Second Quarter year over year comparisons are down but sequential growth is evident in the third quarter. A timeline towards recovery is beginning to take shape.
Manufacturing is expanding (but from a lower base). Factories across the U.S., Europe, and Asia increased production in July but were held back by weak global trade (export orders were soft). Businesses are generally optimistic about future conditions and growth in manufacturing activity is expected to continue over the next six months. The U.S. Purchasing Manager’s Index grew in July for the third consecutive month reaching 54.2, up from a June reading of 52.6. That’s the highest it has been since March 2019.
On August 6, the U.S. Department of State, in coordination with the CDC, lifted the Global Level 4 travel advisory which had been in place since the end of March. “With health and safety conditions improving in some countries the Department is returning to our previous system of country-specific levels of travel advice.” The virus does not appear to be spreading on planes due to air filtration, circulation, and mask requirements. Air travel and airports have not been hot spots. Delta’s CEO Ed Bastian reported there have been no cases that have been traced back to air travel passenger contact when sitting in rows near a passenger who later tested positive.
Flight operations are focused on load and cost efficiency in each served air travel market. With current lower flight demand levels, newer narrow-body aircraft are more desirable. These are the first units returning to service. Older narrow bodies are next, subject to accumulated engine time and maintenance cycle demands. With country travel restrictions in place, long haul wide-body passenger flights are not economical. Many expect the Boeing 737MAX* (when it returns to service in extended twin-engine operations), along with the AirbusA321LR/A321XLR to be flying long-haul routes. These single-aisle aircraft are designed to allow point to point operations in a lower demand environment, making a business case for such aircraft to operate profitably on longer transatlantic routes in a recovering Covid-19 environment.
On August 1, 504,043 freight cars remain in storage (30% of the North American rail freight car fleet). But rail carload traffic (excluding grain and coal) is trending in the right direction. In July carload traffic originated on U.S. railroads averaged 208,403 units per week, the highest since March. Auto sales in July were their highest since February with North American carloads of motor vehicles and parts reasonably close to their pre-pandemic levels. It is well known that the consumer drives the U.S. economy and that consumer spending is driven by job growth. That spending is closely correlated with the goods related side of the economy. The economy created 1.8 million jobs in July down from 4.8 million new jobs in June, and 2.7 million in May. Over 9 million jobs have been created in the last three months and unemployment has fallen to 10.2% in July, down from a record high of 14.7% in April.
Sequential improvements are pointing to the beginning of a recovery. If you are uncertain about the future, include cash, cost control, maintenance of financing flexibility, and implementation of investment strategies that will protect your competitive position. For opportunities that can deliver that and lead to long term value creation? Call RESIDCO.
* The 737MAX has the same fuselage width at the B757 which flew trans-Atlantic regularly.
The Global economy is projected to contract 4.9% in 2020, with World merchandise traffic falling 13 to 32% and a 50 to 60% decline in air passenger revenue miles. In response, more than two-thirds of governments across the world have scaled up fiscal support with budget measures now standing at 6% of GDP on average. Covid-19 lockdowns, trade disagreements, and changing Class One Rail operating methods have impacted the cash flows and profitability of transportation assets that serve the Air and Rail investment segments.
Despite deteriorating economic conditions, Rail carload freight has remained profitable for the Class One Railroads. The impact of Precision Scheduled Railroading (“PSR”) is evident as they have maintained profitable operations even with freight volumes decreasing (U.S. rail traffic for the first 29 weeks of 2020 decreased 12.8% compared to last year). Class Ones are focused on carload traffic which drives their PSR operating models. ‘Pricing discipline’, longer train lengths, and a reduced need for equipment and labor have improved operating ratios. The Class Ones are all reporting second-quarter profits (examples: CSX $499 million, Union Pacific $1.1 Billion, Norfolk Southern $392 Million, Canadian Pacific C$635 Million, Canadian National C$545 Million and Kansas City Southern $109 Million).
While Air cargo flights have surged, travel restrictions have resulted in a steep contraction of regional, mid-haul, and long-haul passenger demand. Second-quarter losses across all the U.S. carriers demonstrate this. Delta, the world’s most profitable airline prior to the pandemic, reported a 91% decline in revenue and a second-quarter operating loss of $3.9 Billion (plus an additional $3.2 Billion non-operating write-down related to fleet restructuring and write-downs of investments). United’s revenues were down 87.1% with a reported net loss of $1.6 Billion (after adjustments a net loss of $2.6 Billion). American reported an operating loss of $2.5 Billion and a GAAP net loss of $2.1 Billion. Southwest (the only investment-grade rated carrier in the U.S. airline industry) reported a second-quarter net loss of $1.5 billion (excluding special items).
All are parking portions of their fleets and adjusting network schedules as they focus on returning to break-even cash flow. The downturn has extended to aircraft manufacturers Boeing and Airbus. Boeing delivered just 20 aircraft in the second quarter, down from 90 last year (their lowest quarterly total since 1963). Airbus delivered 74, down from 227. The International Air Transport Association aptly summarized the situation. At the end of 2019, the commercial passenger jet fleet in service was 23,710 units (including regional jets, single-aisle, and twin-aisle). The equivalent fleet needed to operate in 2020 is 16,360 units (at a 62% load factor).
Gulfstream delivered more high-end private jets in the second quarter (32) than Boeing’s total commercial deliveries. Budget carriers like Southwest can set up and dismantle specific point to point routes based on profitability (legacy carriers need their whole hub and spoke network to work to stay cash positive). Yes, the recovery’s timing remains uncertain, but transportation assets under a lease that span the expected term of the pandemic provide attractive alternative investments.
To find and unlock these pockets of opportunity? Call RESIDCO.
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.
Domestic economies are beginning to reopen as evidenced by the number of TSA airport security screening checks. They totaled 87,534 April 14th and by May 25th had tripled to 257,451. “We’re past the trough in terms of peak damage”. Much of the pickup reflects the states’ decisions to open parts of their economies. While global supply chains remain fragile the mechanics of transportation decision making remain unchanged. What is the payoff from the trip? Is it high value/time-sensitive? Where is traffic currently being allowed, and what mode is most cost-efficient?
Globalization fostered the ever-increasing specialization of labor across countries. The Covid-19 crisis has demonstrated the weakness of over-reliance on extended supply chains, whether for manufacturing automobiles, aircraft, or pharmaceuticals. ‘Just in time’ easily can become ‘just too late’. An example: the U.S. relies heavily on Mexico for parts and vehicle production. Thirty-nine percent of auto parts ($60.8 billion) were imported from Mexico in 2019. Without Mexico, the Detroit auto industry will be unable to effectively restart production. Going forward the private sector must re-examine supply links, border restrictions, risks, and define solutions.
Increased taxes financed the spending that helped the U.S. get out of the Great Depression in the 1930s. From 1929 to 1939 the corporate tax rate rose from 11% to 19%, capital gains tax rates went up from 12.5% to 22.5%, and personal income tax rates jumped from 24% to 62% (the top marginal rate was 91% in 1960). With the current level of deficit spending and lost tax revenues due to lockdowns, it’s not hard to imagine higher taxes. But borrowing now amounts to a transfer of economic activity from the future to the present.
With air travel demand picking up, how full will planes be? Single-aisle airframes generally have 3+3 seating. Leaving all middle seats vacant implies a maximum load factor of 67%. On a fleet-wide basis, the International Air Transport Association has said “social distancing would mean a maximum load factor of 62%.” That would require a different business model than the airlines have been using. Break-even loads vary with changing cost and airfare fluctuations (in 2019, the systemwide beak even load factor was 73.8% while the actual load factor was 84.6%).
Class One Railroad operations remain strong with freight car velocity, terminal dwell, and car trip compliance improving. The Roads are running fewer and longer trains on tight schedules (Precision Scheduled Railroading). As traffic has declined, crews, locomotives, and freight car resources are being ‘balanced’ to meet the lower current volumes and improve operating ratios. New equipment deliveries are down and an equipment surplus hangs over the industry.
The Global economy: the European Union’s borders remain closed to non-nationals until mid-June, and China has suspended entry of foreign nationals. U.S. tensions with China are escalating over trade, technology theft, the coronavirus, and Hong Kong’s independence. Managing a transportation portfolio in this turbulent ‘New Normal’ requires an ability to identify and seize opportunities the markets are currently offering. As demand recovers, focus on improving your odds of success. 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.
Market Competition
When a National Bank invests in personal property, the Code of Federal Regulations, Title 12 Part 23, and the Office of the Comptroller of the Currency provides regulatory investment guidelines. Prior to the early 1990s, banks entered into personal property leases only when they were the functional equivalent of a loan (meaning leases had to be “net, full-payout leases”).
As bank regulations relaxed, banks began to enter the operating lease markets by creating operating subsidiaries that met regulatory investment requirements. With their low cost of capital, banks quickly became significant market competitors. Wells Fargo1, CIT, PNC, and Citigroup are examples. They own a significant portion of the national fleet of 1.6 Million units. But with 400,000 railcars in storage and 2019 lease rates down 10 to 20% from the prior year, it has become a challenge to remarket or sell off-lease “nonearning assets” given current market pricing.
Other than intermodal and autos, railcars carry grain, coal, crushed stone, sand, gravel, primary metal products, chemicals, iron and steel scrap, petroleum products, lumber, wood and paper products, and other high-volume, low-value commodities. Shippers want to manage their supply chains and inventory investment by controlling transport capacity and linking deliveries directly to production lines, customer factories, distribution centers, and ports of entry/export.
With several modes of transportation available (truck, rail, air, and river), shippers and railroads are aware of the value of consistent delivery, pricing, and volume; this is what is driving the Class One focus on ‘Precision Scheduled Railroading.’ But by reducing service in insufficiently profitable secondary lanes, the Class 1 railroads are deciding to grow margins and cede market share to alternative modes. The result is the Class One Railroads are using fewer railcars and locomotives.
Rail Traffic as of January 2020
Exacerbating the oversupply of equipment U.S. rail volumes fell (again) in January (their 12th straight decline). Excluding coal (which was down 13.8%) and grain (down 11.6%), U.S. carloads were down .6% in January. Carload gains included chemicals, grain mill products, and metallic ores (carloads of iron and steel scrap were up 5.2%). U.S. intermodal originations fell 5.4% and have now fallen for 12 consecutive months.
Job gains, the Institute for Supply Management’s (“ISM”), Manufacturing Purchasing Managers Index (“PMI”), the Non-Manufacturing Index (“NMI”), housing starts, and consumer spending were bright spots, all higher in January.
Positive trade developments (the new U.S.-Mexico-Canada Agreement – “USMCA,” and the China “Phase One” deal) are being offset by the unknown economic impact of the Chinese coronavirus outbreak. In January, coal carloads averaged 69,706 per week, the lowest January average since before 1988. In the first 10 months of 2019, coal accounted for less than 24% of U.S. electricity generation, down from 27% in 2018, and 50% in 20052. Moreover, weekly average grain carloads in January (19,635) were the lowest for January since 2013.
Investment Solutions
Railcar leasing can provide stable and predictable cash flows as freight volumes return, and the Class Ones show tangible benefits for shippers, such as consistent delivery and pricing that is market competitive. As markets adjust, how can investment results best be managed? For restructuring solutions, seek the advice of independent, unbiased, and experienced counsel. Call RESIDCO.
1Wells Fargo maintains they are the largest railcar lessor in North America, with more than 175,000 railcars.
2Ibid.
Labor and Equipment Demand
Eliminating hump yards and running fewer, longer, ‘scheduled’ trains, the Class One’s are continuing to implement Precision Scheduled Railroading (“PSR”). It’s transforming rail networks, reducing the need for labor and equipment.
The Union Pacific is planning to reduce its workforce by eliminating 3,000 workers this year (after reducing its staff by 11% in 2019). As train speeds increase, the need for rail equipment decreases. It’s estimated that for every one-mile increase in average freight train speed and additional 50,000, additional railcars will be moved to storage. Of a fleet of 1.6 Million railcars, 25% were in storage this January. And train speeds are increasing due to PSR, lingering trade tensions, and to lower freight volumes caused by our slowing manufacturing economy*. Going forward with larger capacity and new cars being delivered, fewer cars will be needed. Added to this, the Rails are losing market share as shippers move product to truck to meet just-in-time inventory requirements.
The Election Effect
Over the years, car ownership has changed dramatically. In 1962 the railroads owned 90% of the freight car fleet. Today, 75% is privately owned. The oversupply of railcars and locomotive power caused by PSR and lower freight volume is acting to reduce market values of existing equipment and lease rates at renewal. The current low-interest-rate environment is depressing lease rate factors available for new equipment. Uncertainty over the fall election and direction of international events (both in the Middle East and Asia) are working to hold the business investment flat. As a result, new railcar deliveries for 2020 are expected to trend down.
Given the election year, Trump signed a “phase one” trade deal with China this January 15th. It provides a measure of relief for rail shippers. China agreed to make purchases of $200 billion worth of U.S. goods over a two-year period, doubling its agricultural purchases to $40 billion. Whether China will honor this agreement (which includes ending its practice of forcing foreign companies to transfer technology to Chinese companies as a condition for access to the Chinese market) is an open question.
The agreement won’t fix everything. There will be a continuing lack of cooperation over technology, national security, military, and political ideologies. These are significant and continuing issues. As the U.S. and China pursue their own national and economic interests, the conflict will continue. A degree of economic decoupling is likely and the future of freight traffic between the two countries remains unanswered. At stake are a stronger economy and global influence.
Globalism, which fostered complex supply chains spanning multiple borders, is retreating. The U.S. has become unilateralist and is rewriting trade rules to prioritize its interests while shunning trade blocs. Bilateral deals have been completed with Canada, Mexico, now China, and soon with Britain, as it has left the E.U. The economic impact of the coronavirus in China is unknown, but airlines are suspending flights and businesses are shutting down operations there.
Investment Risk Planning
As fiscal stimulus fades and global growth slows, U.S. GDP growth is expected to remain at 2%. Even though we’re in the longest bull market in history, overall uncertainty has not been reduced. Tariffs have led to a decline in business investment. While change is certain, how we react to events, preplan for them, and manage through them is within our control.
Struggling to price investment risk and looking for answers? Call RESIDCO.
*The U.S. manufacturing sector contracted for five straight months through December, the Institute for Supply Management.
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.
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