Engine leasing: ‘a sexy industry with a remarkably short memory’
Written by Jon Sharp for Aviation Finance
The last few years have seen the longest period of sustained and significant profitability for the airline sector in history. IATA continues to predict the continuation of the bull run with 2018 expected to create further outstanding profits for airlines. This is excellent news for the aviation industry as a whole, with the airlines being at the apex of the whole industrial complex of production, maintenance, operations and the supporting nance industry. But is it good for everyone? I here consider today’s economic conditions from the point of view of the engine lessor.
The engine leasing industry has been around since jet engines started flying, whether as a by-product of OEM product support or as a commercial venture designed to provide spare engine cover over the period it takes for the shop visit of an installed engine. It only evolved into a product offering an alternative way of financing the acquisition of an engine on a long-term basis some thirty years ago and since then has gone from strength to strength, weathering global crises and the economic cycles that came with them.
It became bigger business when the engines themselves became larger and more complex, and therefore more expensive. (ELF’s first engine purchase in 1990 was a JT8D-17 for which we paid the princely sum of $1m; a GE90-115B today can mean an investment of $37M). With the increased prices of this essential equipment, airlines saw the sense in taking a long-term lease. This was particularly so when the airlines’ balance sheets were not so strong because their financial performance was usually variable, at best.
Furthermore, according to the accounting practices then common in most jurisdictions, a long-term lease did not show up as a liability on the airline’s balance sheet. Balance sheet weakness meant borrowing options for the airline were limited and so a lease was a perfect way of conserving cash while at the same time avoiding the inevitable residual value risk that was so difficult to predict in a volatile global economy.
The engine lessors however were content to lease to those airlines with weak balance sheets, placing their faith in their ability to successfully repossess a valuable asset that they could remarket, if not immediately, at least in the next upturn. The key to surviving the regular economic cycles was in riding the downturn (hopefully buying assets at that time relatively cheaply) and placing them and ultimately exiting them in the upturns. The point being that the lessors could span the cycles and make longer-term decisions about their assets – the relationship between airlines and engine lessors is naturally very symbiotic, therefore.
However, many airlines are now cash-rich in a way they have not seen for many a year, plus they have relatively strong balance sheets (which with changes to accounting rules in some jurisdictions may now have to show long-term leases as liabilities) which will support other forms of financing that may be cheaper than leasing, which has been moved in some cases to the back burner. In such cases, what has been forgotten is the residual value risk – because the continuing bull market is fuelling demand and so values – and that much of the finance available today from a saturated market emanates from sources either with no aviation experience or with short memories.
Whilst the market share of long-term engine leasing may therefore be slowing, there are nevertheless vast quantities of engines on order as the airline industry continues to prosper, so the established participants in the long-term engine leasing business are at the very least holding their own. When the next (inevitable) downturn occurs they will undoubtedly accelerate their market share as start-ups and other forms of finance shrink back from lending to weaker balance sheets, and the airlines will remember that these asset values are highly volatile.
Accordingly, the current economic climate may not be optimum for the long-term engine lessor, but it is a golden period for the short-term engine lessor. Airlines are flying at high intensity, MRO shops are flat out, demand for spare engines is strong and at the same time older equipment is being kept in the air particularly as delivery and EIS issues continue with some of the new generation engines.
Meantime the OEMs are having to support the operation of these new in-service motors by creating large pools of spare engines that they need to control in order to rotate them most efficiently around the installed fleets experiencing those EIS problems. The engines in those pools are of course provided by the OEM as a product support function on terms and conditions that are unattractive to a commercial lessor. As the teething problems are resolved, the OEMs will no longer increase their pools until equilibrium is reached and that is the time when the long-term lessors will wish to seize the opportunity to build their own commercial support fleets. Also even when the engine specifications stabilise, there will be many years before the demand for spare engine cover arrives in sufficient strength to justify investment for the short-term engine lessor. (Remember the ‘bow-wave’ of CFM56-7B shop visits that never happened?). Current conditions therefore dictate that the best investments for engine lessors are not in the newest technology but the current generation engines for which demand remains high.
This demand, due to continued strong passenger and cargo traffic, coupled with the EIS problems has led to record numbers of lease extensions over the last few years – excellent business for the engine lessor, short- or long-term. Demand for certain of the current engine types exceeds supply so purchase prices for those types are overheated; sellers see their residual value assumptions justified, as long as the bull run lasts.
In summary, it is presently difficult to source engines (at reasonable prices) to support growth throughout the life cycle. Both the new generation and current generation engines are in short supply for the reasons explained above; parts companies cannot acquire current or previous engines on sensible economics in order to supply the strong demand for USM (used serviceable material) coming from the MROs some of whom are facing component shortages. Traditional players whether in leasing or parts businesses are competing with new money trying to find a home in a sexy industry with a remarkably short memory. Established players are rubbing their hands at the prospect of a downturn.