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:: August 2013 Letter ::

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Dear Fellow Mid-life Non-Malcontents,

I turn 50 this month. No condolence cards, please. Iím not whining. Iím one of the happier and luckiest people youíll meet. Great wife, two great kids, great house, great friends, great job, great boss, good health. My wine cellar is at peak capacity. The problem with everything being great is that almost everything, and that means quite a lot of things, can only get worse. I didnít say I was an optimist.

To put it another way, for me at age 50, most change is bad. As I hit this milestone, I feel a strong affinity with the jetliner industry. For the past ten years weíve enjoyed a remarkable and unprecedented market expansion. In all, the large jetliner market expanded by a 9.7% CAGR between 2003 and 2012, with no real interruption. The market has rarely seen growth like this, and weíve never seen it without any kind of cyclical downturn. More remarkably, the best growth years actually came after 2007, despite the world economic disaster. But the circumstances that created this jetliner market growth over the past ten years, particularly over the past five years, were unusual, and in some ways aberrant. And most of these circumstances, like my life, can only get worse.

Take, for example, interest rates. They are still scraping record low levels, hovering just above 0%. Fun fact: nobody will pay you to borrow money. If interest rates change, they change for the worse. The Federal Reserve, having opened up the cash floodgates in 2008/2009, is now slowly closing the spigot (funny how metaphors for liquidity often involve liquid). This will likely lead to higher jetliner finance rates.

Then thereís oil prices. The $80-110/bbl range has proven to be a remarkable sweet spot. Higher prices would impact airline profitability and/or travel demand. Lower prices would be worse, making those undervalued and depreciated 737 classics, older A320s, and many other unloved jets more attractive, and reducing the incentive for airlines to re-fleet with new jets.

Iíd count the highly unusual divergence of oil prices and interest rates as a third factor that can only get worse. For over 30 years, interest rates and oil prices moved in close proximity. But over the past five years, they have ripped apart, juxtaposing the above two factors (cheap cash to allow jet buys, expensive fuel to incentivize re-fleeting) for the first time in decades. (You can watch me explain the significance of this at http://vimeo.com/66808533, around the 6:00 mark). Convergence of the two trends would be disastrous.

Emerging market growth has been another big market driver over the past decade or so, particularly in China and India. Even that clown from Kingfisher made a go of it, before sheer common sense caught up. Yet as Paul Krugman put it in the New York Times last month, we may be hitting a BRIC wall. Russiaís growth was purely due to growing resource prices, which are no longer growing. The rest of the economy is based on government confiscation of other peopleís property and citizen rights suppression. Brazilís new national pastimes include rioting and economic stagnation. China, the big driver, is hoping for a soft landing. India, the second growth leader, is coping with slumping numbers and a collapsing rupee thatís at an all-time low, which complicates jet financing. The good old days of 10-20% traffic growth are over.

Finally, donít forget successful airline industry restructuring. For decades the industry was a hopeless mix of low entry barriers, high exit barriers, and chronic overcapacity. But over the last decade thereís been a remarkable transformation. Europe got three big mergers under its belt, and even got rid of some of the marginal zombie players. Even the Arab Gulf Fifth and Sixth Freedom carriers poaching all that traffic from legacy airlines has proven to be a manageable problem, so far. The US market has benefitted from two mega-mergers. It isnít just that larger airlines are bigger customers; more importantly, theyíre a better credit risk, further improving their finance terms for buying new jets.

Airline industry restructuring, too, shows signs of coming to an end. Thatís the current events part of this letter. The US Department of Justice suit against the American/USAirways merger, which appears to be orchestrated by some deeply clueless individuals, could potentially derail this process. Iíll leave it to my airline analyst counterparts to explain why this suit is imbecilic. But from the standpoint of the jet industry, one of the biggest challenges we face is bridging the gap between the 737NG/A320ceo and the 737MAX/A320neo (these families constitute half of the jetliner market by value). Between them, American and USAirways have 210 current generation single aisles on backlog. Kill this merger, and many of these orders would likely vanish. The odds of a 2015/2016 production downturn would increase.

Obviously, this market commentary/mid-life assessment isnít completely ironclad. There are forms of change that could conceivably be better: I could win the lottery or spend more time at the gym (guess which is more likely). The jet market could benefit from more traffic, and a recovery in air cargo.

Yet the primary drivers of the remarkable 2003-2012 jet market boom are the ones listed above, and all of these are starting to worsen. Thankfully my life hasnít yet worsened, but the dark clouds surrounding the market slightly increase my feeling of existential dread.

Still, I am not making the case that this market is a bubble. Most of the growth drivers described above are still largely intact. Tealís annual jetliner market survey, published last month, calls for $979.5 billion in large jetliner deliveries in 2013-2022. Thatís much bigger than the $573.4 delivered over the last ten years, but considering that 2012 saw $89.6 billion in deliveries, weíre only looking at modest growth to an average of $98 billion in deliveries. Iím making the case for a market thatís starting to plateau.

A plateau is kind of a best-case scenario; to reiterate, most change would not be good. And come to think of it, Iíd be delighted if my life stayed on a nice plateau for the next 15-20 years. August Teal Aircraft reports include the World Rotorcraft Overview, the C-130, F-22, HondaJet, AW139/189, AS350/EC130, and the Citation series. Enjoy the last of summer, which, in life terms, I will too. Maybe Iím more optimistic than I think.

Yours, ĎTil The Department Of Justice Files A Suit Against Change,
Richard Aboulafia
 

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