:: October 2011 Letter ::
The Picture of Dorian Gray, Oscar Wilde’s only novel, told the story of a hedonistic man who led a decadent life with no visible ill effects. There was one catch – he had a portrait in the attic showing him aging badly, worsening every time he inflicted something unhealthy on his corporeal body. For three years, the jetliner industry has been as externally resilient as Dorian Gray. Despite a global financial meltdown and the worst economic downturn since 1945, jetliner output grew at a respectable pace through this year, just about the only industry on the planet to grow through a catastrophe. The OEMs are planning an even steeper ramp-up.
So, where’s the portrait in the attic? Look at ILFC. The second biggest lessor has written down the value of its fleet by over $1 billion this year. According to Bloomberg, credit-default swaps on ILFC more than doubled between May and August. But it’s not just ILFC. They just happen to have the oldest fleet of the big lessors. There’s actually a series of portraits, together comprising the fleet of slightly older planes that have lost a lot of their value. These older jets remind us that the fundamental market conditions driving jetliner demand aren’t good. Record jetliner output isn’t the result of capacity growth, with a rising tide lifting all boats. It’s mostly about replacement.
Now, I know the mantra…with high fuel prices it makes sense to replace older planes with newer ones because the fuel savings can be greater than the lease payments blah blah blah. There’s truth in that, and lessors with younger fleets are doing well enough. Earlier this month GECAS said its annual portfolio review wouldn’t result in any serious write-downs. I don’t see any threats to today’s production rates, and there’s even room for growth.
But the OEMs are now planning a 15.9% compound annual growth rate (CAGR) output increase through 2014. That number reeks of double-digit hubris. It’s more than hubristic; it’s every bit as decadent as Dorian’s lifestyle. That 15.9% CAGR, by the way, will produce a 2014 market that’s 70% larger than 2010’s near record level of output. That’s the kind of ramp-up that you see in a recovery, even though there was no downturn from which to recover.
That 15.9% plan didn’t produce guffaws when traffic looked good. But traffic numbers are not good. We’ve had four months of negative air cargo traffic, a sure sign of either a slowing economy (at best) or a double dip recession (at worst). Even in China, the CAAC this month lowered its passenger growth forecast from 13% to 8%. As IATA Director General Tony Tyler recently put it, “The Industry has shifted gears downward. There is not a lot of optimism.” Sure there is. Look at the OEMs with their 70% output growth plans. That’s optimism, in an oblivious way.
If you haven’t read the book or seen the cheesy horror-infused 1950s British movie version (spoiler alert!): It doesn’t end well for old Dorian. There are at least three ways that the handsome OEM dandies might forcibly re-join the portrait in the attic.
First, there’s the problem of persistent older equipment. Sure, 737 Classic and older A320 values have been hit, and continue to fall. That doesn’t mean they’ll be retired the way JT8D-powered jets will be. Some planes to be retired, like the replicants in Blade Runner, might not want to be retired. Combine clever remarketing and cheap prices, airline capacity reductions due to slackening traffic, and cheaper fuel (perhaps significantly cheaper), and you’ve got older equipment staying around longer than the new build guys want. Thus, when all the lessors start marketing their horde of new jets to Air Batguano, they might come up against cheap and cheerful 18 year old planes that still have economic value. Besides, it’s not as though the numbers of old jets justify the anticipated jet output. Sure, it makes sense to replace the 1,000 or so MD-80s still flying. That’s about one year’s single aisle production at the planned rates.
The second way is finance problems. Once, an aircraft industry analyst could scan the news, see a headline like “eurozone crisis threatens bank lending” and safely look away and resume eating Cheetos. Sadly, those days are gone. The market is far more dependent on third party finance now, particularly with the lessors that have placed so many of the orders in recent years, and the 2008 crisis shows a dangerous volatility in our financial system. In Europe, there’s a serious risk that key banks are getting out of the jet finance game. The finance gap might be filled to cover the current level of deliveries, but that huge ramp-up? Even if the export credit guys get back in, and even if the Mideast banks increase their presence, the money might not be there.
Third, the new single aisle generation is coming, with serious consequences for the current models. Up front pricing indicates that there will be little or no premium paid for A320neos and 737Maxs. They will likely sell at the same price, implying a relatively fast and painful impact on current A320 and 737NG values. Guys who piled on late to the current generation game, of course, are most vulnerable. Hence Steven Udvar-Hazy’s insistence that Boeing must do an all new jet, which would be less threatening to his new portfolio’s values than a re-engine. Udvar-Hazy is merely talking his book, as they say in the finance biz. Also, I can’t imagine why customers would line up to take record numbers of the last copies produced of the older models, particularly if traffic growth stays anemic. Ramping up right up until the new models enter service in 2015/2017 makes no sense for anyone involved.
Finally, there’s hubris itself, which implies not knowing when to stop. Ignoring the above threats, the OEMs are talking about moving beyond that 70% increase. You’ve got Airbus hinting at a ramp-up to 50 single aisles per month. But they may have to use their own money to finance some of these deliveries (a man can have lots of friends, as long as he always picks up the bar tab). And they probably won’t make much money with this ramp up either – despite the “strong demand” implied by past rate increases, Airbus commercial margins have remained dismal. Looking at precedent, Boeing will likely follow. Talking about rate hikes like these resembles Dorian preening himself in front of a mirror.
So, that ILFC painting in the attic is a reminder that today’s jetliner production boom isn’t due to organic traffic growth demand. It’s due to a fragile mix of high fuel prices and third party financial interest (including a degree of asset speculation). That 70% growth target should be viewed as a little too handsome given the circumstances.
Teal aircraft updates this month include Embraer’s Phenom/Legacy and KC-390, CRJ, CL-415, Hawker 200, the C-5, OH-1, Caravan, and the military inventory appendix. Have a great month.
Yours, ‘Til My New Portrait Is Finally Done,
© Richard Aboulafia 1997-2006, All rights reserved.