The commercial airline industry is a global phenomenon which has been on an exponential growth trajectory over the past half century since mass air travel was first made possible through the advent of large capacity, jet-powered airliners. WESLEY POLLARD and CHARLES YETERIAN dissect the aviation financing sector.
The industry statistics make impressive reading and are collated by the International Air Transport Association (IATA) which is the trade body for the sector representing 264 airlines or approximately 83% of scheduled air transport services. According to IATA, there are more than 100,000 flights a day carrying 3.7 billion passengers and 50 million metric tons of freight per year on 26,000 aircraft flying on 51,000 routes. The industry generated revenues of US$718 billion in the last financial year but the economic multiplier effect of aviation means that an estimated 3.5% of global GDP relies on this industry.
One of the fundamental characteristics of the airline business model is its capital-intensive nature given the aircraft, the means of service provision, are very expensive to acquire with unit purchase prices that can be up to US$300 million depending on the aircraft type. The manufacturing sector for passenger aircraft over 100 seats is dominated by the US Boeing Company (Boeing) and European Airbus Group (Airbus) which have a relatively equal market share. Between them, Boeing and Airbus currently deliver 1,400 new aircraft per year with a cost to airlines estimated at US$125 billion.
The financing of both these new deliveries and existing fleets draws on financing sources from around the world of which an increasingly important contribution comes from Islamic financing. In fact, the key feature of aircraft as a long-lived asset which has an intrinsic and quantifiable value is particularly suited to this method of financing and it’s becoming more attractive to airlines beyond just those with an Islamic connection in their ownership or base of operations. The almost US$1 billion UK government-backed Sukuk issued by Emirates Airline to finance four A380 deliveries in 2015 is just one example of an innovative product from the Islamic financing stable that has been adapted to the aircraft financing arena. Ijarah of commercial aircraft is a prime example of Shariah compliant financial services offering a good opportunity.
Review of 2016
The current (2016) year is shaping up to match 2015 as the most successful in commercial aviation history from a profit perspective. The US$35.3 billion in net profits reported in aggregate in 2015 by the world’s airlines was the first time that a ‘normal’ level of profit, one that exceeded investors’ weighted average cost of capital, had been achieved by the industry. However, certain regions of the world, particularly North America, had more than a fair share of this profit to the detriment of the African and Latin American regions that were adversely impacted by local economic challenges. In 2016, airlines in the Middle East/Asia and Asia regions are expected to show a sustainable level of profits.
A great deal of the profit improvement over the past couple of years has come from relatively low oil prices that began to decline in the latter half of 2014 and efficiency gains as more new technology and fuel-efficient aircraft enter service. Airlines have also become more proficient in driving down non-fuel costs and boosting ancillary revenues but, perhaps, an equivalent contribution has resulted from disciplined (generally speaking) capacity management with record high load factors and aircraft utilization. As a consequence of these factors, the majority of airlines have been generating strong levels of surplus operating cash flows which they have been using to pay down debt or invest in new equipment. This period of improved profitability has also helped to strengthen airlines’ financial metrics and make them more bankable to lenders and investors from a credit perspective, especially in the current low cost of financing environment.
Preview of 2017
Many industry commentators have speculated that the current operating environment for airlines is ‘as good as it gets’ in terms of profitability and the industry has reached the ‘top of the cycle’. Evidence cited is from slowing passenger traffic and weak global GDP growth, the trend for declining yields in both passenger and freight markets and the potential for over-capacity due to Airbus and Boeing increasing production rates on their most popular single-aisle models. This doesn’t necessarily mean the industry is immediately set on a down-cycle but there is a growing acceptance that low oil prices and insatiable traffic demand growth will not hold sway indefinitely even though a sudden material change is unlikely.
The global airline industry consumes an enormous amount of capital expenditure that, for the most part, requires external financing to support aircraft acquisitions. Boeing forecasts the need for approximately 40,000 new aircraft deliveries costing US$6 trillion over the next 20 years which provides exceptional opportunities for Islamic financing providers to tap into this demand. The need for many European and US banks to accommodate impending Basel III regulations should also reduce some of the fierce competition in the aircraft financing arena thereby helping to improve returns. A financially healthy airline industry, the returns available and a good track record of the asset class in value retention combine to make the aircraft financing sector a potentially win-win proposition for Islamic financiers.
Wesley Pollard is the vice-president of research and risk management and Charles F Yeterian is the senior advisor at Novus Aviation Capital. They can be contacted at [email protected] and [email protected] respectively.