Blain’s Morning Porridge – Jan 19th 2022: Global Travel may reopen – but just how uncertain is the outlook for aviation?
“A good landing is one you can walk away from, but a great landing is when you can still fly the plane the next morning”
This morning: Airlines are likely to get a knee-jerk boost when global travel reopens post pandemic, but the outlook facing the aviation sector in terms of balance sheet shattered airlines, struggling aircraft manufacturers, reluctant consumers and a glut of older aircraft has seldom been so uncertain. Yet, in times of confusion there is opportunity!
In the rich etymological tradition of the Morning Porridge, I have a new word for you this morning: Preighter.
It’s a portmanteau of passenger and freighter, meaning a light “cargo in cabin” aircraft. During the pandemic the volumes of cargo carried on passenger aircraft skyrocketed. It proved quick, efficient and easy to ship emergency PPE and medical equipment around the globe strapped to seats, jammed between luggage racks and stowed in galleys and cargo bays. With airline passenger numbers still below 1999 levels, many unemployed passenger aircraft have now had their seats taken out and netting installed to hold down light-weight packages and boxes being shipped around the globe.
Preighters are a cheap solution to rising logistical needs. A Preighter doesn’t require the full conversion to Freighter. Floors and doors don’t need rebuilt and strengthened, and planes can even be returned to full passenger service.
The cost of sending a shipping container to Europe from has famously risen from $1500 in Jan 2020 to over $14000 today – making air freight look more attractive on a relative basis. Air Freight costs have also seen substantial rises, but one key factor for Preighters has been enabling the success of next-day delivery for the ETSY/Amazon generation. I’m told fulfilment centres in Asia are regularly flying preighters full of individually addressed boxes of overnight orders for direct distribution to Europe and US consumers.
Does it mean that finding a use for a small number of the thousands of aircraft that have been sitting in desert boneyard storage since the pandemic began nearly 2 years ago means aviation is saved? No. Not in itself. The aircraft were available and no one was using them. Is it economic to use a $150 million jet to shift carboard boxes full of air and a $10 consumer commodity around the globe? The impact of air-freight and preight on aviation’s carbon footprint is substantial. While your daughter may rage at your new non-electric car, don’t dare tell her that must-have dress for tomorrow’s party will contribute to the eviction of polar bears from the artic oceans.
Aviation has always been one of my favourite asset classes.
I retain a boyhood fascination with planes, and developed a financiers fascination with the returns they can generate. It’s a tremendously complex asset class that involves airlines, manufacturers, consumers, governments and economic cycles. It’s never been a market as ripe with uncertainty – which also means uncertainty. As the global economy reopens post Covid, the next few months are going to be critical for the aviation sector:
- Bringing aircraft back into service is not a quick clean and polish operation – it’s expensive at a time when airlines are absolutely strapped for cash. Shortage of planes in service is a real possibility at some point.
- Are consumers about to splurge on holidays and travel with the money they’ve “saved-up” by not-going-out during the pandemic? Or, will inflation, rising energy prices and low wages conspire to cut discretionary holiday spending, causing a double whammy to doddering airlines?
- Will business travel return – or have we learnt that a zoom call might be more difficult but is far more cost effective?
- How will airlines address the “covid-debt” they were forced to take on through the pandemic? What will happen to deferred aircraft purchases – which now have to be paid or deposits lost? How might they attempt to raise money by sale and leaseback, or to monetise routes, landing slots and even monetising passenger loyalty programmes? (One US airline has its loyalty programme in a subsidiary valued at $30 bln – and, yes. Their auditors signed off on it.)
- What can the aircraft manufacturers do to move aviation forward. Airbus’ plans to launch hydrogen powered aircraft by 2035 increasingly look like an attempt to gaslight Boeing, which remains damaged goods after the Max crisis. (Hydrogen aircraft are a massive distraction from reality – see this article: Hydrogen can’t power the green flight revolution.)
- New more efficient aircraft are required, but Boeing squandered its cash on stock buybacks and crashing labour relations. Airbus is struggling with skills shortages. It may be time to replace these ailing dinosaurs – but the costs of entry look prohibitive.
- How many of the (particularly Asian) airlines being propped up by their respective governments will survive and thrive? How many airlines will still default.
- What will rising interest rates, the end of corporate QE and tighter money mean for aviation liquidity in an increasingly stressed market?
To invest in aviation, you could just go buy stock in a plane maker or airline you like – a well trod and proven way to convert a large fortune into a smaller one.
Or you could own aircraft. In the past, the returns from owning aircraft as real assets have been substantial. Most airlines don’t own their planes – they lease them, paying a rental to the leasing companies that own them. In sound markets that’s a substantial annuity stream, but is made more complex by factors including:
- Will the likelihood and financial health of the airline to meet its rental obligations – Credit Risk
- What will the aircraft be worth at the end of the lease in terms of re-lease, resale or scrap “part-out” value – Metal Risk
- The outlook for air travel – currently battered by the pandemic, and rising fears about carbon emissions and global warming – Market Risk
All these key metrics are negative at present. There is no real consensus on what aircraft valuations are likely to be, or agreement on the direction and evolution of the market, the alternatives including relative merits of new or older aircraft types, the underlying market and half-a-dozen other factors I’ve already forgotten about. What everyone does agree is the credit outlook for airlines is dire.
At the moment the aviation market is focused on smaller, single aisle regional planes – typically A320s/321s and older B-737s. Smaller planes will fill faster during times of stress. They won’t restore global travel. I recently had the utter misfortune to fly the 6 hours from Cairo to London on a packed A321 – it’s not pleasant doing long motorway journeys on a minibus.
Some aircraft are doomed. Love them or adore them the super-jumbo A380s only suit the densest routes. The last entered service last year and earlier ones are already being scrapped. There is zero demand for the type. A-330s have had their day. Older B-777s are jaded. Some aircraft can be repurposed as freighters. A380s can’t! Newer B-777s may do very well as long-haul routes reopen. Yet the darling of the recent Dubai airshow, the B-777x is unlikely to serve airlines during my career.
Even the super-efficient new types have problems. The new composite fuel-efficient Airbus A-350 has apparently stumbled into a crisis. Paint deterioration on its carbon skin has caused Qatar to ground them. Apparently, there may be similar problems with Boeing’s B-787 Dreamliner. As for the Boeing 737 Max – it’s very attractive to cash-strapped airlines as they can negotiate massive discounts, but recent Air Canada load imbalance problems hint the software failures that killed 346 passengers and crew, and should have killed Boeing, continue to haunt the type.
The consensus on the airlines is “difficult”. When I suggested to one aviation investor there may be value in Junk Airlines his response was: “you mean all of them. All airlines look like junk.”
Airlines will spend at least the next 10-years cash-strapped paying off the 2-years of the pandemic. It means some airlines with modern fuel-efficient fleets are bound to do better than airlines flying older aircraft that won’t now be replaced or upgraded. (I see this on the Dubai-London sector where BA’s A380 look tired and don’t come close to what Emirates flights in terms of service and comfort. BA’s newer A350s are better – but still not worth paying more for when Emirates are just so much better.)
With global interest rates set to rise, and the liquidity that’s been available from central banks’ corporate QE bond buying programmes disappears and roils markets, timing for cash-strapped airlines could not look worse. Trying to refinance in adverse bond markets is never easy, demonstrating the wisdom of airlines that funded last year: “Never fund when you have to, fund when you can!”
At present, senior debt financing on the “right” aircraft earmarked for the strongest airlines is tighter than pre-pandemic levels. That makes some sense on the logic things can only get better once the global economy reopens. But why take any risk on aviation when government bond yields are rising? But, buying a stub of higher yielding junior debt on a solid aircraft, or even taking a risk on one owned by a junk operator can achieve very substantial risk adjusted returns!
Aviation remains a market I’ll dip in and out of. If the right opportunity comes up… buying hats on! Aviation is a market crying out for someone to find a new disruptive way of doing it better – when I spot them, I’ll let you know….
Five things to read this morning:
Out of time and back to the day job. (Sorry for no comment y’day – busy morning!)
Strategist – Shard Capital