Written by Jon Sharp and published in The 2018 Engine Yearbook.
Global and industry-specific events have conspired to create considerable uncertainty for asset managers, writes Jon Sharp, president and CEO of Engine Lease Finance.
I have written this piece for the Engine Yearbook several times in the past and this is without doubt the most challenging occasion on which I have been asked to do so. With so many uncertainties currently besetting the industry, it is very difficult to pick out definite long-term trends and to make any predictions for the future. The job of strategic thinkers in this industry is becoming harder.
First, consider the obvious global uncertainties: Brexit; the threat of military action involving North Korea, including the threat of nuclear war; ongoing terrorism is many parts of the world; an unpredictable leader in the White House; and aggressive posturing by Russia. The rational macro-economic forecaster might as well give up and go fishing.
Against this daunting backdrop, and for us engine guys working at a less lofty level, there are still plenty of imponderables in our own industry. I will attempt to focus on several here.
The big picture, at first glance, is encouraging:
There is much talk of the entry-into-service (EIS) problems with these new engine types. The Pratt & Whitney geared turbofan (GTF) in its various forms is the most commented upon, perhaps due to its radical design but also because there are several thousand already on order. The inter-related problems of design changes and a ramp-up of production rates are causing a big headache for the OEM.
Of greater concern to me is the continued high production rates for aircraft and therefore engines, particularly for the Airbus A320neo and the Boeing 737 Max. Both P&W and CFMI have struggled to keep pace with the manufacture of the GTF and LEAP, respectively.
This results in nearly every engine coming off the production lines and going straight to Boeing or Airbus for installation on new production aircraft, with very few being made available as spares. This has forced investors either to continue investment in CFM56s and
V2500s, or to engage in cut-throat competition to acquire the few spares that do become available by means of sale and leaseback.
Concerns over production delays and technical problems have meant that some investors have converted their Neo and Max orders back to CEOs and NGs, which will extend the production runs and ultimate lives of those aircraft and the engines they host. Obviously, oil prices will have a say in that over time, but for now at least it has resulted in stronger lease rates for current-generation engine types in the spot market.
The new engines have a production lead time well in excess of 12 months. To harness sufficient high-tech industrial capability to meet the aircraft makers’ production rates is massively challenging, both logistically and financially, and unprecedented amounts of capital and human resources have been invested to meet demand. But what happens when there is a downturn? For there will be one, we just do not know what will kick it off (see the second paragraph of this article and take your pick). Hitherto, production rates have never approached current levels, so my concern is that when the downturn comes, it will have a dramatic effect and that aircraft will be parked and orders cancelled at unprecedented levels. One analyst forecasts that a major downturn would result in 5,000 parked aircraft.
IATA predicts continued strong economic performance from the world’s airlines through 2017, which is good news for all of us involved in any sector of this industry. But the warning signs are there: oil prices are wobbling; overcompetition has driven down fares; and, at the time of writing, three large European airlines are in various stages of bankruptcy administration, with others struggling in the Middle East, the Americas and Asia Pacific.
The oversupply of capital in the aircraft and engine leasing markets must shoulder some blame for this. Lessors (particularly new entrants chasing critical mass) offer airlines carelessly cheap options to extend their fleets, options which they have taken perhaps unwisely, but in the knowledge that it will be the lessors who ultimately take the hit. The same increased competition in the leasing market has meant that for many participants, the sale-and-leaseback market is no longer viable, so they have been turning to placing orders direct with the OEMs.
This is evidenced by the fact that at this year’s Paris Airshow, the percentage of firm orders placed by lessors exceeded 70% of the total, against the existing global fleet share of 46%.
The widebody market is exhibiting some particularly worrying trends from an investor’s perspective. We are seeing aircraft being broken up relatively early in their lives, after as little as 10 years, because the lessor sees that as a way of liquidating its asset in a finite timescale rather than having to reinvest in the asset at the end of the first lease, a process which would most likely involve extensive refurbishment, a heavy check, engine and landing gear overhaul and perhaps new avionics. This all demands not only new funding but also considerable downtime, as well as management and remarketing expertise, which some lessors do not possess in-house.
Another caution for the would-be investor in widebody engines is that the LLPs may never require replacement due to the long stage lengths being flown. Airlines therefore resist the payment of reserves to cover LLPs; however, the lessor/investor needs to claw back that part of its investment which was integral in buying the engine in the first place. If the lessor takes the traditional end-of-life (EoL) route and breaks the engine for parts, then aside from what it may recover from non-LLP parts, it can only recover value for the remaining LLP life, and even then may fail to recover anything at all, because of the above point that widebody engines rarely require LLP replacement, so the market will be limited. This can mean that the lessor never recovers its initial investment.
For all components in the new generation of engines there is also a question hanging over residual value due to a potential lack of repairability for expensive parts. This might be due to a combination of complex geometric design, processes such as additive manufacturing, and the use of new materials such as ceramic matrix composites. Furthermore, as OEMs become more protective of their aftermarkets, will they licence repair schemes to third-party service providers or not? Thus the traditional business models in play today may not may not apply to new engines.
END OF LIFE
The ability to liquidate engines through the EoL and part-out processes is vital to engine lessors. There are fortunately many companies in the industry who exist just to do this and so the market is currently buoyant. At Engine Lease Finance we handle all aspects of an engine’s life, from brand new to EoL. The key stages are, in brief:
1. A ‘financial’ product of what is typically a 10-year operating lease where the airline has full care, custody, and control of the engine;
2. A short-term leasing/spot market/AOG service where the engine’s green-time is burned off;
3. A part-out capability. We operate separate divisions in the company specialising in each of these functions, all under the same overall management.
Of course, there may be several refurbish versus sell decisions during the second stage, depending on how robust the continuing demand is for that engine type. We decided to bring the third capability in-house, for reasons of control and for sharing in the profit from that activity. After an in-depth survey of the market we acquired a majority shareholding in Inventory Navigators (INAV), based in Chicago. ELF has thus acquired its own direct route to the EoL market and INAV benefits from a stream of engines from ELF’s portfolio as well as our global reach and particularly strong finances.
ELF is owned by Mitsubishi UFJ Lease and Finance Company (MUL), who now have a vertically and horizontally integrated group of companies through the aviation leasing sector. The group owns approximately 575 commercial jet engines of all types, so having the full range of EoL options is fundamental to the business. ELF has now accumulated 28 years of thorough industry knowledge and this is precious; when associated with a strong parent company and third-party funding, all wrapped around a fully integrated product line, we consider ourselves strong enough to weather any downturn, despite some of the seemingly pessimistic observations made above.
I trust we will still be writing for the Engine Yearbook in another 28 years’ time. I just wonder what the benefit of hindsight will tell us then.