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Fleet Report & Outlook 2017

Airline Leader

Oriel reviewed its piece written in Jan-2016 and many of its thoughts panned out during 2016. In particular, the growing gap between the values of aircraft sold naked and those transacted with a lease in place. In Oriel's opinion, this gap has reached unprecedented levels as new lessors and investors seeking yield have fuelled a value bubble for aircraft with leases attached.

CAPA partners, Oriel, share their views on the outlook for 2017.

Oriel reviewed its piece written in Jan-2016 and many of its thoughts panned out during 2016. In particular, the growing gap between the values of aircraft sold naked and those transacted with a lease in place. In Oriel's opinion, this gap has reached unprecedented levels as new lessors and investors seeking yield have fuelled a value bubble for aircraft with leases attached. The most common sentiment heard in 2016 in the aircraft leasing space must have been 'it is difficult to find opportunities that meet our investment criteria'. Perhaps it is no great surprise then that public lessors are in share buyback mode? Or maybe expectations of returns that can be made in leasing need to be revised.

The obverse is that it has been a good year to sell down encumbered assets either directly or through Asset Backed Securities structures, the latter being particularly attractive for older assets. We can understand the frustration of the lessor community that the latter type of deals are not always reflected in appraised market and base values, which relate to naked aircraft.

As such, we would contend that 2016 suggested that capacity demand had softened based on the observations of the naked aircraft pricing and placement of used aircraft on lease. These are probably better indicators of the demand for aircraft in their primary role; moving people (or cargo) from A to B. On a panel we shared with a remarketer in Hong Kong, the view expressed by them was that pricing and/or lack of offers for all assets they were offering suggested slower demand for lift. The following 'heat chart' shows the gradual reduction of the number of aircraft with the market values at parity or above base.

The widebody sector travails have continued with airline deferrals and lack of demand which prompted the following quote noted in Reuters in Jun-2016: "Would we ever order the 787 again? Sure," said an executive with a leasing company that has Boeing 787s in its portfolio. "Will we order it this year? Not a chance." There are simply too many widebody jets for the demand right now, he said.

More recently Avolon CEO Domhnal Slattery questioned the depth of the secondary market of the 777-300ER once the initial operators deem them surplus to requirements.

In the used narrowbody space, 2016 witnessed 737-800 lease rates and values 'come back to the pack' after many years of defying gravity. The achievable rates for used -800s have probably left some investors slightly disappointed. Compounding this - and it is not unique to the -800, all aircraft are vulnerable - is what we term 'lease rate compression'. In essence, for younger aircraft lease rates and values cannot command the premium history would suggest is appropriate. Aircraft have much improved reliability and for an airline the utility of a six or 10 year old aircraft is the same. This inevitably impacts the achievable lease rate of the younger aircraft.

Aircraft with the Market Values at parity or above Base

aircraft with the Market Values at parity or above Base

Average Aircraft Age

Average aircraft age

The chart above shows the six, 10 and 15 year constant age lease rates expressed as a percentage of new aircraft lease rate in the same year. We can see that six-year old aircraft saw lease rates come down from 87% of new in 2002 to 78% in 2017, 10-year olds' lease rates came down from 70% on new in 2007 to 63% in 2017 and 15-year olds' lease rates were 56% of new in 2012 and are now 52% of new.

All in all, we would describe the performance of values and lease rates in the last calendar year as underwhelming, which probably reflects the bias of the conference circuit that appraisers attend.

However that observation applies only to one half of any transaction. For the airlines 2016 was, for the most part, a stand-out year with the stars in almost perfect alignment. Notwithstanding the low interest rate environment, the intense competition to place aircraft off lease has also contributed to the softer lease rate regime. For new aircraft sale and leasebacks, pricing and lease rates have both moved in the operators' favour as manifest by some extraordinarily low lease rate factors.

If 2016 was a step backwards from 2015 what are the portents for the next 12 months? We know US interest rates are rising, in what (for now) is the most important global economy. This is likely to keep the value of the dollar strong. Oil prices have recovered quite dramatically in the last 12 months, compounded by the exchange rates and hurting airlines with weak local currencies. Higher interest rates will filter through into financing costs and lease rates, though arguably used equipment will benefit. We believe a general and fair comment would be to say that airlines are looking at capacity growth with more circumspection in 2017.

Age lease rates as a percentage of new aircraft lease rate in the same year

age lease rates as a percentage of new aircraft lease rate in the same year

The latest 'heat chart' shows the current state of play for the world commercial fleet. The increase in the number of aircraft with their market value above base is unfortunately nothing more than a technical consequence of the year change: the base values show their annual depreciation in one step while market values are more likely to reduce over the course of the next 12 months.

The current state of play for the world commercial fleet

the current state of play for the world commercial fleet

The coming year will see the A320neo joined in service by the A321neo and the 737 MAX 8. Against a back drop of increasing oil prices, they should see their lease rates and market values improve relative to the ceo and NG variants. The improved fuel burn of the new generation types has opened up new longer range routes that can be served directly, though the corollary of this will be negative for widebodies. We also believe that environmental benefits of these technologies have been undervalued.

A non-standard variant is a subject which we believe appraisers should perhaps be addressing more readily. History has shown that values of early versions of the A320-200 (CFM56-5As and A1-powered) and A330-300 depreciated much quicker than the later, improved versions. Going forward, we expect the A321neo CabinFlex (introduced in 2019) will run a different value profile to the A321neo entering service this year. The latter's value performance being impaired by a smaller customer base. The chart below illustrates the relative value retention of late built A321-200s and the A321neo and CabinFlex versions.

The Bombardier CSeries, though handicapped by the GTF engine issues, had a successful year with entry into service and significant orders from Delta Air Lines and Air Canada. Another significant order would help to bolster residual value expectations.

For the A320ceo and the Boeing NG families of aircraft, we expect the coming year to be similar to 2016, though value declines to be more moderate than noted recently. It is also worth noting that values for this group of aircraft will behave with greater elasticity in response to demand.

One type which may have some hidden value is the 737-900ER. Historically, the variant has suffered in comparison to the -800. However, we think that recently the lease rates have held up better than the -800s and with less exposure to lessors and a much younger fleet, competition for secondary leases maybe less intense. It would seem to be a natural home for current -800 LCC operators in slot congested airports in Asia.

The widebody sector third party owners have experienced a difficult year in terms of values and lease rates that are achievable, though the pleasing aspect would be the reluctant but realistic expectations of what aircraft can sell or release at the end of the first lease. It is probably too early to say if this poor value retention will eventually translate into reduced operating lessor exposure to widebody aircraft. It appears to us, the historical levels of financial success of leasing widebodies is dependent on the first lease being extended or selling down with the significant lease term remaining and full-life compensation. Single-digit returns over long term are more realistic in this sector.

Although no type has escaped the downward pressure, we anticipate for the latest technology aircraft a recovery in market values (or values declining less than depreciation), albeit this does appear unlikely in 2017. It is difficult to envisage a market scenario that can lead to a significant value rebound for the older technology, which now encompasses the A330-200/300 and 777-300ER. In our opinion, from this point onwards market values keeping pace with base balue depreciation would be a good outcome!

For the larger regional jets/mini mainliners, we have seen some softening in values and lease rates across the board. Arguably the most successful type, the Embraer E190, was relatively more severely impacted. Though the rates are far from dire and aircraft are placed, we sense a modicum of disappointment by third party owners. We suspect that rents achieved by the A319 and 737-700 are impacting E-Jets coupled with increased churn as fleets are replaced or rolled over.

The turboprop sector has been very buoyant for a few years, but in the last year much of the heat has dissipated from the market. The type most impacted has been the younger ATR 72-500s with increased availability of ATR 72-600s putting a downward value pressure. This is not always bad news, as it has opened new opportunities and any increase in the oil or mineral extraction activity will give a fillip to the market.

The cargo market has been characterised by two distinct segments though one has effectively undergone a name change with package business renamed e-commerce/e-trading or e-etc!

Relative value retention of late built A321-200s and the A321neo and CabinFlex versions

relative value retention of late built A321-200s and the A321neo and CabinFlex versions

This sector is flourishing and is contributing to strong rents and values for types that support this business model, most notably the 737 Classic freighter and the 767-300ERF/SFs. The Classic feedstock is in short supply, with fewer than 50 suitable aircraft of the more desirable -400 remaining. Hence, it is not a surprise to see the launch of the 737-800 cargo conversion and the already significant orders, which suggest that in the immediate future slots are at a premium. Despite the higher cost of the equipment, we expect the aircraft to have greater utility to justify the capital cost. The 737-800Fs will become the backbone of the narrowbody freighter fleet. Boeing products dominate the sector and breaking this incumbency is likely to be the most difficult hurdle for the A320P2F. Indeed the A321P2F may be the better 'SF' product.

For the widebody freighters (excluding the 767), the proverbial light at the end of the tunnel may now be breaking through the gloom. Traffic in the 2H2016 was showing signs of improvement and we have seen more large freighters parted out which is helping the supply side of the equation. We are expecting the nadir for large freighters has now passed, though any values or rent improvements are likely to be small scale.

Our final thoughts relate to production rate increases that are planned by both, Airbus and Boeing, in the coming years and will eventually lead to nearly 120 narrowbody aircraft produced each month by 2020. Some industry commentators are, of course, questioning the need for these rates, but both OEMs make strong cases for the need to deliver their orders to airlines who want the new technology. Where do we, at Oriel, sit in this debate? Assuming that there is no dislocation in the finance markets our £1 would be on the rates happening. The risk is any slowdown will lead to some over-supply and no doubt most value and lease rate pain will be felt by the middle aged aircraft from the current offerings.