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Aviation Investment Returns

U.S. Economic Expansion

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

Growth in Aviation

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

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

Aircraft Investment

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

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

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

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The State of the Aviation Industry in 2018

Demand in Aviation

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

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

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

Operational Economics

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

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

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

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

The Future of Aviation Leasing and Investment

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

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

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

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

 

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

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An Investment Roadmap – Risk-Adjusted Returns

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
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Confident About Growth

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.

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Transportation Asset Values and Tax Policy

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.

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