RichardAboulafia.com 

:: July 2013 Letter ::

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Dear Fellow Excess Liquidity Observers,

Got cash? Most businesses do. Corporations now hold a record level of total assets in liquid form. Financial institutions have access to cash from central banks at record low rates (just bring a wheelbarrow). But there arenít many good places to put this cash. Real estate, emerging markets, commodities, and many other sectors are either too volatile or too sluggish. Jetliner finance, however, has been a great choice. Airlines seek newer jets to cope with high fuel prices, and jets are tangible and mobile products, offering solid double digit returns. Despite the potential risk of overcapacity jet finance returns are still higher than most other investment opportunities. This dynamic has helped boost the jetliner market to a new peak, with a record level of transactions funded by third party financiers.

A lot of smart money has already gotten into this game. But at the Paris Air Show, a fresh new approach emerged. Doric, a German finance company with a limited aviation finance presence, signed a memorandum of understanding to order 20 A380s, to be leased to airlines. This plan represents a way to finally defeat the historic trend of strong profitability and investment security that has bedeviled the jet finance business for decades.

A key part of succeeding in jet finance is identifying assets with near-universal appeal and best-in-class performance and economics. Thus, the great external finance boom has heavily benefited a handful of blue-chip jets: the A320, 737-800, A330, and 777-300ER. Marginal types like the A340-500/600 have been sent to an early grave. In an earlier time it might have lingered on, but today nothing kills a plane faster than a harsh judgment from third party financiers. Similarly, the A380 has attracted exactly zero orders from operating lessors.

To achieve their goal, Doric will likely do what it has already done for the 18 A380s it sold and leased back to Emirates and Singapore. In conjunction with Nimrod, a specialist investment fund, Doric sold shares to investors, who get good quarterly dividends (8.25% for the latest batch) tied to A380 lease revenues, as long as the airlines pay. Once the planes come off lease, the investors get the proceeds when the A380s are sold.

Hereís the rub: A380 residual values are likely to be hugely disappointing to these investors. Doric is a financial lessor, with little experience in remarketing aircraft. Thereís no guarantee of any kind of secondary market, which would be devastating for a lessor. Thirteen years after the program was launched, there are just ten A380 users today, and a broad user base is necessary for a healthy secondary market. There will be no cargo conversion program due to the nature of a double-deck design. Again, the fact that operating lessors have shunned the A380 speaks volumes.

Thereís not much of a primary market for the A380 either. Nominally, the backlog is 157 planes, but this includes five for a dead airline (Kingfisher) and ten for an airline that looks set to abandon long haul flying (Hong Kong). Air Australís two planes, by some reports, have been cancelled, and were kind of a lark from the start. Virgin Atlantic has deferred its six planes until 2017, and has implied it might never take them. Removing all of these means an effective backlog of just 134 A380s. British Airways, a key user, told Aviation week in July that it had no plans to order more than the 12 A380s it currently had on order. There have been just 167 net A380 orders over the last ten years, or fewer than 17 per year against a stated production goal of 30 per year. That 167 figure contrasts with 3,442 net orders for all other long haul twin aisle types.

While Emirates remains the one enthusiastic user (accounting for a remarkable 90 of the 262 total orders), they have taken just 33. Emirates may want more, but it will take some time to digest the 57 they have on backlog, and thereís no guarantee they wonít change their fleet strategy as the new long-haul twinjets come on line. Just to recap, removing those 57 Emirates planes from the effective backlog leaves just 77 planes on backlog for other customers.

Embarrassingly, Doric executives stated that they would seek new A380 users, implying that Airbus simply hasnít been sufficiently aggressive in selling the type. Presumably, they also have plans to profit by picking up the large numbers of 20 euro notes that people routinely leave lying on the pavement in Frankfurt.

A380 proponents say that time is on the planeís side. They point to a growing air travel market and increasing congestion driving demand for larger planes. This ignores the lessons of the last decade, when international passenger demand grew by a strong 75%, yet average plane size on international routes got smaller. Route fragmentation is still playing out, translating to a strong airline preference for smaller long-range twinjets. Airbus is quite aware of this trend. There have been more than twice as many A350XWB orders as A380 orders (678 to 262), even though the A380 has been on the market for twice as long.

The A380ís thin primary market diminishes the likelihood of the Doric MoU becoming a firm order. There are limits to speculation, even with other peoplesí money. Buying niche planes like the A380 without a definite end user is probably one of those limits.

On the other hand, itís easy to see why Doric would like this order to work. Many other lessors have done well in the jet finance business, and Doric is quite late to the game (which is never a good idea in any investment trend, even if thereís no jetliner orders bubble). As a result there just arenít many production slots available for popular jets over the next few years, while Airbus has said that there are gaps in the A380 production plan starting in 2015. Also, Doric already has the largest A380 portfolio in the finance world. Helping to rescue this distressed program is in their best interests, even if it implies doubling down on a risky asset. On top of that, they have no familiarity with being an aircraft operating lessor. Perhaps sheer ignorance is a defense too.

Itís easy to write off the Doric A380 MoU as a harmless fishing expedition, and proof that thereís too much money in the world chasing too few good ideas. Itís more troubling to consider what it means for the fate of the A380. This yearís Le Bourget saw statements from Airbus executives about the possible need for an A380 upgrade, which, given the youth of the plane, is an astonishing comment on the planeís technical performance. Airbus canít build its other jets fast enough to meet market demand, yet the A380 continues to suffer from chronic market indifference. If the Doric MoU is trotted out as a sign of resurgent demand for the quadjet, does that mean program salvation is indeed a long shot?

On that note, Teal July Aircraft Binder reports include the Commercial Jet Transport Overview, plus updates of the Embraer E-Jet series, 747, UH-60/MH-60, CSeries, DHC-8, C919, C-27, UH-1/412, Hawker 800, and EC 120. Enjoy your summer.

Yours, ĎTil Investors Embrace A380 Timeshare Condos,
Richard Aboulafia
 

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