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Long Term Residuals Need to Reflect Changing Market Structure

September 4, 2017

Residual values typically project forward for 20 years or even longer but to assume that the current status quo will persist for such a length of time fails to appreciate how markedly the demand for existing aircraft can change over such a timeframe and how values and lease rentals will be impacted.

Twenty years ago, in the late 1990s, compound inflation rates of more than 3-5 percent were regularly used as the basis for future value projections through to 2017. Such rates of inflation, which saw the assumed price of new aircraft rising by a similar rate, inevitably resulted in the future values of aircraft being higher than the actual outcome. This decade has also seen the virtual replacement of nearly all aircraft models but even ten years ago in 2007 there was an expectation that the A320 and B737-800 would continue to be produced virtually unchanged through to the mid 2020s.

A 20 year residual value forecast made today therefore needs to encompass a myriad of changes. Expecting that the A320neo and B737MAX will still be in production as of 2037 needs to be compared to the assumption in 1997 that the then new B737-700 would still be in production as of 2017. Some countries have already stated that cars powered by petrol or diesel will be banned as of 2040; Tesla has opened a showroom in Europe’s car capital – Stuttgart – and car manufacturers are scrambling to halt the considerable slide in sales of diesel powered vehicles. Having already started, another ten years will see the far greater use of not only electric but also autonomous vehicles. The oil companies are already needing to consider the implications of the move to electric vehicles and will likely seek to install charging points at not only existing gas stations alongside new consumer outlets that will distract drivers during the time needed to recharge their vehicles but also at existing retail outlets.

Aviation will also see significant changes in the next 20 years that will make the current crop of A320neos and B737MAX aircraft much less attractive. Residual values should already be compensating for change. The difficulty lies in identifying what changes will take place; the magnitude of such changes in terms of relative efficiency; and the timing of such events.

GE Aviation has revealed considerable progress in hybrid electric propulsion. GE has been undertaking research since 2015 and is already in talks with airframe manufacturers as to how to employ such technology in new aircraft types. Boeing may well consider this for the B797. A new electric motor developed by GE has already driven a propeller designed by Dowty. By marrying a gas generator to the electric motor then a hybrid system is possible that offers 98 percent efficiency compared to the current 90 percent and effectively reduces waste heat by 80 percent. The ability to generate thrust from a current jet engine offers considerable potential and Airbus has also announced its intent to develop a demonstrator within 20 years using hybrid technology. The development of new thrust technologies is based on fact and needs to be assessed in terms of residual values while assuming that the status quo will be maintained is dependent on a belief.

Meanwhile Boeing is pursuing autonomous flight technology for passenger carrying purposes. The growth of the airline industry is being hampered by the absence of pilots, by the cost of training of pilots, and the expense of pilots once trained. With the airlines having pared other expenses to the minimum, flight crews represent a major expense. Boeing estimates that there will be a need for some 637,000 extra pilots over the next 20 years. Moreover, a large proportion of aircraft losses are due to pilot error rather than mechanical malfunctions. Even 25 years ago, aircraft regularly flew with a cockpit involving three crew members – two pilots and a flight engineer. The barriers to reducing this to a single pilot and eventually no technical crews, are being eroded. A single pilot will ally passenger concerns while virtually all flights will be performed autonomously. A cabin crew member may even be flight trained to cope with emergencies. Aircraft already regulatory fly 90 percent of a flight automatically and with new navigation systems there will be even less need for the second pilot to handle radio traffic. The ability for ground based personnel to take control just as with current drone technology may be another means of reducing the need to even design aircraft with a conventional cockpit. Boeings AI system will be tested next year with a B787 ecoDemonstrator available in 2019. Operating a passenger aircraft remotely is already seen as feasible in ten years or less. Apart from technology changes, there is also the effect of new market entrants to consider as well as increasing aircraft size and environmental pressures. Failure to take account of the changing market will see overly optimistic residuals.

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