www.airlineeconomics.co Airline Economics Global Aviation Finance & Leasing Guide 2016 145 144 Airline Economics Global Aviation Finance & Leasing Guide 2016 www.airlineeconomics.co T he last two years have welcomed the introduction of numerous passenger to freighter “P2F” conversion programmes for current generation narrow body aircraft. These announcements, taken in conjunction with the impending introduction of the NEO and MAX, have made the business of accurately forecasting the residual value of mid-life aircraft a complex one. Recent announcements coupled with imminent platform updates from the two principal manufacturers promotes uncertainty with regard to the residual value of current generation narrow body aircraft. An October press release issued by Airbus outlined its plan to escalate its A320 production rate from 42 to 60 units per month by mid-2019, with similar ambitions echoed by Boeing. This increased output coupled with the introduction of the NEO and MAX over the next 18 months could potentially lead to accelerated depreciation of base and current market values. Despite strong demand for newer variants as evidenced by the growing backlogs on order books, current generation requirements are robust. With lower fuel costs expected to persist for the near future, utilisation of older aircraft remains steady - if not increasing as UBS indicated it its November 2015 paper, Tracking Tails to Pin Down the Aftermarket - and airlines are seeking to extend leases. With global passenger numbers forecast to double over the next 20 years according to the Boeing Current Market Outlook 2015-2034, the narrow body fleet is expected to grow to approximately 30 thousand units by 2034. This level of demand provides plenty of scope for the remarketing of older aircraft. Now recent announcements in the air cargo industry with regard to narrow body freighters may positively influence future demand for current generation aircraft. AIR CARGO MARKET Following the global economic collapse in 2008-09, growth of world air cargo traffic was slow following its initial fall and recovery. Whilst 2015 saw slightly weaker demand compared to the high growth experienced over the previous two years, there is a consensus that the long term growth rate is hovering around 5 percent. Boeing are forecasting an annual growth rate of 4.7 percent over the next 20 years with a doubling of the current Revenue-Tonne-Kilometre, according to the Boeing World Air Cargo Forecast 2014-2015. Airbus, in Current Market Outlook 2015-2034, is slightly less optimistic forecasting a rate of 4.4 percent. As part of Boeing’s presentation, the company expects the current world freighter fleet to grow by over 50 percent in the same period. Currently 35 percent of all freighters are narrow body conversions. Boeing expects this share to have increased to 40 percent by period end, approximately double the current size. Two of the fastest growing markets are Intra-Asia and domestic China, the latter investing heavily in its infrastructure, building an additional 30 airports and developing dozens more. Both sectors are well- placed to take advantage of the narrow body freighter, where express delivery is required to support a fast growing e-commerce market. In addition to supporting emerging markets, there will be replacement requirements in North America and Europe to replace aging fleets. PASSENGER TO FREIGHTER CONVERSION The B737-400 P2F conversion is one of the most popular narrow body freighters currently available. However, as supply is diminishing, the current generation of narrow body aircraft are reaching a point in their respective life cycles where they are being investigated as viable alternate replacements. In the past two years numerous conversion programmes have been introduced. Airbus, in conjunction with ST Aerospace and Elbe Flugzeugwerke, as well as the PACAVI group, has announced P2F initiatives for the A320 and A321. Boeing is investigating the feasibility of the B737-800 conversion, along with PEMCO, IAI-Bedek and Aeronautical Engineers, Inc. (AEI). The latter recently announced deals with GECAS and Aviation Capital Group bringing potential orders for their B737-800 P2F to 50. The certificates for conversion are expected by mid-2017 to 2018. The industry is forecasting a production rate of 50 to 60 aircraft annually, with AEI envisaging completing over 300 B737- 800 conversions alone within the 15 years following the certification. A big unknown is Airbus’ place within the narrow body freighter market, currently dominated by Boeing. When the B737-400 runs out, if current operators want to stay with Boeing they will have to transition to the B737- 800. Airbus conversions may encounter reluctance with operators willing to switch from a known platform to the lower capacity A320. Despite this, at a recent conference one conversion company was targeting a 10-15 percent market share for Airbus conversions within five years, citing a comparatively cheaper inventory and providing a more attractive option. The A321 P2F program facilitates an obvious entry point into the market. This is the only current generation aircraft that could be considered as an alternative/ replacement of the B757 freighter. NARROW BODY RESIDUAL VALUE Most conversion companies are in agreement that the current aircraft price is prohibitively high, due in large Conversion challenges Daniel Logan, director of portfolio management, Apollo Aviation Group, investigates the challenges of valuing aircraft with increasing passenger to freighter conversions.
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www.airlineeconomics.co Airline Economics Global Aviation Finance & Leasing Guide 2016 145144 Airline Economics Global Aviation Finance & Leasing Guide 2016 www.airlineeconomics.co
APOLLO AVIATION APOLLO AVIATION
The last two years have welcomed the introduction of numerous passenger to freighter “P2F” conversion programmes for current
generation narrow body aircraft. These announcements, taken in conjunction with the impending introduction of the NEO and MAX, have made the business of accurately forecasting the residual value of mid-life aircraft a complex one.
Recent announcements coupled with imminent platform updates from the two principal manufacturers promotes uncertainty with regard to the residual value of current generation narrow body aircraft. An October press release issued by Airbus outlined its plan to escalate its A320 production rate from 42 to 60 units per month by mid-2019, with similar ambitions echoed by Boeing. This increased output coupled with the introduction of the NEO and MAX over the next 18 months could potentially lead
to accelerated depreciation of base and current market values. Despite strong demand for newer variants as evidenced by the growing backlogs on order books, current generation requirements are robust. With lower fuel costs expected to persist for the near future, utilisation of older aircraft remains steady - if not increasing as UBS indicated it its November 2015 paper, Tracking Tails to Pin Down the Aftermarket - and airlines are seeking to extend leases. With global passenger numbers forecast to double over the next 20 years according to the Boeing Current Market Outlook 2015-2034, the narrow body fleet is expected to grow to approximately 30 thousand units by 2034. This level of demand provides plenty of scope for the remarketing of older aircraft. Now recent announcements in the air cargo industry with regard to narrow body freighters may positively influence future demand for current generation aircraft.
AIR CARGO MARKETFollowing the global economic collapse in 2008-09, growth of world air cargo traffic was slow following its initial fall and recovery. Whilst 2015 saw slightly weaker demand compared to the high growth experienced over the previous two years, there is a consensus that the long term growth rate is hovering around 5 percent. Boeing are forecasting an annual growth rate of 4.7 percent over the next 20 years with a doubling of the current Revenue-Tonne-Kilometre, according to the Boeing World Air Cargo Forecast 2014-2015. Airbus, in Current Market Outlook 2015-2034, is slightly less optimistic forecasting a rate of 4.4 percent. As part of Boeing’s presentation, the company expects the current world freighter fleet to grow by over 50 percent in the same period. Currently 35 percent of all freighters are narrow body conversions. Boeing expects this share to have increased to
40 percent by period end, approximately double the current size. Two of the fastest growing markets are Intra-Asia and domestic China, the latter investing heavily in its infrastructure, building an additional 30 airports and developing dozens more. Both sectors are well-placed to take advantage of the narrow body freighter, where express delivery is required to support a fast growing e-commerce market. In addition to supporting emerging markets, there will be replacement requirements in North America and Europe to replace aging fleets.
PASSENGER TO FREIGHTER CONVERSIONThe B737-400 P2F conversion is one of the most popular narrow body freighters currently available. However, as supply is diminishing, the current generation of narrow body aircraft are reaching a point in their respective life cycles where
they are being investigated as viable alternate replacements. In the past two years numerous conversion programmes have been introduced. Airbus, in conjunction with ST Aerospace and Elbe Flugzeugwerke, as well as the PACAVI group, has announced P2F initiatives for the A320 and A321. Boeing is investigating the feasibility of the B737-800 conversion, along with PEMCO, IAI-Bedek and Aeronautical Engineers, Inc. (AEI). The latter recently announced deals with GECAS and Aviation Capital Group bringing potential orders for their B737-800 P2F to 50. The certificates for conversion are expected by mid-2017 to 2018. The industry is forecasting a production rate of 50 to 60 aircraft annually, with AEI envisaging completing over 300 B737-800 conversions alone within the 15 years following the certification.
A big unknown is Airbus’ place within the narrow body freighter market,
currently dominated by Boeing. When the B737-400 runs out, if current operators want to stay with Boeing they will have to transition to the B737-800. Airbus conversions may encounter reluctance with operators willing to switch from a known platform to the lower capacity A320. Despite this, at a recent conference one conversion company was targeting a 10-15 percent market share for Airbus conversions within five years, citing a comparatively cheaper inventory and providing a more attractive option. The A321 P2F program facilitates an obvious entry point into the market. This is the only current generation aircraft that could be considered as an alternative/replacement of the B757 freighter.
NARROW BODY RESIDUAL VALUEMost conversion companies are in agreement that the current aircraft price is prohibitively high, due in large
Conversion challengesDaniel Logan, director of portfolio management, Apollo Aviation Group, investigates the challenges of valuing aircraft with increasing passenger to freighter conversions.
146 Airline Economics Global Aviation Finance & Leasing Guide 2016 www.airlineeconomics.co
APOLLO AVIATION
part to engine expense. The common consensus held is that within the next four to five years, suitable aircraft should depreciate to within attainable range. Typically aircraft around 15 years old would be considered suitable candidates for conversion. The current market value of similar vintage NG and CEO aircraft would not merit the investment to convert, in particular the A321 and B737-800. Appraisers such as Avitas and Ascend believe current market values will continue to increase to a peak in 2019 after which there will be a gradual downturn. It remains to be seen whether there will be a dramatic fall off in value, as was seen following Boeing’s previous Narrow Body introduction. With an expected conversion price circa US$5 million, it could be reasonable to hypothesise that aircraft anywhere above the US$7 million mark would be too expensive to consider. As it stands, it may be too early to invest in a 737-800 acquisition for conversion to freighter, however it is quickly becoming an economical life extension for existing owners.
When determining asset residuals for acquisitions, it requires a significant and active presence in the market, reflected in unique asset depreciation rates and a servicer capability to monetise the asset. While forecasted future values from the
appraisers can be used as a benchmark, many other factors may significantly influence these, such as future interest rates, fuel prices, and world GDP.
In considering the sizing of the fleet, Boeing has predicted narrow body retirements will reach 450 to 500 annually by the end of the decade. If this forecast, and those of the appraisers, have correctly captured the expected conversion rate alongside retirements, there may not be any material impact on appraised residuals. However if forecast aircraft retirements are primarily focused on aircraft aged 20 to 25 years and assuming sustained demand for mid-life narrow bodies, required yield on converted aircraft may dictate that end-of-life aircraft provide the most attractive supply. Given an expected conversion rate of 50 plus aircraft per year, there could be potential for strengthening of actual market values of particular vintages. Alternatively if residual values depreciate to a point where 15 year old aircraft become affordable, those that remain unconverted would benefit in an already active market, for example, the 737-800 fleet. Assuming a slight softening of depreciation rates applied to market value appraised residuals, and factoring in aircraft retirements, in a given year, following certification of the conversion programme, there could
conceivably be a positive net increase to the market value of mid- to end-of-life fleet of between US$1.25 billion to 1.50 billion.
Future valuations are underwritten based on the supply of retired aircraft as compared to the overall demand. Any aircraft converted is one less aircraft retired into the parts market, and one more aircraft to be supported by the same. At this early stage it is difficult to appreciate what impact keeping an additional 750 plus aircraft flying will have. It is conceivable however, that current valuations may ultimately be too conservative.
Apollo Aviation Group (AAG) is a leading multi strategy investment manager specialising in commercial aviation, with assets under management totalling approximately US$ 2.5 Billion. Targeting mid- to end-of-life aircraft and engines, AAG has a track record of creating value by managing aircraft and engines through their last lease and retirement. Founded in 2002, AAG has offices in Miami, Dublin and Singapore. The current AAG fleet comprises nearly 100 in-production aircraft, with 40 lessees across 29 countries. Approximately 80 percent are current generation narrow bodies. Split between Airbus and Boeing variants, the fleet has an average age of approximately 15 years.
Image courtesy of Aeronautical Engineers, Inc
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