Global airline deleveraging is driving down risk

By Kostya Zolotusky, Managing Director, Capital Markets Development,
Boeing Capital  

Careful observers of airplane financing trends have noted over the years that lenders have been placing greater emphasis on the value of airplanes as assets, and relying less on airline credit worthiness as the basis for funding Kostya Zolotusky, Managing Director, Capital Markets Development, Boeing Capital Corporation airplane purchases. The reason was simple: The value of airplane assets had proven very solid, both through cyclical industry downturns and a punishing series of economic shocks, including geopolitical conflicts, spiking oil prices, regional currency crises, the SARS epidemic, and even the financial turmoil of the global recession. Airplane assets have recently become even more valuable components of financier portfolios around the world as the number of signatories to the Cape Town Treaty, which ensures the rights of aircraft creditors, continues to expand. While aircraft collateral has greatly expanded the scale and scope of aviation finance, airline credits have remained an important part of the overall industry financing structure. This raised the question of which side of the airplane-asset/airline-credit equation investor confidence would settle in the long term. Solidifying airline credit Historically, many investors shied away from funding airplane purchases because the aviation industry is cyclical and airline profitability notoriously volatile. The airplane investment community tended to be limited to a relatively small group of specialists who had learned how to manage the risk attendant to that volatility. But in the past few years, new players have been entering the airplane financing market, many without deep experience in the aviation industry. To better understand the evolving aircraft financing market, BCC analyzed the airline business environment. We looked at the many variables that contribute to airline success or failure, including management strategy, labor costs and commitments, industry cyclicality, regulatory issues, environmental concerns, and revenueversus- cost considerations. We identified the role of leverage in the airline capital structure as crucial to this understanding. Compared to other aviation industry participants, airlines had an unenviable combination of high volatility and low average return on investment credit. We analyzed the various participants in the industry: airlines, investors and financiers, airplane and engine manufacturers, and all the companies that support the industry, such as maintenance providers, caterers, and airport operators. When we compared industry participants in terms of profitability and return on investment, airlines came out on the bottom. When we compared the volatility, the equivalent of investment risk, for these participants, airlines topped the list. The focus on airline leverage High risk and low return on investment is not the formula for investor confidence. So we decided to analyze the role of airline leverage. We divided airline leverage into two categories: operating leverage and financial leverage. Operating leverage is to cover all the infrastructure costs necessary to keep the airplanes in the air, the tickets being sold, and the payroll being paid. Financial leverage for most airlines entails primarily the debt required for the purchase and ownership of airplanes. On the operating leverage side, airlines traditionally owned all the aspects of the business that pertained to operations. This included internal services, such as the reservation systems, catering, and airplane maintenance. These are fixed costs that do not decrease appreciably if the airline reduces operations to match fluctuations in passenger demand. Fixed costs typically amounted to three-quarters of the cost of doing business for an airline. Reducing fixed costs The world's airlines dramatically reduced capacity at the onset of the global economic crisis, greatly reducing the impact to airline margins and enabling airlines to quickly respond to resurgent demand. Airlines have aggressively reduced fixed costs as a percentage of total cost during the past decade and a half. In the late 1980s, airlines recognized that owning all the disparate aspects of their operations created a very difficult business structure. Because such a high proportion of their costs were fixed, airlines could not reduce costs by cutting back operations or reducing capacity when economic down-turns reduced passenger demand and airline revenues. Airlines therefore began to aggressively outsource their operating infrastructure. The results are astonishing. Today, fixed costs at airlines typically add up to slightly less than half the total cost of doing business. This is a tremendous achievement by the management teams running the world's airlines. Transforming fixed costs to costs that vary in proportion to actual demand has given airlines the flexibility and the incentive to manage capacity. As a result, for the first time in the history of commercial aviation, when the economic downturn of 2008 hit, airlines could cut operations to reduce costs when passenger demand sagged. In a dramatic reversal of precedent, airline margins closely tracked or even slightly outperformed the global GDP changes during the recession. In all previous economic slides, the inflexible fixed cost structure of the airlines exaggerated the effects of economic turmoil, driving margins to sink far below the depths of global GDP decline. This is strong evidence that reducing fixed costs has allowed airlines to limit airline exposure to the risk of market cyclicality. Fluctuations in airline operating margins have historically vastly exaggerated variations in global GDP growth. Successful deleveraging enabled airlines to respond to the recent global economic crisis with margins that matched or beat the swings of the global GDP. Managing financing costs Airlines have been making equally encouraging advances in managing financial leverage. Airlines are able to accumulate a large amount of leverage precisely because they own airplanes. Airplanes are a solid investment. So airlines have been able to borrow heavily on the value of their fleet, even though the airline business as a whole ranks among the highest in terms of risk. But the readily available capital was a double-edged sword. Airline financial leverage amplified the effects that any variation in revenue had on profitability. When the economy slid, airline profitability suffered massive losses. When there was an economic uptick, airline profitability surged. Airlines are pursuing two strategies to reduce their financial leverage. First, they are outsourcing the debt by leasing many of their airplanes, rather than buying them. Second, they are reducing their borrowing by making larger down payments. Outsourcing leverage to lessors Boeing analysis of airline economics has long indicated that, for most airlines, the decision to buy or lease airplanes is neutral in terms of the total economic value of the airline. Over the past two decades, the growing share of the global fleet that is on operating lease supports this finding. The number of leased airplanes in the global fleet is rapidly approaching 50 percent of the world's total operational fleet. That is precisely what would be expected if the buy/lease decision is economically neutral. Infrastructure costs as a percentage of total airplane investment level off when the fleet size reaches about 50 airplanes. Economies of scale, therefore, are not scalable beyond that point. The percentage of the global commercial fleet on operating leases has been growing steadily since 1970. Currently more than a third of operating airplanes on operating lease. The proportion should reach 50 percent in the near future. Organic deleveraging Our industry has long believed that airlines needed leverage to expand their fleets to gain a competitive advantage over smaller airlines. In addition, economies of scale bring down operational cost per passenger as the fleet gets larger. However, airlines learned that once the number of airplanes in the fleet gets to about 50, further economies of scale are not very scalable. Consequently, airlines began to focus on the scope of their business. Scope is the airline's ability to better utilize its assets and customer base. For example, by increasing airplane load factors and scheduling more flights per airplane each week, airlines can earn more revenue with the same assets. For the past 10 years, airlines have been achieving higher load factors and greater airplane utilization than had ever been considered sustainable. In addition, airlines have come to recognize that the captive audience occupying seats is an asset that can generate revenue. Beyond charging for checked luggage, airlines have made selling movies, food, and other products and services on board an integral part of their operations. Before the passenger even reaches the airport, the airline can earn ancillary revenue from each passenger by selling "clicks" to hotels, restaurants, entertainment, tourist attractions, and car rental sites on their online reservation systems. These revenue enhancements are helping airlines increase the cash on hand, which gives them greater flexibility to manage financial leveraging. Airlines around the world have been aggressively deleveraging and have significantly less debt than was typical of airlines a decade and a half ago.   Girding against future shocks There has been a material reduction in publicly listed airline leverage since early 2000. We asked airline CFOs the reason for their deleveraging. The near-unanimous reply was, "Never again will my business be in the precarious position it was in after 9-11." After 9-11, a lot of strong, healthy airlines came to the brink of insolvency. As an industry, airlines began to deleverage. And they held true to their resolution even through the years 2004-to-2006, when capital was more abundant and credit easier to obtain than ever before in history. During the most recent test of airline resolve, the financial crisis and economic recession which began in 2008, it would have been natural and even justifiable for airlines to borrow in order to defend against the most severe and unpredictable financial crisis since the Great Depression. Yet airlines maintained relatively low leverage, compared to the pre-9-11 level of indebtedness.   A more flexible asset/credit balance Today, the cash position and debt profile of most public airlines reflects those efforts. For the industry this means a future in which airplane financing is structured on a healthy balance between airplane asset value and credit worthiness of the airline that operates the asset. This new balance will give airlines much greater flexibility to weather the inherent volatility of the industry. With lower leverage, airlines are less exposed to shocks from outside the industry. Significantly, financiers are realizing that lower leverage makes the airline business less risky. Credit rating agencies look at volatility and risk. Lower risk merits higher credit ratings, freeing the way for more capital investment.