Once approved by the Surface Transportation Board, the combination of the Canadian Pacific and Kansas City Southern (the two smallest Class One Railroads by revenues1) can be expected to drive a modal shift from truck to rail. The combined “Canadian Pacific Kansas City”, or CPKC, will remain the smallest Class One.  After the combination, a single rail transportation network will stretch across the North American continent and deep into Mexico. 

The KCS connects the Gulf Coast Mexican ports of Veracruz and Tampico and the Pacific port of Lazaro Cardenas to Laredo, Texas. KCS has lines running north from Texas through Kansas City to Illinois and southeast to the U.S. Gulf Coast ports of Brownsville, Corpus Christi, Port Arthur, New Orleans, Gulfport, and Mobile. On a revenue growth basis, the CP and Kansas City Southern have been the two best performing Class One railroads for the past three years. After the new U.S.-Mexico-Canada (“USMCA”) trade agreement came into force last year (July 1, 2020), KCS, with its operations in Mexico, (the “Kansas City Southern de Mexico”) became a natural acquisition target. That July, the Blackstone Group Inc. and Global Infrastructure Partners considered a takeover bid for the KCS, which when made, was rejected. It was a strong indication of the upside growth any subsequent consolidation would offer.  

The current combination has no route overlap and will create direct competition with the trucking industry (and other Class Ones) in the U.S. Midwest (the Dallas to Chicago corridor) and into the South. “The combination will provide a transportation solution for manufacturers seeking to bring factories back to North America after the pandemic exposed the risks of relying on overseas supply chains.” Mexico is a crucial supplier of vehicles, auto parts, electronics and food, and a major customer of grain, fuel, and consumer goods. Trade across the three nations is expected to grow, and the CPKC is targeting $800 Million in revenue gains by 2025 from the following sources: intermodal, automotive, and dry bulk (cement and grain carload traffic). The combination does not reduce choice for rail shippers, rather it expands their market reach and opens alternative shipping lanes.  The benefits of single-line service will shift trucks off U.S. highways, reducing truck congestion and carbon emissions in the Chicago to Dallas corridor. “Rail is four times more fuel-efficient than trucking. One train can keep more than 300 trucks off public roads and produce 75% less greenhouse gas”.

The question for rail equipment investors: “Will the combination results in reduced or increased rail equipment demand?” 

Pro: The combination will create rail traffic growth by expanding rail shipper market reach, taking truck traffic off highways, and improving rail transportation alternatives for grain, autos, and auto parts, energy, and intermodal shipments. It will eliminate the need for interchange between two systems, allow a bypass of Chicago congestion via the CP route through Iowa and reduce carbon emissions in the City of Chicago. It may also reduce the need for public investment in highways and bridge repair. 

Con: Securing approval from the Surface Transportation Board (industry concerns remain over a loss of competition from previous rail mergers). The CPKC is positioning for post-pandemic rail growth. How to identify the impact on rail equipment demand from this combination?  

Call RESIDCO.                               

 1Kansas City revenues in 2020 were $2.6 Billion, CP revenues in 2020 $5.756 Billion. 

Glenn P. Davis, 312-635-3161 

davis@residco.com  

As vaccinations increase and COVID cases fall, a stronger domestic economy is coming. With the $1.9 trillion fiscal stimulus bill becoming law (the ‘American Rescue Plan Act’), the Organization for Economic Cooperation and Development has said the U.S. economy will accelerate twice as fast as expected this year. Congress has now authorized six major ‘stimulus’ bills totaling $5.3 trillion1. The world economy is expected to grow 6% this year, the fastest rate in almost half a century. For the first time since 2005, the U.S. is expected to make a bigger contribution to global growth than China. Europe’s growth will lag as vaccine rollout has been slower there, and Eurozone governments are not contemplating additional fiscal spending on the scale of the U.S. due to concerns about over-borrowing.  

As demand recovers, commercial air carriers and rail operators will increase their use of lease financing in fleeting decisions. On March 2nd, during the company’s fourth-quarter earnings call, AerCap Chief Executive Aengus Kelly said he expects airlines will shift more toward leasing as they rebuild their balance sheets. Leasing companies currently own half the world’s commercial aircraft fleet. Over 70% of railcars are privately owned. If AerCap’s recent deal with GECAS is approved, the combined aviation leasing company will control more than 2,000 aircraft (with an additional 500 on order). Lease financing provides the needed flexibility for both air carriers and Class One railroads. And, for unencumbered assets, it provides cash through Sale-Leaseback financing.  

As the outlook for domestic travel improves, U.S. airlines are asking the Biden Administration to develop credentials to allow travelers to show they have been tested and vaccinated for COVID-19. It has been done in Iceland (the first country to issue vaccination certificates to citizens who have had both vaccine doses), and in Poland. The International Air Transport Association (IATA) has developed a ‘Travel Pass’ health passport app (a ‘digital health passport’) as a solution. European countries are putting support behind this initiative.  

With the size of the U.S. domestic fiscal stimulus, the roll-out of vaccines, and pent-up demand, rail freight and domestic air travel will pick up. Net job gains in February 2021 were a preliminary 379,000, much more than most economists expected. The Purchasing Managers Index rose to 60.8% in February 2021 matching the highest it has been, an indication domestic manufacturing can expect continued growth. China is once again a major customer for U.S. agricultural goods. In the first eight weeks of this year China has purchased nearly triple the amount of U.S. soybeans as compared to 2020 (grain accounted for nearly all rail carload gains in February, up 15.7% compared to February 2020). With continued near-zero interest rates, housing market activity is driving growth in carloads of lumber and wood products (combined U.S. and Canadian carloads were up 3.2% in February, their sixth straight year-over-year gain).

In the post pandemic recovery, “We see the demand for leasing increasing. Maximize your air and rail portfolio after-tax returns. Call RESIDCO.   

Glenn P. Davis, 312-635-3161 

davis@residco.com  

1  The size of the stimulus ($5.3 trillion) is a quarter of 2020 current dollar 2020 GDP of $21.5 trillion.  

Energy is a universal and necessary requirement for both rail and commercial aviation. Diesel-powered locomotives pull freight on all nonelectrified railways around the world. Gas-powered turbines made intercontinental passenger flight efficient and affordable.  Because many believe fossil-fuel energy unfavorably impacts the environment, there is a growing belief that climate risk must be considered in evaluating transportation portfolio investment opportunities.

On his first day in office, Biden signed an executive order revoking the Keystone XL pipeline permit, signaling climate as a priority. His order effectively shut down a 12-year cross border project that would have carried 830,000 barrels a day of Canadian heavy oil-sand crude to U.S. refiners on the Gulf Coast (U.S. refiners purchase 98% of Canada’s oil exports). According to the Canadian Government, Canada’s proven oil reserves are third in the world behind Venezuela and Saudi Arabia. Canadian producers have limited and costly options for getting their oil to buyers. It trades at a significant discount to the West Texas Intermediate benchmark to cover rail transportation costs. The cheaper Canadian crude makes it one of the most profitable for U.S. refiners. Without the Keystone pipeline, the Burlington Northern Railroad will continue to carry crude as it moves rail tank cars to the Gulf Coast. Railcars are recognized as a more ‘sustainable’ form of investment, whether in terms of CO2 emissions or energy consumption per load when compared to other forms of transport1.  

Aviation’s share of global carbon emissions is significantly below that of cars and trucks. But at high altitudes exhaust contrails form heat-trapping cirrus clouds.  Can carbon-neutral flight be achieved? Boeing committed on January 22nd to ensure all its new commercial aircraft are capable and certified to use 100% ‘sustainable2 aviation fuel’ by 2030 (existing regulations allow aircraft to use a blend of 50% sustainable and 50% conventional jet fuel). Airbus has announced plans to design aircraft that rely on a turbofan design that includes a modified gas-turbine engine running on hydrogen rather than jet fuel (the hydrogen would be stored in tanks located behind the plane’s rear pressure bulkhead). Rolls-Royce committed to using its technological capabilities to play a leading role in enabling aviation, rail, and power generation to reach net-zero carbon by 2050. GE is researching advanced electric propulsion and fuels to achieve carbon-neutral flight. Last December United Airlines pledged to go ‘100 percent carbon neutral’ by 2050 by using carbon removal ‘direct air-carbon-capture technology’ that would remove an equivalent amount of carbon produced by its aircraft and thus allow its planes to fly on fossil fuels forever. Boeing’s 787 and Airbus’s A350 already emit significantly less carbon than the older jets they are replacing by using lighter materials and more efficient engines. 

Climate isn’t the only thing changingGeneral Motors announced on January 28th it will end the sale of ‘all’ gasoline and diesel-powered passenger cars and light sports utility vehicles and will only produce electric-powered cars and SUVs starting in 2035. Transitioning to carbon-free transportation will be difficult to accomplish, even if vigorously pursued. The risks include shifts in policy, technology, and existing equipment valuations.  For insight into opportunities that will be created during this challenge call RESIDCO.

Glenn Davis, 312-635-3161 davis@residco.com

1 “Railcars are a sustainable mode of transportation and play an important role in the industrial supply chain by transporting our country’s most important products across the North American continent in an environmentally-friendly manner.” Trinity Industries.

2 Sustainable aviation fuel reduces CO2 emissions up to 80%. 

A consensus is typically believed to be a rough picture of what is to come. By nature, we tend to move in crowds and weigh recent experience more heavily. Not knowing any better, we extrapolate the future from the present.  Most are now expected to be vaccinated by mid-2021. When the pandemic clears, economists think GDP could grow 4 to 5% or more. The Fed will keep interest rates low, unemployment will be down to 5%, and inflation up to 2% by the end of 2021. Central bankers will continue to target growth, inflation, and unemployment1 (total nonfarm employment rose by 245,000 in November and the unemployment rate edged down to 6.7%). Growth, income, and the ability to service debt depend on a return of robust demand. The unexpected? The next Administration’s announced policy preferences are contrary to growth.2  

Domestic aviation markets will recover with low-cost carriers leading the way. The low-cost carriers can flexibly modify schedules, follow changing traffic demand patterns, and move aircraft around to take advantage of those changes. Southwest Airlines (known for its discount fares) is starting flights at O’Hare International Airport in 2021.  It will keep its existing hub at Midway International Airport and is expected to continue using its fleet of existing 737s. With Southwest at O’Hare, American and United will have to adjust. Similarly, Ryanair Holdings, Europe’s largest low-cost carrier, is in talks with airports in Germany, Austria, Spain, and Portugal. Ryanair is banking on the MAX to add capacity when air travel rebounds. With the MAX back the Cirium Fleet forecast anticipates 360 MAX deliveries in 2021 with 570 MAX in service by the end of the year. 

To smooth relations with the incoming Biden Administration, and as part of a strategy to de-escalate trade tensions in order to allow the U.S. and UK to move forward to the next phase of their trading relationship, the UK has said it will suspend retaliatory European Union tariffs on Boeing jets resulting from the EU-U.S. dispute over subsidies to their respective commercial airframe makers after the Brexit transition period ends on December 31st. But the fleet surplus will continue through late 2022 as local issues continue to impact international travel (since recent news of a new variant of the COVID virus came out of the U.K. nearly 50 countries have again banned flights to and from the U.K.).  

Domestically, certain segments of U.S. manufacturing have made surprisingly strong recoveries.  Auto production is back to pre-pandemic levels and residential construction activity has been robust. Rail intermodal has recovered strongly as online e-commerce replaced traditional retail store sales.  

This has not been a normal recession. The pandemic interrupted the supply of goods and eliminated global passenger transport. The recovery will be uneven, and available facts suggest 2021 will be challenging. With a cost base better than network carriers, low-cost carriers are seizing the opportunity for market penetration. Transportation equipment leasing and flexible asset management solutions work to keep the economy moving. As the recovery unfolds your portfolio should hold the right mix of air and rail transportation assets. For opportunities that maintain portfolio cash flow in this new environment call RESIDCO.

Glenn P. Davis, 312-635-3161 davis@residco.com

1 Caution: current monetary policy inflates asset pricing.

2 The Biden team believes the role of government is to direct and manage the private economy through macroeconomic policies; increasing taxes, government regulations, and spending (trillions) more than collected.  Even at current low-interest rates, the U.S. currently spends as much on interest as the combined budgets of Commerce, Education, Energy, DHS, HUD, Interior, Justice & State.

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.

The coronavirus was the turning point. Schools and universities are being closed. Public activities are being canceled. Air travel and supply chains are being disrupted. Companies are telling employees to stay put. The virus constitutes a force majeure event.  

Even before the U.S. ban on travel from Europe, Air Carriers were reacting by trimming capacity, reducing both domestic and international flights. Southwest Airlines Gary Kelly has said, “The velocity and the severity of the decline is breathtaking, there is no question this is a severe recession for our industry and for us, it’s a financial crisis” (Southwest had previously said reduced bookings could result in as much as $300 million in lost revenue in March alone).   

China, in an attempt to contain the outbreak from spreading imposed travel restrictions. Many Chinese factories halted production in February. Worldwide, these shutdowns will impact industries from auto parts to pharmaceuticals. 

A key trade flow indicator economists examine is the volume of the Trans-Pacific trade. This trade lane accounts for 40% of the world’s gross domestic product.  Despite the recent Phase-One trade deal, the volume of U.S. products moving to China remains depressed. As the virus spreads, political leaders throughout the world are imposing broad travel restrictions. The result is less passenger and freight traffic to move.  

Trading relations often come with unseen risks. China’s entry into global markets resulted in a global over-dependence on low-cost Chinese production. The virus has exposed this weakness, and its effects are rippling through the interconnected world economy. “This coronavirus is a wake-up call.  We are much more vulnerable than we thought.”  Business leaders are scrambling for solutions as they face supply chain disruptions and current market uncertainties. Finding alternative suppliers isn’t easy. Future patterns of trade among nations will change in order to create more supply chain redundancy.   

Economic contractions are not a ‘bug’ of free-market systems, but rather a feature. Short term incentives act to create unsustainable swings in everything from product designs to supplier and labor relations. Competition over the delivery of fuel-efficient planes drove the Airbus 320neo and Boeing’s 737MAX (over the past 10 years Boeing and Airbus orders totaled more than 20,000 jetliners). Then, air carriers were more concerned about the cost of jet fuel, their single highest expense after labor.  

Surprisingly, when Russia refused last week to join OPEC in its call for crude oil production cuts, the Saudi response was to make the biggest price cut to their crude in more than 30 years  Lower oil will help the U.S. consumer, hurt U.S. shale producers, but have little impact on current Air Carrier operations. 

The impact of the virus on travel is so large it has resulted in the International Air Transport Association increasing the potential demand shock to the global airline industry upward from its February estimate of $29 billion to a loss of $113 billion in revenues in 2020.  

Public market liquidity is a convenience, to be taken advantage of, or to be ignored.  We are at a turning point. For actionable insights, call RESIDCO.

U.S. domestic coal production peaked in 2008.  The decline that followed was driven first by the politics of climate change and then by the shale gas revolution.  Our coal production takes place in three major coal-producing areas, ‘Appalachia’, the ‘Interior’ (Illinois, Indiana), and the Powder River Basin’s ‘Western Coal[1]’.  Substantially all moves by rail.  With the politics of pipelines delays, many thought crude by rail would take the place of lost coal volume.  But the real drivers for coal, crude by rail, and shale gas are the economics of energy[2] production and transportation.  The politics of exiting the Paris climate accord and curbing of environmental regulations will not change market forces.

Often viewed in isolation, energy commodities are connected by transportation economics.  Historically, the railroads have generated more revenue from coal than from any other single commodity.  Even with its decline, coal continues to represent a major share of rail tonnage and top line revenue[3].  Exports of coking coal, used to make steel, have been a traditional area of strength, and coal pricing has been supported by ongoing demand from China which imported 23.5% in the first six months of 2017[4].  At current prices U.S. steam coal exports are competitive in Asia (East Coast or Gulf Coast to India, California to China or North-East Asia[5]).  Amazingly, after our exit from the Paris Climate accord, steam coal exports to Europe have grown.  France’s nuclear regulator ordered safety checks on a number of the country’s reactors (almost 80% of France’s electricity comes from nuclear energy[6]) requiring the country to rely more on coal fired power.  While Germany is replacing its nuclear units with renewable energy (wind and solar) it has increased its use of coal as a backup to renewables (over 55% of German electricity generation comes from fossil fuels[7]).  Shale gas is more efficient and burns ‘cleaner’ but prices have been rising and power producers have responded by switching back to coal.  Meanwhile, environmentalists are arguing ‘fracking’ poses public health risks due to water table contamination, waste fluid air pollution, earthquakes, and unknown climate change impacts[8].  There is no question that domestic coal production is facing headwinds.  According to data from the American Association of Railroads, 22% of the country’s 220,000 coal gondolas were in storage this May and 26% of the 142,000 hoppers had not been used in the last 60 days[9].

History demonstrates energy commodity shifts take years to fully transition.  Wood gave way to coal in the 1800s.  Until the shale revolution ushered in a new era of plenty, the prospect of oil supply running out was a doomsday scenario.  Now coal is being squeezed by shale gas.  How rail traffic behaves in the years ahead will depend on energy pricing competitiveness.  Coal is becoming more competitive as natural gas prices increase (the U.S. is expected to become a net exporter of natural gas in 2018[10]).  Since the industry can expect fewer government regulations and a more supportive administration in Washington, the future role of coal in the U.S. energy mix is expected to stabilize.

Our investment strategy is to seek those exceptional or minority cases where we are confident of current cash flows and future values.  The answers are in the economics.  If you are looking for rail insight, call the Rail Experts.  Call RESIDCO.

[1] At 1.13 billion tons Wyoming accounted for 41% of U.S. coal production in 2016.  Association of American  Railroads.

[2] Department of Energy, August 2017 report: Shale Gas(economics) are to Blame for Coal Plant Closures.

[3] In 2016 coal accounted for 31.6%[3] of originated tonnage for U.S. Class I railroads, far more than any other commodity.

[4] Reuters, July 31, 2017, U.S. Coal Exports Surge.

[5] The Asian benchmark price for thermal coal (Australian port of Newcastle ended at $92.28 a ton on July 28, steady from $94.44 at the end of 2016, but almost double the $50.63 at the end of 2015.

[6] Institute for Energy Research, October 24, 2016.

[7] Ibid.

[8] As a result, New York, Maryland, and Vermont have banned fracking!

[9] The Blade Business Writer, Rail Unit Profits The Andersons, May, 28, 2017.

[10] U.S. Energy Information Administration, Natural gas prices in 2017 and 2018 are expected to be higher than 2016, January 23, 2017.

The Importance of Infrastructure

Infrastructure is one of the main factors of economic growth. This includes power, water, telecommunications, ports, roads, and rail. In a report by McKinsey Global Institute, the projected requirement for infrastructure investment is estimated to reach $57 trillion dollars from 2013-2030. This is to keep up with global GDP growth targets. According to PWC, globalization enabled free movement and distribution of goods around the world, while travel and people to people linkages enabled the movement of data and currency. Such massive activity is only possible through physical and digital infrastructure. Due to the expected shift in economic and demographic trends, there is an enormous need for boost infrastructure spending.

According to the Business Roundtable, statistics show the need for improvement in America’s infrastructure spending: the infrastructure quality of the U.S. currently ranks at no. 16 globally, behind France, Japan, and Germany. Among the world’s top 50 airports, the U.S. only has 4 included in the list; delays and congestion have amounted to $24 billion losses in 2012 alone. Around 25% of rails around the country is marked as “good” or “excellent.” Clearly, there is a lot of room for improvement. The U.S. economy would greatly benefit from massive infrastructure spending.

An article by the Council of Foreign Relations mentioned the current state of U.S. transportation infrastructure. Many highways and bridges in the U.S. will reach the end of their maximum expected lifespan, thus the need for adequate capital investment in order to conduct major repairs to these infrastructures. The last era where transportation infrastructure has benefited was during former President Eisenhower’s time until the 1980s. Afterward, spending on transportation infrastructure has significantly declined.

Short and Long-term Benefits of Infrastructure Investment

Infrastructure investment can have short-term and long-term economic benefits.  Building and construction efforts will result in a boost in employment; more jobs will be created. Long term gains involve sustained economic growth with greater benefit for the population, with better services and smoother flow of people, goods, and services associated with high-quality transportation, better roads, rail, airports, and seaports, among others.

Admittedly, transportation infrastructure requires a significant amount of capital investment, and traditional government funds may not be enough. This is where the private sector can come in. The Financial Times mentioned that some policy experts advocate for greater private sector involvement in infrastructure investments, mainly through public-private partnerships or PPPs. PPPs are projects done in long-term contracts, with direct cooperation between the public and private sector. Private capital can then fund infrastructure through municipal bonds. Ultimately, there are risks and returns to be considered but this may vary depending on the project involved. As mentioned in the article, a public-private sector partnership may result in lower costs in terms of technological or operational components or expertise, compared to a public sector-led initiative.

The bottom line is that there is a massive need for transportation infrastructure investment in the United States, and there is no better time to invest than now. Investing in transport infrastructure means investing in the future and ensuring long-term economic benefits for the country. This unique opportunity is sustainable and its effects are long lasting. As emphasized in the Business Roundtable report, the following benefits can be obtained with increased investments in the transportation infrastructure:

Increased GDP growth – investment in transportation infrastructure will generate more jobs; the maintenance and repair projects will further boost employment and create jobs that are permanent and well-paying, which can benefit the middle class, resulting in an increase in GDP growth.

Increased productivity – Efficient and modern infrastructure translates to greater productivity by improving safety, reducing labor costs, fuel expenditures, travel time and other unnecessary effects of uncertainty. Supply chains run more smoothly and the cost of doing business is lower.

Increased international competitiveness – High-quality infrastructure will attract foreign direct investments and encourage businesses to expand their operations.

Investing in Transportation Infrastructure

Investment in transportation infrastructure will result in highly sustainable, short- and long-term economic gains.  It is a win-win solution and a unique opportunity that businesses should take advantage of. Infrastructure plays a crucial role in providing employment opportunities, increasing productivity and boosting international competitiveness, and is a proven key factor in driving economic growth. To know more about investing in transportation infrastructure, call or visit RESIDCO for more details.

 

Aviation investment is driven by profitability and the prospect for future growth. Recent mergers have resulted in the number of major carriers in the U.S. decreasing from 10 to 4[1]. This consolidation has created an oligopoly and helped the remaining players[2] take a more balanced approach to capacity management. They now control 80% of the domestic market and a good portion of the international market. With better control of available seat capacity and a developing consensus that jet fuel pricing is going to stay low for the foreseeable future, the industry has become attractive to investors[3]. Add new sources of revenue like charging for baggage, premium seats, and early boarding, combined with fuel saving new engine and equipment technologies and you have double digit returns on invested capital. With high barriers to entry, pricing control, and management talent, the industry appears positioned for a bright future.

Operator fleeting decisions are based on mission, seat mile profits, operating cost, maintenance requirements, reliability, flexibility, and fleet commonality (for pilot substitution, training and spares inventory purposes). Earnings and profit making capability of equipment is valued. Newer aircraft have higher ownership acquisition cost but lower emissions, lower fuel cost, maintenance savings, and a better passenger experience; but, in the current fuel market, the efficiency gains of newer models do not offset their higher ownership cost. New equipment will be needed to serve market growth, but the economics of investing in mid-life aircraft remain.

Since demand is sensitive to the business cycle and equipment supply, investment horizons require the ability to identify appropriate market entry and exit opportunities. Long asset lives require knowledge throughout the investment term and skill to determine the impact of new technologies, exogenous market events, replacement demand, competing aircraft values and investment economics[4].

There are a lot of different kinds of planes. Which are the most profitable? What is the optimal time to enter and exit? Keys include age, seats, units sold and remaining in service, combined with an analysis of a carrier’s mission, market, models, engines, avionics, and fleet operations dynamics. Is the equipment market liquid, can equipment be traded, reconfigured or parted out? Knowledge of asset values and lease rates allow a connection of investment choices with outcomes and translation of these opportunities into action. It requires searching for the best opportunities, both here and abroad, and an experienced management team with a focused investment strategy.

With profitable experience and deep relationships, we effectively manage asset concentrations, credit exposures, and counterparty risks. For long-term strategies and an in depth understanding of the characteristics of aviation equipment combined with the ability to select and manage asset investment for better than average returns contact us directly.

RESIDCO, aviation and transport investment specialists.

[1] Consolidations include Delta and Northwest in 2008, United and Continental in 2010, Southwest and AirTran in 2011, and American and US Airways in 2013.

[2] American, Delta, United, and Southwest.

[3] Warren Buffet picks a company or industry based on his estimate of its success over the next 10 to 20 years. He’s recently invested in U.S. airlines. Why? The industry is enjoying strong finances and good control over capacity.

[4] United Airlines, for example, recently decided to refurbish all 21 of its B767 aircraft that had originally been slated for retirement. Delta extended the use of 15 of its B757s.

Government taxes to encourage (or discourage) a variety of economic activities. The rates set influence the market’s required before-tax rates of return for both individual and business investments. From a social standpoint, taxes are designed to finance public projects, redistribute wealth, and provide basic services. Since self-interest is basic to human nature this creates private incentives to engage in tax planning. Such planning has long earned the blessing of the U.S. Courts.

When you invest, whether you are an individual, or a business owner, the taxing authority is your silent and ‘uninvited investment partner’. Effective planning involves more than being aware of current marginal rates; it requires an evaluation of the longer term results of your decisions, not just for yourself but for all participants. Each party and counter party has their own current and future marginal tax rates. These future expected after tax cash flows affect current actions and decisions. Understanding this concept is important since it directly influences the prices at which assets are traded now, and, what future pricing might be.

Naturally, most taxpayers pay no more tax than they believe they must. And they spend their time and money to arrange affairs to keep their tax bite as ‘painless’ as possible. Remember, money spent on tax planning is ‘tax deductible’, and the tax savings generated are ‘tax exempt’ because they reduce taxes payable.

Are increased taxes good policy? In 1997, Bill Clinton agreed to lower capital gains rates to 20% based on economic literature suggesting the lower rate would yield more tax revenue. It did. Yet Hillary has proposed to nearly double the top tax rate on long term capital gains to 43.4% from 23.8%. Under current tax policy, ‘capital gains’ are taxed as ‘ordinary income’ if an investor has held an asset for less than a year. After 365 days the current top long term gains rate of 20% applies (plus the 3.8% Obama Care surtax on ‘unearned’ income). Hillary has suggested a ‘sliding scale’ approach requiring ‘capital gains’ tax rates during the first two years holding period of 43.4%, year three, 39.8%, and 35.8% in year four. Investments would have to be held for more than six years to qualify for the current 23.8%[1].

Economists generally will agree that a system of competitive markets is remarkably efficient. Remember Ronald Reagan was elected in 1980 with his message that government is ‘the problem’ and economic freedom was ‘the answer’. The dominant lesson of the Great Depression and the Great Recession is that when Government overspends, overtaxes, and over regulates, economic freedom is suppressed and economic growth is impacted[2]. How is transportation investment best and ethically encouraged? Transportation asset Investors with a sound investment strategy hold diversified asset positions intended to weather volatility on the way to their longer-term objectives. Working with a firm that has a history of excellence, expertise and ethics produces results.

Call the air and rail transportation experts. Call RESIDCO!

[1] National Center for Policy Analysis, Hillary Clinton’s Capital Gains Tax Proposal, Brief Analysis No. 825, April 14, 2016 by Pamela Villarreal.

[2] WSJ, “Why This Recovery is So Lousy”, August 4, 2016, Phil Gramm and Michael Solon.