/barrel since November 2014 (West Texas Intermediate crude is expected to average $5/barrel lower in both 2018 and 2019).
Transportation Investments Remain Promising
The U.S. and World economies are the basis for longer-term growth for both aviation and rail. The FAA baseline forecast for U.S. air carrier passenger growth over the next 20 years averages 1.9%. This baseline forecast assumes economic growth remains solid as both consumer and business spending expand (the recent Tax Cuts and Jobs Act acting as a near-term stimulus for both).
Compared to the baseline, optimistic cases are marked by more favorable business environments and lower fuel prices. Pessimistic cases are characterized by weakened consumer confidence, higher energy pricing, and higher interest rates which lead to a contraction in the commercial real estate and curtailed investment and spending. Will rising oil prices, rising interest rates, and an international shock lead to a stock market that falls sharply and an end to our long-running expansion?
Rail investment
For Rail, volume growth is continuing. Both petroleum and coal car loadings are improving. Total U.S. rail traffic for the first four months of 2018 has risen 3.2% year-over-year, is a shade below where it was in 2015, but otherwise is higher than it’s been in the last 10 years. The number of railcars in storage continues to decrease (but an oversupply remains which continues to impact demand and suppress pricing). The industry reported quarterly orders of 10,000 railcars for only the second time since the second quarter of 2015. While challenging, the North American railcar markets are improving.
Aviation investment
The Aviation industry consolidated with three major mergers in the last five years*. The bankruptcy of Republic Airlines in February 2016 is a reminder that the resulting financial pressures on regional carriers have not abated. But buried in United’s fleet plan for 2018 is the addition of 40 Bombardier CRJ200s and one Embraer ERJ-145 resulting in a net increase of 38 small regional jets in its feeder fleet. With crude oil pricing increasing, will carriers act to remove older less fuel-efficient aircraft? And, how will the U.S. act to engage with the rest of the global economy?
Industry knowledge, experience, and analysis allows us to adjust for unexpected variances in key variables. RESDICO has the investment insights that produce results. Contact us today!
*The top six, American, Delta, United, Southwest plus Alaska/Virgin and JetBlue account for more than 85% of U.S. airline industry capacity and traffic.
Investment in air and rail assets involves complex disciplines.
These include financing, legal, bankruptcy, jurisdictional analysis, documentation skills, insurance knowledge, residual collateral value expertise, tax structuring, accounting (under the new lease accounting rules), and an understanding of the after-tax cash economics of loan vs. tax lease pricing.
Secured lending is a credit risk and collateral value game. Lease finance is the preferred option, deriving value from the tax benefits the lessor passes to aircraft and rail equipment end-users. These tax benefits take the form of lower rents, flexible terms, early buyout options, upgrades, and the equipment maintenance and remarketing skills the lessor provides.
The Tax Cuts and Jobs Act and Impact on Transport Investment
The Tax Cuts and Jobs Act (TCJA) changed aircraft and rail equipment investment economics. It will change end-user equipment procurement strategies.
C Corporation tax rates have been permanently reduced to 21%, and the corporate AMT eliminated. Non-corporate pass-through entities access to a 20% ‘Qualified Business Income’ deduction is subject to various inequitable limitations and to sunset at the end of 2025.
The Act’s swift passage left application of many of its provisions unclear. As a result, technical corrections through legislative action or regulatory guidance will be required. Some of the significant provisions that affect both C Corps and pass through entities include the following:
100% Expensing
100% Bonus Depreciation is available when equipment is placed in service: 7-year MACRS for aircraft or rail equipment used predominantly in the United States, 12-year straight line for aircraft or rail equipment used predominantly outside the United States.
If the equipment is eligible for 7-year MACRS, the TCJA will permit U.S. taxpayers to elect the higher 100% bonus depreciation (or fully expense the acquisition). Access to bonus depreciation phases down for property placed in service after December 31, 2023, by 20% every year thereafter until it disappears completely in 2027. A significant change allows bonus depreciation for used equipment if the property is ‘new to you’ (note that bonus depreciation would not be available to purchases from related parties).
Ultimately, this full expensing combined with the new interest expensing limitations (see below) will make leasing more attractive.
Sale-leaseback
For example, consider a sale-leaseback. The TCJA will allow the lessor in a sale-leaseback to claim full expensing even though the user of the equipment remains the same. That means end users who have acquired and depreciated air or rail equipment will be able to enter into a sale-leaseback with a third-party lessor and continue to use the same equipment.
The sale proceeds could be used to reduce outstanding debt eliminating interest expensing limitations described below. Each pass-through entity or corporation (including members of a consolidated group) can make their own depreciation election for property placed in service, in each year, by each asset class (disregarded entities or trusts are not allowed separate elections).
However, such depreciation elections will apply to all assets in each class. That means if an entity makes a certain election for rolling stock, that election will also apply to commercial aircraft since both are in the same depreciation class.
Interest Limitation
The TCJA changed financing economics by including a limit on the current deductibility of interest expense. Section 163(j) limits the deduction of “Net Interest Expense” to 30% of the taxpayer’s EBIT (starting in 2018) or tax EBITDA starting in 2022, with any interest expense disallowed carried forward indefinitely. Eliminating a current deduction for 100% of interest translates into higher financing cost. Asset-based Bank Lenders will not be as impacted as non-bank lessors. Non-bank lessors may have to use Section 467 rent structuring to create ‘deemed’ interest income for tax purposes.
The Tax Cuts and Jobs Act provisions will require technical corrections. RESIDCO is leading a pass-through entity interest group that will explore investment alternatives and advocate for private non-corporate owned lease finance investment.
The goal? Level the competitive playing field!
Changing Tax Consequences
Whether you are an investor or a service provider, the Tax Cuts and Jobs Act (the “TCJA”) has changed the tax consequences for entities that compete in the transportation equipment lease finance marketplace. Investment stands on the marginal revenues and cost (including tax) it generates. The great news: TCJA reduces the after-tax cost of capital in our capital-intensive transportation sector.
The foundation of the TCJA was a reduction in the C-Corp tax rate from 35% to 21%. But such a one-sided decrease caused the competitive business playing field to severely tilt. For Equipment Leasing firms and service providers organized as Partnerships, Trusts, S Corporations, or Sole Proprietorships who are considered Pass-Through Entities (“PTEs”) TCJA created new complications with marginal benefit and an adverse tilt of the playing field.
You may recall prior to the subject TCJA and before considering capital gains tax, PTEs were subject to a 39.6% rate or an additional 4.6% over the 35% C-Corp rate. Therefore on $100 of income, the highest bracket PTE was subject to an additional $4.60 or a premium of 14% over the $35 a C-Corp would pay on identically derived income. Under the new TCJA, PTEs are subject to a reduced 37% rate or 16% over the new 21% rate for C-Corps.
Now on $100 of income, PTEs would pay an additional $16 or a premium which is 76% over the $21 a C-Corp will pay on identically derived income. PTEs would have lost the significant advantage over their C-Corp competitors if no additional relief was provided.
Section 199A
In the TCJA, Congress created a deduction for Qualified Business Income (“QBI”) of PTEs enacted under Section 199A and it is among the TCJA’s most complex components. On its surface, Section 199A allows owners of PTEs a deduction of 20% against income from their business. The intent was to reduce the effective top rate for PTEs from 39.6% under the old law to 29.6% under the new law (a new 37% top rate * a 20% deduction = 29.6%). With the 20% QBI deduction, PTEs might lessen their competitive disadvantage over C corporations ignoring capital gains.
But controversy and grey areas remain. The new Section 199A QBI deduction is not fully available to all PTEs. It is subject to both W2 and investment caps. Yet PTEs compete head to head in the leasing marketplace with C-Corps who are not subject to such limitations. PTEs now find themselves at a competitive disadvantage against their C-Corp counterparts who manage investment decisions to maximize after-tax cash to the corporation, not the individual investor. Individuals who have built successful businesses and created jobs as PTEs are faced with competing against this lower C-Corp tax rate without full access to the Section 199A deduction.
Aftermath
The TCJA has created competitive disadvantages. Air and rail investment alternatives have economic consequences and the tradeoffs between C-Corp and PTE equipment investment require clarification. Investors and service providers need clarity in order to make informed decisions regarding cash flow, entity structuring, and investment planning alternatives.
The significant wealth of private equity is invested through PTEs and into transportation equipment. These PTE investors must compete for capital. ‘Grey’ areas in the TCJA are subject to interpretation. There is a need to develop a solid understanding of decision alternatives that give rise to planning opportunities while understanding how to integrate that knowledge into the larger picture of after-tax investment decision making.
This is a call to action. If you are interested in the developing consequences of the TCJA on transportation equipment investment, please contact us. RESIDCO is leading an effort to gain regulatory clarifications, technical corrections and devising optimal entity structures to enhance the impact of the TCJA for transportation equipment investment.
When comparing investment returns it is misleading to simply look at headline figures. At first glance, it might seem an investment that gained 12% last year is better than one that gained 9%. In reality, it depends on how much risk was involved in generating those returns. The more risk (or volatility), the less probable the returns. The simplest way to measure risk is to look at the standard deviation of the returns. The larger the standard deviation, the riskier the investment.
Investors use the ‘Sharpe’ ratio, a ‘rewards to variability ratio’ to better compare alternatives. The ratio uses the standard deviation (a measure of volatility) to measure the ‘risk adjusted’ return. It’s a measure of the excess return over the risk-free rate relative to the standard deviation. It helps answer the question: “Is the ‘risk adjusted’ return worth the investment risk I am taking”?
Investing in commercial aircraft has historically demonstrated returns that adequately compensate for variability. Aircraft are hard assets with long useful lives*. It’s common for a commercial jet to remain in service 25 years or more. Some even longer, such as a 1970 Boeing 737-200 (serial number 20335), which is still flying with Airfast Indonesia (registration PK-OCG, based in the city of Jakarta, Surabaya and Denpasar). At 47 years, it may be the world’s oldest commercial passenger aircraft still in service (the second oldest 737 is registered to Johannesburg based Interair, South Africa, and, Kenya’s Trans African Air has a 42-year-old 737).
Profitability is just as important as equipment longevity. The International Air Transport Association forecasts global air carrier profitability will rise to $38.4 billion in 2018, up from an expected $34.5 billion in 2017. Operating margin, overall revenue, passenger and air cargo traffic, and average profit per departing passenger are all improving. 2018 is expected to be the fourth consecutive year of sustainable profits with a return on invested capital of 9.4%, which exceeds the industry’s average cost of capital of 7.4%.
IATA’s Director General and CEO recently stated: “These are good times for the global air transport industry. Safety performance is solid. More people than ever are traveling. The demand for air cargo is at its strongest level in over a decade. Employment is growing. More routes are being opened.” Operator challenges include fuel, labor, and infrastructure expenses which are rising. Performance drivers? Passenger and cargo growth. All regions are expected to report improved profitability in 2018. Global connectivity is vital to our modern lifestyle.
As a pilot, you identify and avoid turbulence (and if in turbulence, slow your airspeed). Information limitations can impact your ability to see and avoid. Similarly, in piloting investments, techniques are available for avoiding turbulence while enhancing returns. The complexity surrounding aircraft investment and residual valuation requires sector-specific expertise. Generating income, while retaining upside and liquidity over your investment horizon requires contextual expertise. Blue skies or stormy weather? Modern weather and radar equipment suggest you work with investment managers who have demonstrated abilities structuring transactions that produce, regardless of the weather. Generating such results requires an appreciation of risk-adjusted returns.
Aviation and Rail teamwork. We have the investment roadmap. Call RESIDCO.
*Delta operates 860 aircraft with an average age of 17 years, including a 30-year-old 757, and 30-year-old McDonnell Douglas MD-80s. American also operates MD-80s, the oldest of which was delivered in 1986. British Airways oldest aircraft is a 747, registration G-BNLK, which it received on May 4, 1990
According to IMF and the OECD, 80% of the world’s major economies are at full employment. Encouraged by immediate expensing and repatriation of cash from overseas, the U.S.’ traditionally robust consumer demand is now expected to be supplemented by productivity improving capital investment. Transportation investment markets follow traffic demand and with economic growth on the upswing investment fundamentals are favorable.
Aviation Industry
Both Boeing and Airbus single-aisle aircraft are ‘flying high’ with performance metrics investors most care about: cash generation. With order backlogs in place, new equipment deliveries are expected to surpass those of 2017.
The competition between the 737 MAX and A321neo continues. Boeing’s 737 family brought in 745 net firm orders in 2017, up from 550 in 2016; for the 787 Dreamliner family, net firm orders in 2017 were 94, up from 58 in 2016; and, for the 777 family, 60 net firm orders, compared with 17 in 2016. Boeing delivered a record 763 planes in 2017; Airbus 718, and both the A320neo and A321neo order books improved.
However, problems with Pratt & Whitney engines on the A320/321neo Airbus models continue. Engine component failures are causing some of these aircraft to be grounded while engines are repaired or replaced. Both the Boeing and Airbus single-aisle aircraft types will support strong secondary markets long into the future.
Rail Industry
While the broad rail industry environment remains stable, carload traffic (except for intermodal) remains challenged (crushed stone, sand, gravel, petroleum, and lumber and wood products saw carload gains in January). With a tight trucking market, Washington’s infrastructure planning, growing petrochemical production, and shale oil’s return, the Class Ones expect to work this year to build and sustain an ongoing business. Questions remain with NAFTA and coal.
Commodity Pricing
China continues to be a major force in commodity pricing. Price developments in industrial metals will be largely determined by Chinese demand (steel, aluminum, copper). In addition, rising Shale Oil production will act to control crude oil pricing.
Interest Rates
Recent moves to eliminate excessive government regulation (and the passage of tax reform) are acting to boost economic growth. With stronger growth and a tightening job market, interest rates are expected to rise at both the short and the long end of the yield curve. The result is likely to lead to market stress as increasing inflation will prompt the Federal Reserve to raise interest rates even faster than currently expected. Geopolitics and the midterm elections are risks.
Tomorrow’s Markets
For 2018, we expect the world’s major economic regions will exceed expectations. The U.S. expansion will enter its tenth year in March. If it continues through August, it will officially become the longest in history. With the Federal Reserve shrinking its balance sheet and raising rates, market volatility has returned.
Are we at a peak? No.
A recession is not on the near-term horizon as financial conditions have not shown any sign of significant deterioration.
Consider that an investor’s natural aversion to risk often leads to taking more risk at market highs and less at market lows. Today’s environment requires a special degree of foresight and judgment. Attention to economic fundamentals, customer relationships, opportunities, and a focus on long-term results are key. The ultimate risk is not in what kind of investments you have, but in what kind of investor you are. Long-term returns are available to those who focus on disciplined and active portfolio management.
Transportation specialist knowledge is powerful. For uncommon sense call RESIDCO.
The New Tax Law
The Tax Cuts and Jobs Act (the ‘Act’) will be an investment game changer. It is expected to pass Congress and be signed by the President. It will lower the corporate tax rate to 21% and provide for 100% immediate expensing of capital investment (but only for five years).
Currently, the U.S. tax regime employs a ‘worldwide’ system, meaning U.S. taxpayers owe U.S. tax on all their profits regardless of where those profits were earned. The new act will employ a ‘territorial’ system, meaning U.S. companies would owe U.S. tax only on what they earn here. Offshore profits would be subject to whatever tax is imposed by the country where the money is made, meaning you would just pay the local rate and be free to move your funds back to the U.S. Existing offshore profits will be ‘deemed’ to be repatriated and immediately taxed at 15.5%.
There will be a global ‘minimum’ tax of 10% (if you pay a lower rate in a foreign country you will have to remit the difference to the U.S. Treasury). Interest deductions will be limited to the sum of business interest income plus 30% of EBIT (no depreciation). And, since the Act taxes interest earned but limits the deduction for interest paid it has an ‘implicit’ tax on leverage. For those equipment lessors who are taxed as pass-through entities, a ‘deduction’ of 20% of ‘qualified business income’ subject to limitations and phaseouts is allowed.
How The Tax Act Will Impact Equipment Financing and Leasing
Lower tax rates, 100% write-offs, and limitations on the deductibility of interest all impact the economics of the equipment financing decision. If your firm is ‘EBIT’ taxable and has access to equipment investment funding, whether from internal cash flow, bank lines or from the capital markets the lease versus buy decision may change. But, lease financing will remain an attractive alternative in both the air and rail markets. It retains its risk transfer characteristics, term flexibility, and allows those air and rail carriers, who are not otherwise able, to fully utilize the tax benefits of ownership through lease pricing.
Investment managers now have the task of analyzing the Act and acting to improve competitive position. Tax planning and profit shifting is used to exploit gaps and mismatches in tax rules. Since investment platforms seek to maximize after tax returns the goal is to move profits to low-tax entities or jurisdictions where profits will be taxed at lower rates, and move expenses to where they will be relieved at higher rates. The Act’s switch to a ‘territorial’ system will require both air and rail operators and investors to review sourcing rules to determine where income is earned.
Aviation and Rail Investments
Aviation investment has delivered returns better than competing asset classes. Both domestic and international Aviation markets continue to show demand growth with historically high load factors and aircraft utilization rates. Rail carload and intermodal traffic for 2018 is expected to improve. Investors who understand equipment values and the business dynamics of their lessees will continue to support fleet growth in this new environment.
America is successful because of its geography, resources, political system, and decentralization of power. America is a magnet because of our freedoms and business environment. Strong businesses drive growth and create jobs. This legislation introduces the most pro-growth tax policy in decades. With passage investors will be faced with a new competitive landscape. Lease pricing and existing portfolio values will change.
Long term value decisions are best made based on the most probable compounding of after-tax net worth. Risks comes from not knowing what you are doing. Interested in discussing what actions you should take? Contact RESIDCO.
RESIDCO’s size and wholesale capability is a competitive advantage. We respond quickly and creatively to ever-changing market conditions.
70 W Madison St, Suite 2200
Chicago IL 60602 – 4275
Recent Posts
Aero and Rail Investments Post-Election Prospects Remain BrightNovember 5, 2024 - 5:55 pmThe IMF expects the U.S. economy to grow 2.5% in the fourth quarter. Business investment, ample energy supplies, and consumer spending have led to increased productivity. After the Fed cut interest rates by half a percentage point in September economists are generally positive. The Conference Board’s leading economic index indicates continued moderate growth for the […]
Mid-Life Aero and Rail Equipment Delivering Higher YieldsSeptember 11, 2024 - 4:03 pmFor the third quarter of 2024, the Federal Reserve Bank of Atlanta’s “GDPNow” model is estimating real U.S. GDP growth of 2% (a seasonally adjusted annual rate)[1]. July’s World Economic Outlook Update expects the U.S. GDP to grow by 1.9% in 2025[2]. The Bureau of Labor Statistics (“BLS”) Consumer Price Index for all urban consumers, (CPI-U) […]
Fall Election Risk Impact on Aero and RailAugust 5, 2024 - 6:05 am1600 Pennsylvania Avenue. What are markets anticipating? Interest rates, Inflation risk, Global unrest, Trade barriers, Government spending, a new Democratic nominee, or a second Trump presidency? Will there be a pro-business climate after the election, less regulation, more drilling, continued tax cuts, and lower interest rates? Recall the 2017 Tax Cuts and Jobs Act cut the corporate tax […]