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July 22, 2019

MAX (B737EL) Grounding Sees More Stable Values for A320ceo & B737NG

The sustained grounding of the MAX, now likely to extend towards the end of the year, is now having a modest effect on the values of the A320ceo and B737NG.

The grounding of the MAX is not unusual given the tragic loss of two aircraft in such a short space of time in seemingly similar circumstances. The B787 was also grounded for a short time. The return of the MAX to service is without question. There is now a clear difference emerging with respect to how the MAX, a nomenclature that will likely be dropped to reduce negative publicity going forward, as to how the type returns to service. The way in which the possibly renamed B737EL (Engine-LEAP, AVAC www.aircraftvalues.net denoted designation for the possibly renamed MAX) returns to service remains uncertain and delays beyond September are now entirely likely rather than possible. This is because of the way in which the B737EL will achieve a return to service. Traditionally, the airworthiness authority in which the aircraft was originally manufactured provided the certification which, apart from a possibly few minor changes, was adopted by other countries. The FAA and EASA for example have, in recent times, virtually simultaneously granted certificates. However, with the authority of the FAA now perhaps having lost some of its strength, other airworthiness authorities may consider their own requirements as a means of returning the MAX to service. There have been agreements between the airworthiness authorities as to how to achieve a return to service, but the FAA is not likely to be in a position to impose a solution. EASA may become the lead organization allowing other authorities to use the EASA solution rather than devising their own for which they may not be fully equipped. EASA may therefore have different views as to the FAA as to how the MAX should be returned to service, the modifications deemed necessary, the testing requirements, and the additional pilot training. If the certification process becomes fragmented, then a global return to service seems very unlikely before the end of the year.

With such a delay to a return to service for the MAX, the repercussions go beyond the existing grounding and storage of approximately 370 MAX aircraft. The issue is now more one of the delay to the delivery of 50 ore more B737s each and every month and the advantage of those operators who are now receiving A320neos in numbers, a reversal of fortunes compared to a few years ago when deliveries of the A320neo were affected by the GTF issues. Delta has just reported better performance because of the difficulties being experienced by its competitors. Airlines may be in line for penalty payments from Boeing but for the time being they are having to pay for more fuel, potentially surplus pilots, finance and leasing charges, lesser revenue and aircraft storage.

While the aircraft will be parked using a long-term storage program, returning the aircraft to service will not be straightforward or quick. Bringing the aircraft out of storage will likely require calendar-based checks to be performed, modifications to be undertaken, testing, repositioning, etc. Operators will have to find maintenance slots which will cause further delays. Those aircraft that have been stored in areas which have high humidity and/or salt laden atmosphere may see a need for more inspections due to the possibility of corrosion.

The net effect is therefore to see the grounding of 370 aircraft and the possible loss of another 500 aircraft in terms of delays to deliveries throughout this year. With the increased emphasis on higher capacity aircraft in terms of the number of seats on each delivered aircraft including the MAX200, then the number of seats being lost to the market is that much more significant. The days of the B737-8 being considered a 150 seater are long since passed. The proportion of A321s being delivered versus the A320 is that much higher meaning that the market is seeing a significant increase in capacity in terms of seats. This means that the market is more reliant of used aircraft that are either smaller or have lesser capacity. Consequently, the net effect of the grounding and the non-delivery of B737MAX aircraft is to see a far greater reduction in the number of available seats than mere aircraft units suggest.

The net effect of the delay to a return to service for the MAX is therefore to see an increased need for the A320 and B737NG in particular either in terms of retaining the existing units which may have been due to come off lease or to meet plans to expand services. Such demand is however, very temporary in nature assuming that the MAX is returned to service by the end of the year. While in theory the demand is there, it would not seem appropriate to seek to acquire an A320 or B737NG for anything more than a year in which case, buying the aircraft would not be feasible and a short term lease would be expensive. A wet-lease may be a means of addressing the shortfall but there may be a shortage of available aircraft particularly during the peak summer season in the Northern Hemisphere.

The need to be aware of the limitations regarding any reduction in the depreciation profile of the A320ceo and B737NG have therefore to be taken into account. Passenger growth, while still strong, is not as robust as it has been recently and there has to be a recognition that the A320ceo and B737NG are being replaced by aircraft which have far better operating economics. During this period of production cessation of the A320ceo and B737NG, there was an expectation that values would fall by perhaps 10-12 percent per annum with those delivered in the final years particularly exposed. Because of the delay to the A320ceos and now the problems with the B737MAX, the decline is more likely to be 5-7 percent per annum. This lesser fall needs to be viewed in the context of perhaps a greater fall once re-certification of the B767MAX is granted and deliveries recommence in numbers. There is already an expectation that the European market may be subject to surplus capacity next year.

The delivery of new aircraft act as both growth and replacement capacity. The degree to which the new aircraft act as replacement or growth capacity depends on the state of the market and the price of fuel. Should there be strong above trend growth, the new aircraft will act more as growth capacity. Existing aircraft will therefore be retained for longer than might be expected. However, even in a period of strong passenger growth should the price of fuel be high, the value of new aircraft will likely also be strong. Conversely, while older aircraft may remain in service their values will decline that much faster due to the significant differential in operating cost between newer and older. There exists a matrix of how much values change depending on the price of fuel and the relative efficiency of new aircraft versus passenger growth. Should the market be weaker in terms of passenger growth, then the new aircraft will act as replacement capacity, serving to displace the older that much more quickly. The lessors in particular, will be seeking to place aircraft that they have scheduled for delivery and may seek lower rentals to induce placement – although in the current market, rates can hardly fall any further because interest rates are so low.

The experience of past recessions provides a measure of insight into how values can change. The market prior to 2001 was experiencing a reasonable recovery. Values of widebodies were improving while Airbus and Boeing were once again increasing production. By 2001 the problems of the late 1990s in terms of the dot com bubble and the Asian crisis still had their legacy in terms of making the financial markets initially more cautious. The orders placed for the 50 seat regional jets as well as for members of the A320 and B737NG families buoyed the market. Fuel prices were edging upwards and some of the major operators were beginning to feel the effects of a changing market structure in terms of an increasingly liberalized environment. The cost structures of major airlines were however, showing signs of strain. The rise of the EETC and securitizations helped to mask such problems and contributed to higher pricing of aircraft with some values showing similar characteristics as those of the late 1980s. The market conditions prior to 2001 may not have featured the same over inflated pricing of the 1980s but the specific nature of the crisis in 2001 had a severe effect on values. Constraining the improvement in values was the intense competition between Airbus and Boeing which saw more modest increases in net pricing for new aircraft.

In contrast to the 1990s recession the nature of the 2001 event meant that placing a value on virtually any aircraft for the first few months after September was essentially a meaningless exercise. As the event was directly linked to aviation, passenger perceptions were adversely impacted. Though hijackings were prevalent in the 1970s, they failed to have the same widespread adverse impact in terms of travel. In contrast to the 1990s recession the manufacturers had to readjust manufacturing rates although Airbus, partly because of tighter employment laws, maintained similar rates of production. The manufacturers were forced to offer greater purchase incentives. The deal struck by Ryanair was particularly notable. The disparity between list and net prices became ever more apparent with the former failing to take any note of the prevailing market conditions. Once the initial hiatus in trading had subsided, it again began to be apparent that the principal effect of the recession was to accelerate the retirement of older aircraft in favor of the new. However, because of the longevity of A320 production and the delivery rate of new aircraft, newer A320s displaced the older examples as lessors offered new equipment at similar rental levels. While some lessors accepted the need to reduce rentals in order for operators to survive, others failed to heed the lessons of the 1990s recessions and dispose of their assets at heavily discounted prices. Just as with the 1990s recession which saw the demise of Eastern and Pan Am, this recession brought about the collapse of such carriers as Swissair and Sabena and undermined the confidence of investors. However, the use of Chapter 11 in the US failed to generate the corporate collapses that may have shortened the recovery period.

In the months immediately following the events of September 11th 2001 it was considered that the industry would stage a recovery starting in 2002. Such recovery indeed occurred but not to the extent anticipated nor within the all-important US market. For example, the low-cost carriers in Europe enjoyed considerable growth and the European majors are reacting by offering similar low cost fares. New problems have instead emerged.

The volatility in world stock markets affected US consumer confidence and limited disposable income; corporate scandals and tighter accounting rules contained profitability as companies sought conservative valuations of their assets; sustained economic weakness in the worlds largest economy reduced the appetite for air travel; new banking regulations served to increase the potential for supply; high profile media attention on terrorism diverted traffic away from travel and aviation; the uncertainty over the Middle East continued to be a cause for concern for the travelling public; the SARS outbreak reduced demand in South East Asia and elsewhere and saw a shortfall in demand for widebody capacity. In contrast to the 1990s recession, distressed sale pricing became more prevalent as some financial institutions sought to exit aircraft financing. Auctions though failed to reappear. Despite having modern aircraft in their portfolio disposal became the preferred option rather than seeking to lease at lower rentals for the short term. Some of the complex financing of the late 1990s started to unravel such that they allowed aircraft to be sold at hefty discount. Such was the level of discounting that private equity firms, recognizing that a recovery was inevitable, started to acquire aircraft at highly attractive prices.

North America represented an important source of demand for major airlines around the world and continued weak yields and traffic limited the ability of carriers to absorb additional capacity though a large number of aircraft parked in the wake of September 11th were reintroduced into service. The fragility of some US Majors overshadowed the prospect of a prompt recovery. With respect to new aircraft deliveries, despite a few successes, the manufacturers continued to face problems as the US majors sought to defer outstanding orders. The prospect of deflation in new aircraft prices became a reality and as such values of used aircraft were impacted.

The value of older aircraft fell by more 25 percent in the aftermath of 2001 in recognition of the rapid rise in availability and the inability to reinvent. The values of more modern narrowbodies fell by approximately 15 percent while regional jets perhaps enjoyed the least decline at around 10-12 percent. Lease rentals perhaps suffered far greater falls. The lease rentals of the B757 for example fell from more $200,000 to less than $100,000. The lease rentals of the A330-200 declined from $725,000 to around $400,000. The lease rentals of the B767-300ER declined from $500,000 to less than $300,000. One of the most apparent differences between the recession of the 1990s and that of 2001 was to signal that older aircraft were not to re-enter service.

The recovery in lease rentals and values took longer than expected mostly because of problems in the US and on-going issues such as SARS. Lease rentals started to improve once again in 2004. The improvement in lease rentals eventually allowed values to recover. Only by late 2005 was it clear that the market had turned a corner allowing owners and lessor to start to recover their losses. By 2006 the improvement accelerated. Both the recent recessions have been characterized by a decline in values and lease rentals for perhaps 12-18 months after the M event, followed by another 12-18 eighteen months of stagnation. A recovery only seems to become evident after near four years with a clear growth trend occurring after five years. There also exists a clear lag between the behavior of lease rentals and values with values taking perhaps 12 months longer than lease rentals to exhibit a notable change in trend lines.

The lessons to be learnt from both recessions is that the decline in values and lease rentals is swift and the recovery slow. Aircraft on order and still being delivered act as replacement rather than growth capacity and displace older aircraft types. Higher fuel prices inevitably favor such newer aircraft. Those aircraft that have already managed to stage one recovery are unlikely to recover a second time. The disposal of more modern aircraft through fire sales in the early part of the recession fails to appreciate the inevitability of a recovery for those specific aircraft and owners/lessors should instead seek to lease the aircraft for short term on a lower rent, ready to take advantage of higher rentals that will emerge three to four years later. The renegotiation of leases rather re-leasing to another operator may be the preferred option.

The past however, needs to be seen in the context of a changing market. In the late 1980s it was envisaged that should there be a downturn in one region then other regions would absorb any excess. At that time the US dominated the market and such a view failed to materialize.

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