Covid-19 Crisis effect on ELF Strategies – An Article by Tom Barrett for Airfinance Journal Engines Guide 2021.
The independent spare engine financing leasing company has been through many cycles, good and bad. President and chief executive officer Tom Barrett says the lessor’s sound business strategy will see it, and its customers, through the pandemic.
All things are cyclical:
Though the word cyclical is used to describe the Aviation industry, it is important to acknowledge that all things in life as well as in business are cyclical. It is just the timing and causes of the cycles and their peaks and troughs that vary.
This Covid-19 Crisis has affected everyone across the globe in their personal life, work life and broader community life. While some regions are still struggling, right now there is hope that globally we are moving towards a recovery phase in this cycle.
The challenge to us in the industry is for experienced managers and their teams to use their skills to recognize what is happening, adapt to the changed reality and execute revised strategies that reflect the constantly changing circumstances presented. If they do this right, they can continue to successfully deliver the required services to their customers, provide decent commercial returns for their shareholders and ensure their teams are energized and challenged as they navigate these circumstances.
2019 – the peak had passed:
As someone who has been around this industry for 30 years, and has been through four or five cycles, there is no doubt that the Covid-19 Crisis has been the most severe that I have experienced. In 2018, at a time when stored aircraft was running at 2,000, we in ELF, like many, were predicting the cycle was reaching its peak and suggested (provocatively we thought) that parked aircraft might reach 5,000 when the industry turned. We had expected this to be a gradual decline (“soft landing”) and in our wildest forecasts did not predict that it could be anything like the 10,000 figure that we see today.
Had any forecaster then predicted, and been believed, such a radical increase in parked aircraft, it would have prompted many investors in the industry to cease their investment strategies immediately. They would have been right.
During this Covid-19 Crisis, we in ELF have had to repeatedly ask ourselves what is happening? We have debated what will happen to our customers, our own ability to deliver to them and to continuously evaluate the situation of our competitors. Everything has been up for grabs and every historic assumption, that has served us well for 30 years about the engine leasing business has been taken apart and dissected.
The good news and the thing that keeps us so positive for the future of the Company, and our industry sector, is that when we looked at our assumptions, we were able to, even in the depths of the crisis, be confident that the strategic pillars of this business remain sound.
Play to your strengths of (i) customer relationship and (ii) asset focus:
It all (always does) start with the customer relationship and in our case, this means customers that are predominantly airlines spread throughout the world. They have all been badly affected by the Covid-19 Crisis and unlike with previous cycles, it has been a truly global crisis. Any regional variations that have been apparent are more a result of the extent, or lack, of Government support to the industry and the timing of the various waves of the pandemic.
Along with our customers, it has been impossible to plan the future with any degree of certainty.
Some of our longest standing, 30 years and counting customers have been with us through previous cycles, and they know the long-term view and support that they will get from ELF.
It has been even more crucial through the latest Covid-19 Crisis that we engaged, listened, and tried, wherever possible, to reach compromises that allowed us both maintain our business and our business relationships.
It is a source of considerable pride to our company that we delivered on every mandate, awarded pre-Covid, amid the Covid-19 Crisis and none of our customers who engaged have found us wanting in our attempts to fairly address their needs.
In providing services and support to our customers, we continue to retain our asset investment focus. We are not a bank or investment fund. We are an asset owner and manager. With the support of our investment grade parent, Mitsubishi HC Capital Inc., we invest in aircraft engines for the very long term. Our customers for an individual engine may change but our strong asset emphasis remains. We start by providing our sale and leaseback customers with good pricing on the acquisition of their assets and access to our exceptionally low cost of funds by then delivering lease rates that remain among the lowest available in our market. It is our long-term investment horizon and relatively low cost of funds that allows us to provide the customer with the economics they need, i.e., funding or even profit opportunity at the point of conducting a sale and leaseback and thereafter highly competitive lease rates.
Adapting placement strategy to the new realities:
The 2021 realities are that the engine market has switched from a period of undersupply to oversupply within a very quick timeframe. These new realities include uncertainty around early aircraft retirements creating increasing greentime engine supply, prolonged shop visit avoidance strategies, lack of utilization of existing assets supplied and a recovery that will in the near-term hinge on Government management of the inoculation roll-out and cross border travel policies.
Without question, ELF has been forced to adapt to these new realities to ensure that we maximize how we work with customers to get engines placed into operation.
Fortunately, we have been here before and having established a short-term remarketing team in a previous downturn, we can say with certainty that in terms of speed of response to our customer demands and positive engagement on negotiation, there is nothing that our team have not seen before.
It is because of the diversity of our portfolio and individual engine profiles within each engine variant that we can say to every customer, whether looking for access to a newer engine for the long term or cover for a limited shop visit or even some greentime to match their shop visit avoidance strategies, that ELF will have the engine that meets their specific requirements. The strength of ELF’s financial resources and aggressive management of the asset carrying values also allows ELF to compete aggressively when it comes to lease rates in this market segment.
What is new in this cycle is the adoption by airlines, mostly those in bankruptcy, of a power by the hour (PBH) model for leasing. This has been a new development and although it is not in the lessor’s interests, or the long-term interests of the industry, it clearly is necessary for some airlines to ensure they can survive in the shorter term. In this area too ELF has been capable of selecting specific engines that can match the airline’s requirements.
However, when people ask whether this is the new model for engine leasing, ELF is confident that we are right that this is a model suited and sustainable in a period of oversupply. When the supply and demand re-balance, as they will for sure, then these PBH arrangements will no longer be possible or if offered, as some would have seen before, they will reflect exorbitant short term lease rates.
For this reason, it remains ELF’s conviction that airlines, who are required to plan in multiyear cycles, are best served by managing the cost of spare engine procurement through the combination of long, medium and some short-term arrangements. When doing so, they will be able to rely on ELF to provide the most competitive long, medium, and short-term rates reflecting the then market realities.
Along with pressure on our airline customers, we have seen our MRO customers (both independents and airline owned) suffer through this Crisis. All of them have suffered the same dramatic drop in demand and along with airlines, they have had to throw out long term forecasting in favour of narrow Crisis focused strategies. In this area too ELF has had to adapt and one positive side effect of our buildup of inventory engines is that it is allowing us, for almost the first time in 30 years, to discuss programmes with the MROs who are managing work for their own or third party significant fleets. In this area ELF and our majority owned parts company INAV, acquired in 2017, are putting forward compelling propositions to supply short and medium-term engine leases and very competitive pricing on the used serviceable material (“USM”) that INAV have been able to competitively source through this Crisis. In past industry downturns this was not an option open to ELF as we did not have the required scale of engines available nor the access to an in-house parts company where this combined service could be delivered.
Current versus new technology strategies:
Reflecting the long-term investment strategy whereby ELF owns and holds assets for a considerable number of years, our portfolio emphasis is always on the latest technology and more populous engines. Unlike some of our competitors we are not restricted by any particular OEM or even market segment, be it regional, narrowbody or widebody equipment. Instead, we rely on our own internal analysis of each engine type, considering all the relative attributes that we determine are relevant to our investment.
Within this model, it is no surprise that the current technology CFM56-7B, CFM56-5B and V2500-A5 have been the engines to the fore of the leasing market for the last 20 years. Now as the B737NG and A320ceo are in the process of being replaced by the Boeing 737-Max and Airbus A320neo and the LEAP-1A, LEAP-1B and PW1100G engines, our emphasis inevitably is moving to these engine types.
However, it must be said that we remain convinced that the current technology engines still have several years operation and we are still of the view that, at the right price, they continue to represent a good investment prospect. The dynamics of the retirement of the host aircraft does of course get factored into our investment decisions. Once again, it is here that our detailed market knowledge and experience allows us to make decisions with confidence.
While the LEAP and PW1100G engines have been a focus for the last few years, the lack of reliability on their entry into service (“EIS”) combined with the cessation of the MAX deliveries, has meant that there have been very few opportunities to acquire each of these engine types. As the EIS have been overcome, and largely unrelated to the pandemic impact other than it allowed the OEMs time to fix the issues, we are now seeing LEAP and PW1100G deliveries increase. This combined with our continued extremely low cost of funds is presenting us with significant opportunities to meet our customers’ requirements for liquidity and economic value. Having met these customer expectations at the outset, our comfort with owning an engine for the entirety of its operation and the fact that engines have not been commoditized to the same extent as aircraft, does ensure that the vast majority of our customers know that when they do a deal with ELF that they will have a lessor who will be with them through the cycles ups and especially, as our customers are now finding in this Covid-19 Crisis, downs.
It will continue to be the case that we will maintain the strategic imperative of investing in assets we expect to lease a few times through their period of ownership and therefore the new technology LEAP and PW1100G engines will be to the fore of our investment strategy in the years ahead.
As mentioned previously ELF is not restricted by virtue of OEM or market segment in its investment decisions. This has meant that ELF has always played an active role in owning widebody engines. Sometimes these widebody engines have come as part of a narrowbody/widebody package but also it has often been the case that ELF has sourced widebody engines individually or as part of a widebody only package. Although the same more populous attributes used for our narrowbody strategy must be tempered because of the sheer lack of widebody deliveries, we are very comfortable to invest in the ones we identify as the better investment candidates. This will continue, reflecting our long-term ownership model through the current Covid-19 Crisis.
In fact, one interesting development in the current Covid-19 Crisis is that the OEMs are being forced to reconsider and re-calibrate their ownership strategy. This is beginning to open the market in an interesting way.
Like all in the industry, the proposed GECAS sale to AerCap has our attention. In ELF’s case our interest is in what it will do to the GE strategy around its widebody deliveries. This is where we have found the soon to be sold OEM in-house lessor to be extremely competitive to the detriment of our ability to penetrate this market in the numbers that we would have previously planned.
There is no doubt that other widebody OEMs are looking at their own strategies and it is likely that their imperatives to strengthen their manufacturing base as they come out of the Covid-19 Crisis will provide excellent opportunities for the independents of scale. As the largest independent owner of engines from all OEMs ELF is uniquely positioned to speak to the Global airlines, with diverse fleets, about all their engine requirements. Having been a modest leasing enterprise for the first part of our history, as we now see the OEM ownership on some engine applications reduce, we do see tremendous potential for us to invest and expand in the widebody segment for the newer technology engines that we rank as good investment candidates.
All of this is consistent with our long-term investment horizon and ELF is comfortable to continue to invest in this segment of the market, even while it is evident that the widebody segment will take some time longer to recover than the more domestic focused narrowbody market. In taking this approach, we are of the view that we are truly meeting our customers requirements in good times and more importantly in bad times as we see today.
Opportunities – investment:
In the depths of this crisis, there is some blind optimism and “wishing” that it will all get better. As in previous cycles there are many, e.g., banks, who will exit aviation rather than provide liquidity when needed and others who will opportunistically enter at the bottom to make the aggressive returns that their private equity investors will demand over the near-term. At both ends of this, these providers (although there are many good people working for them) do not truly deliver what the customers need today, namely consistent, and competitive access to a variety of funding sources. ELF has consistently shown its ability to deliver full asset value at market leading rental rates with flexible offerings that our customer will value as the recovery takes hold and into the longer term.
As we have seen the new technology deliveries of spares increase and the current access to competitive liquidity options for our customers reduce, we have increased our investment targets for 2021. We will, if we achieve them all, see an increase over 2019 levels. Should our customers require, this is a level that we can increase further as we match our access to competitive funding rates with competitive lease rentals for our customers.
Having grown the portfolio through each of the cyclical downturns in our 30-year history, we are extremely confident that we will look back at this cycle as one where we were able to use our considerable scale to provide our existing, and new customers, be they widebody, narrowbody or regional operators of domestic or international focus, consistent and competitive liquidity at the time they really need it. Our engine specialization and long-term investment horizon allows our customers know that when ELF is their engine provider, that they will get the value for money that they clearly need in the downturns.
Opportunities – placement:
As the current period of massive oversupply has come about, ELF has seen inventory grow to the point that it is now at unprecedented levels. Obviously, this is not the best scenario for a lessor, but it is the inevitable consequence of the business having to engage with the realities of our customers.
One consequence of this increased inventory is that ELF has seen opportunities to deliver new offerings to an expanded population of customers.
As the world narrowbody fleet transitions in the next few years and the current, and probably future too, oversupply continues, one interesting development for us at ELF has been the synergies and opportunities that we have seen come about as we bring our parts company and existing technology portfolio together to offer the MRO segment a premium programme product.
This programme offering is allowing us to offer programs of size whereby we can deliver engines all along the scale from zero-time since overhaul to greentime and almost run-out and to combine it with the USM offering from our INAV parts company. As many of the parts being offered have come from engines that we have owned since new, with complete operating histories being available, we see this as an attribute that many of the competitors cannot provide. This reliability combined with the extremely competitive pricing that we can offer due to the long hold periods for our assets is allowing us to increase our penetration with the MROs in a way that was not previously possible. It is the scale that we can provide that is allowing the MROs, be it for their own or a third party’s fleet programme, be confident that we will deliver through the period ahead as shop visits begin to be required in decent numbers.
This programme of scale is not limited to MROs and as airlines have brought increased focus on cost/shop visit avoidance, ELF is now able to offer to help through flexible and cost-effective lease placements that allow airlines to postpone shop visits of their own and leased/financed assets. In doing so ELF and the customer are saving, in this immediate period of this Crisis, the need for considerable cash outlay. Not good news for the MRO but reflecting the reality that they see whereby most are suggesting that the full recovery of shop visits will not occur until 2024 at least.
ELF – a parts player:
One tremendous difference for ELF in this cycle has been the opportunity afforded to us to liberate the value in our engines through our in-house parts company, INAV. This has provided a seamless and transparent outcome for ELF. In the past ELF was at the mercy of the third-party parts market when it made the decision not to invest further in its assets.
We will continue to bring the synergies provided by INAV and ELF combining our offering to ensure that airlines, but particularly MRO customers, can see flexible and competitive offerings. Depending on the retirement profile of the current technology aircraft, this use of current engines and USM will materially impact the customers opportunity to keep costs, and cash outflows, down as the recovery comes.
In overall terms I just want to acknowledge that along with the rest of the world, the aviation industry and all our customers, ELF has been detrimentally affected by the Crisis.
As we embrace the challenges of this current market, and attempt to see the future ahead, it is critical that all lessors do refocus and consider how best to meet the customers’ requirements in the current market.
Within ELF we have reviewed and revised our model. Our placement activity has switched to meet the airlines requirement for flexibility around lease tenors and lease terms. In doing so we are seeking to stimulate the demand for our product that will allow the airlines profitably return to the skies as the travel market reopens globally.
This work also allows us deliver, through MROs, new products that give the airlines the best support that the combined strength of the MROs, ELF and INAV can provide. In doing so the current technology operators are supported in keeping their costs and outflows down.
In terms of sustainability, ELF has always been at the forefront of investing in the newest most fuel- efficient aircraft engines. Though a consistent objective, the transition of world fleets to the Boeing 737-Max and A320neo aircraft, combined with their more fuel-efficient engines allows ELF tangibly to move on the industry’s credentials in this area. From ELF’s point of view, we will continue to invest through the cycles and as customer requirements to fund these assets grow, we will continue to extend our access to competitive funding to meet the customers’ needs.
As has been a hallmark of our independent path since 1990, ELF will continue to pursue the right engines regardless of OEM or market segment. In doing this, and with OEM updated strategies brought about by the Covid-19 Crisis, ELF will continue to invest through the cycles in the widebody space. To this end we look forward to working with OEMs to find the best way to support our mutual customers.
With the recovery still difficult to predict, and tough times still to come for us all, I can say with certainty that ELF’s door is open, and that we are ready to provide the most cost effective, across the spectrum of engines, flexible offerings to our customers in the market. In doing so we will ensure that we are around to see the challenges and opportunities of many more cycles to come.