Covid-19 and air transportation: is this apocalypse now?

While clearer skies may have been welcomed by some, for the airline industry it’s the time of mourning.

 With revenue losses expected to the tune of US$300bn, the industry has become one of Covid-19’s most prominent victims thus far. Its decline has been steep and unprecedented, dropping to the levels last seen in the mid-1990s in just a few short weeks. The recovery will take time, and it’s not clear as yet if all market actors can be resuscitated to full health.

 In this piece, I reflect at the challenges ahead for the market participants as the world recovers from the pandemic.

Where do I park?

The current outbreak is affecting 97% of the global air transport market. With 65% of the global fleet grounded, most airlines are running at 10-20% capacity. Others have halted operations altogether. While it was near-impossible to get flight slots out of the busiest airports in the past, now airlines are running after parking spots and engine covers.

Based on a 3-month lockdown period globally, the International Air Transport Association (IATA) estimates that airlines will lose in excess of US$ 300 billion in 2020, with traffic down 50% versus 2019. The fall in fuel prices to its lowest level since 1999 and reduction in other variable or semi-variable expenses will only partially offset the drop in revenues, resulting in historical losses for the industry.

Traffic is not expected to rebound quickly and could take between 3 to 5 years to come back to pre-Covid-19 levels. The prospect of a global recession, coupled with passenger behaviour and encouraged social distancing measures will continue to severely impact air traffic growth in the short term.

It is likely that a number of airline operators will cease to exist. Industry profitability has been dominated by a small number of major airlines with stronger balance sheet and cash balance. However, most airlines were already highly leveraged and with low cash balance before entering the Covid-19 crisis. Cash balance will be deflated in the short term with the additional risk of limited (if any) cash generation over the peak summer season. Unable to ‘earn their living’ during the holiday season, many operator will run into financial difficulty next winter. In particular, capacity will be reintroduced at a much faster pace than traffic will return, which will affect load factors and yields in the midterm. Flexibility offered to customers (vouchers and other offers) will also affect cash revenue generation of airlines in the near term – unless consumers can be persuaded to spend more to compensate for in-flight ‘social distancing’ measures, if introduced. As many have been conditioned to view air travel as a ‘commodity’,  that may be a hard pill to swallow.

Whilst suppliers (including lessors and banks) have offered support to many airlines (e.g. lease rentals and debt moratorium), this will create additional liabilities for airlines in the medium term. State support, where offered, will also add liabilities in the medium term, which may only delay the inevitable for some operators.

Due to the regulatory framework around foreign investment in airlines globally, limited airline consolidation activities should be expected, except, perhaps, in the US and European markets.

Cargo rates are on the rise

With 50% of the air cargo capacity currently grounded (from passenger belly hold capacity), demand for air cargo has artificially surged, prompting cargo airlines to re-commission planned retirement capacity and passenger airlines to turn passenger aircraft into ad-hoc cargo aircraft. Urgent requirement for medical equipment and pharmaceutical products has largely contributed to an increase in air cargo demand in the short term, meanwhile e-commerce continues to strive with lockdown measures and shop closures in many countries. Sudden reduction in capacity has driven rates up for air cargo.

As passenger capacity is returned to the market, there may be excess capacity developing in some markets with a resulting drop in air cargo rates. The reopening of markets (including plants and other manufacturing facilities and shops) and economic stimulus may benefit air cargo to an extent although the prospect of a global recession and potential protectionist measures in some regions may have an adverse impact on international trade flow and the cargo market as a result.

The air cargo segment will most likely continue to consolidate around a reasonable number of dedicated freighter operators to serve the specialised/outsize products and e-commerce markets.

Fleet will be forced to retire

With 65% of the global fleet of commercial aircraft now grounded, leaving the global fleet to the level it was in the mid-1990s!

A number of aircraft types will be permanently retired from airlines fleet during or after this crisis, in particular older, less efficient and out of production aircraft types. Only a very limited number of these aircraft will be candidates for cargo conversions. In fact, cargo conversions will probably be focused around in-production platforms (e.g. A320, B737NG, A330, B777), which feedstock will now be available at a more reasonable value.

Trading of current generation of in-production aircraft will continue in the future (albeit, perhaps at a less aggressive rate than seen recently), although values and lease rates are likely to drop to new lows in the near term. Whilst some airlines may take the opportunity of this crisis – and have the financial flexibility – to accelerate the replacement of their existing fleet with new equipment, other operators may prefer to retain, possibly grow their fleet with current generation aircraft. Such decision will be driven by the liquidity and access to leasing and financing options of operators. In particular, when taking into consideration cash lease redelivery or disposal costs, discounted lease rates and lower fuel prices in the near term, renewing leases or retaining the current fleet may become a more financially attractive option than going new, especially as most airlines will look at conserving cash in the near term.   

Whilst Maintenance and Repair Organisations’ (MRO) capacity may artificially increase in the near term due to the sharp reduction in the global fleet in operations, the gradual return of the fleet into service may create new pressure on the MROs, in particular to the extent some MROs have fallen victim of the crisis. Paradoxically, the increase in feedstock in the near term may add competitive pressures on the MROs with a significant number of engines and parts becoming available. As such, there should be opportunities (albeit, reduced) in the part-out space.

Brand new aircraft may not get to fly

All Original Equipment Manufacturers (OEMs), including Boeing and Airbus, will face deferral and cancellations of new aircraft and engine orders in the near term, including Boeing MAX order cancellations on aircraft that have already been produced but not delivered since the no-penalty cancellation window now opens-up under most contracts. Additionally, a number of white-tail aircraft are to be expected in the short term, which will add pressure on values for both new and used aircraft. We expect that OEMs will reduce production rates in the medium term to rebalance the supply/demand and protect values.

Whilst the current situation may have presented an opportunity for both Airbus and Boeing to address the chronic delays in deliveries of new aircraft, the issue may ultimately be exacerbated through the impact of the Covid-19 crisis down the supply chain. With many facilities now closed or at reduced capacity, employees being furloughs or permanently laid-off and financial difficulties coupled from the direct and indirect effects, a number of suppliers (the smaller in particular) may be at risk. Resumption of activity will most likely take time, which may in turn affect the OEMs production timeline.

The Boeing 737MAX recertification and re-entry into service may have to be further delayed to 2021 and the certification process of new program such as the B777X may be delayed as well as the research and development into new aircraft programmes (e.g. the  New Midsize Aircraft or “NMA”) put on hold in the near term. Nevertheless, some new production aircraft shall continue to see sustained demand going forward, such as the A321neo and its longer range variants, as its payload range capabilities and cost efficiency may appeal to operators.

Avoiding a liquidity crunch will be a win for the leasing segment

It has been reported that close to 80% of lessees have approached lessors for lease payment deferrals or lease restructurings and all aviation Asset-Based Securitisation (ABS) have been affected by reduction in lease cash flows or default risk in the short term.

Liquidity and asset management expertise will be key to lessors’ going through this crisis. Lessors with substantial liquidity reserves or access to additional liquidity will have the capacity to sustain a period of time with substantially reduced or limited operating cash flow from leases and manage potential defaults, in addition to underwriting new sale and lease back transactions – acting opportunistically or to support customers. Additionally, whilst the prospect of repossessing and transferring or selling aircraft is limited in the short term, asset management capabilities (including established technical expertise) will prove very valuable in managing current portfolios and preparing for actions as and when necessary. Funds with a longer term investment strategy (hold-strategy), liquidity and with access to reputable asset management resources will equally be better placed to go through this crisis or opportunistically seize new opportunities and realise value later.

Should the current situation continues for an extended period of time and some airlines default, some ABS or smaller lessors with limited access to liquidity and/or limited asset management capabilities will be at risk, which may trigger some distress/discounted sale. There will probably be no ABS issuance in the near term and further consolidation in the aircraft leasing sector.

Mind the funding gap!

The industry may be facing a funding gap in the short to medium term, which may exacerbate some of the points discussed above.

With the exception of closing transactions already in the pipeline, it looks like most financial institutions have put aircraft financing on hold at least for the short term. Specific products such as the Japanese Operating Lease (JOLCO) and ABS also seem to be temporarily closed. As experienced in previous crises, and given the extent of the Covid-19 impact on the air transport industry, it may not be unlikely that a number of banks and financial institutions or investors elect to withdraw from the sector. It may disproportionately affect those that may have most recently entered the market in search for good yields or those that may not have developed a specialised expertise in this field. Some loan portfolios may be offered on the secondary market in the near term.

In past crises, the export credit agencies, historically major payers in aviation finance, have been able to step-up their participation in aircraft financing as other players retracted to support the deliveries of new aircraft from OEMs. However, with export credit being marginalised since 2015 as a result of strong commercial debt and capital markets and the regulatory challenges in both the US and Europe, there is little prospect for a sharp increase in export credit capacity in the short term, especially as it may require some to redevelop their aviation units. Backstop financing from the OEMs will also be limited as result of their own financial priorities.

Whilst the private insurance market has developed some innovative products since 2018, to seize opportunities offered in this sector and to some extent to address the absence of export credit, the appetite of the insurers to underwrite more aviation transactions may be minimises. It will to a large extent be dependent on the insurers’ own general balance sheet resilience through this crisis and the resilience of their nascent aviation finance exposure.

Nevertheless, financial institutions with the balance sheet, experience and expertise in aviation finance and long term vision may be best positioned to seize opportunities in the short term. If there was ever the ‘survival of the fittest’ test for the industry, this may be it.

Sylvain Gloux - April 21st, 2020