Aviation – an asset class ripe with opportunity, and more than a few issues..

Blain’s Morning Porridge – May 10th, 2023: Aviation – an asset class ripe with opportunity, and more than a few issues..

“Just say those words, we’ll whip those birds, down to Acapulco Bay..”

This morning: Aviation is booming. Airlines are buying planes. Passengers want to fly. There are just a few little problems… There aren’t enough planes. That makes Aircraft as an Alternative Asset a great investment opportunity.

Let’s go a bit off-piste on this Morning’s Porridge and talk about one of my favourite asset classes: Aircraft. I retain a childhood fascination for planes. My dad was an aviation engineer and passed on to me his addiction to aviation museums and aircraft models. I and am a complete anorak at airports and airshows. I can tell different marks of Spitfire apart from the sound of the engines.

There is lots of news in aviation at present – the rapid reopening of the global travel following Covid, when it was probably the sector most impacted by lockdowns, the extremely high prices airlines are able to charge for tickets, and global shortages of pilots, engineers, ground staff, and cabin crew following the pandemic. Some airlines prepared better for reopening and are now doing superbly well – others, including the UK’s Flag Carrier, are still making excuses for dismal service.

Yesterday was the news Ryanair is spending $40 bln to buy 300 new Boeing 737 MAX – it will have received a massive discount on the order. Across the globe airlines are revamping their first and business class cabins, anticipating high spending passengers are going to ramp up their spending on travel. Even the discredited White Elephants of the Skies – the Airbus 380s are finding new life as airlines hang on to the planes they had expected to dump.

I suspect many readers of the Morning Porridge don’t think about aviation as an asset class in its own right. But it is.. there is money to be at every stage of a plane’s life cycle.

Aircraft are a great example of an Alternative Investment – real assets generating real returns for investors. Essentially its very simple: most airlines don’t own all their own aircraft – they rent them from Aircraft Leasing Companies who manage the planes, and finance them through a variety of bank loans, complex – often tax driven structures, and through securitisation. The rents earned by the aircraft pass to the investors. Most deals are set up with standard securitisation waterfalls, tight documentation and produce highly predictable returns.

Aside from the global no-see-um shock that was the pandemic, or the madness of badly run airlines, aviation is actually quite predictable. The information is all there: we can predict the number of people flying, the value of the aircraft, and the credit strength and management quality of the airlines. From that information we can form a pretty accurate expectation of what return can be generated from an aircraft investment. Leased assets, such as planes, have a very different and stable return outlook than, say taking a speculative punt on new tech or trying to fathom what a bank might be worth five years down the line.

We can also predict the price of an airplane at every point in its life – prices are available if you are prepared to pay for it. We know, or can guess, what it costs new – which is seldom the price listed by the Original Equipment Manufacturers (OEMs); mainly Boeing and Airbus. New aircraft are in great demand – banks want to fund them and airlines want to brag about the modernity of their fleets.

After maybe a decade or so, most new aircraft come to the end of the original lease and are released on to the aviation market, usually taken up by a smaller airline. The plane will be reconfigured – maybe removing business class, or putting in tighter seats, and rebadged, before resuming service looking new in all respects except for the number of flight cycles in the documentation. A number of years later that lease will expire, and it will probably be released to an even smaller airline. After that it may undergo conversion to a freighter, or a preightor (flying internet order packages straight from Asia to the US or Europe for distribution).

Finally, after a service life of some 20-30 years, the plane is retired and scrapped. In what is called “part-out” the still serviceable parts of the plane (and every single component is carefully documented and serviced through the plane life-cycle) are sold on the second hand market.  Items like landing gear and actuators are always in demand. I understand there is a Canadian charter airline flying a B-737 built in 1976! A large number of 30 year old B-767 and B-757s are still in service, one is over 40-years old – they will continue to fly if they meet maintenance and service criteria. There is even a 38 year old B-747 flying somewhere in Iran alongside a 42 year old A-300!

What we know today is global travel is reopen, all airlines are reporting fuller aircraft. UK airports are trying to restrict flights because they can’t cope with the influx of passengers (yes – someone in management should be fired.) Now, we’re about to see Chinese tourists return to the skies. Premium travel in first and business is growing faster than economy. Airlines are spending money to up their game to attract the big spenders…

But, there is a massive but… actually three

A shortage of planes:

The global market is massively short of aircraft. During Covid the OEM’s cut production while global aircraft fleets were grounded. This has created significant labour and supply chain bottlenecks as they struggle to get back to speed. In Boeing’s case poor industrial relations, and the firm hamstrung by the MAX scandal, is a crisis. Airbus finds itself short on the trained engineering manpower it requires to produce at pre-Covid volumes. Across aircraft manufacturing there are multiple supply chains issues as suppliers find they can source the supplies they need to meet the orders from the next firm up.

Deliveries are simply not keeping up. Boeing has over 4,500 B-737 Max on order but is currently only producing 38 per month. That will rise, but it still means new deliveries will be stretched into the next decade. Airbus has over 6000 of the competing A320neo series on order – but is batting out 50 aircraft per month. There is an order book of 440 A350s, but Airbus is only delivering 3 per month. Boeing is struggling with quality control on the fantastic B-787 Dreamliner and is only putting out 2 new planes each month into a 571 order backlog!

In the next 20-years, it is estimated the commercial aviation sector will need 40,000 new aircraft. Order today for delivery in maybe 7 years time… if you are lucky. For at least the next 10-years the OEMs are going to be playing catchup just to stand still.

Engines:

Airlines want new aircraft with greener engines because that attracts investors who want to peacock their green investment credentials by buying clean, carbon efficient, fuel efficient planes they can highlight in corporate green-bragging brochures. The problem is the new clean green engines on the new aircraft are more fuel efficient, but experience shows they require longer and more frequent maintenance on the ground, thus making them as costly as older aircraft types that use 15% more fuel, but are more reliable.

New Aircraft Types:

The replacement of current aircraft types by wholly new designs to achieve more carbon-neutral, renewably powered, efficient aircraft types is decades away because of underinvestment and resource allocation mistakes by the OEMs.

The Boeing 737 is as old as myself. It stretches back to the early 1960s. It was a fine design in its heyday, but over decades it was stretched into a wallowing fat cow. The MAX was a step too far. The new bigger engines were fuel efficient but destabilised the plane – resulting in the death of 346 passengers, Boeing trying to blame the airlines before admitting flawed software they hadn’t told pilots about was to blame.

$40 bln to develop a new plane. Everyone in aviation wants replacements for both the B737 and A320 single aisle planes. Both have reached the end point in their evolutionary development. But, Boeing, after spending some $50 bln on share buy-backs doesn’t have the capital or credentials to develop a new fuel efficient, weight saving new design. Airbus would need state subsidy to develop a new plane, which would attract the ire of American lawmakers. If both OEMs decided today to launch new aircraft, we would not see them in service until the middle of next decade. Hydrogen or electric aircraft are even further away.

What is the Solution?

This morning I’ve barely scratched the surface of the aviation market, but the answer is obvious. The conclusion is simple – facing a shortage of new aircraft, and new designs being decades away, the solution is to use older aircraft for longer.

Airlines are planning to use their existing aircraft for longer – it’s the only way they can meet their schedules. We are seeing it happen in the Gulf where Emirates has pretty much given up on new B-777X and A-350s replacing their A380 superjumbos. They are renewing leases and refurbing the 380s to keep them in service for longer. (And rescuing the hordes of German retail investors that funded them!)

Across the rest of the global aviation industry there will be increased demand for older single aisle regional jets and the larger twin aisles. It will push up the value of mid-life aircraft. It’s a clear investment opportunity – and its one we are working on with a number of aviation partners.

If you are interested in a deal which will produce a double-digit return secured on a diversified portfolio of Metal Risk (Aircraft Types) and Credit Risk (Airlines), then get in touch soon. We are still working out details on the trade – but will be ready shortly. (This is purely for professional fund managers and family offices, the min ticket will be $3 mm plus.)

Stuff to Read About Aviation This Morning

FT         High Spending Holidaymakers fill airlines first-class and business seats

WSJ      Boeing Wins 737 MAX Jet Order Worth Up to $40 Billion From Ryanair

WEF     Decarbonising Aviation – This is what the shift to alternative propulsion will require

Other Stuff…

Bberg   Xi’s Latest Crackdown Snares Experts Hired by Hedge Funds, CEOs

Torygraph         Make India part of G* and watch democracy beat China at its own game

Out of time, got to fly (see what I did there), and back to the day job…

Bill Blain

Strategist, Head of Alternative Assets, Shard Capital