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The Possible Effect of the Coronavirus Outbreak on the Aviation Industry and Aircraft Values

In this edition of mba Aviation’s Insight Series, Sloane Churchill, Analyst – Asset Valuations, uses analysis of the effect of the SARS outbreak of 2002-2003 on aircraft values and the aviation industry to provide insight on how today’s Coronavirus might take its toll.

Key Concepts:

  • SARS increased volatility of market values for older vintage and out of production aircraft types more than newer vintage and in-production types, though market values generally recovered within three quarters. It is likely Coronavirus will similarly effect aircraft market values in the short term, but will have no long-term effects.
  • The timing of the Coronavirus outbreak over the Chinese New Year, slowing economic growth in China, and extensive travel restrictions are expected to make a larger dent in RPK’s than during SARS.
  • No health epidemic of the past 20 years has had a long-term effect on global financial markets, with most recovering with a year. While global airline stocks have taken an immediate hit due to the Coronavirus outbreak, it is not anticipated to have long-term effects on airline stocks.

The Possible Effect of the Coronavirus Outbreak on the Aviation Industry and Aircraft Values

Though the Coronavirus outbreak in China is reminiscent of the SARS outbreak in 2002 – 2003, the effects on the aviation industry have the potential to be quite different. So far, the Coronavirus has infected over 45,000 people, mostly in mainland China, leading to over 1,100 deaths. This Coronavirus is proving to be faster spreading, though less deadly than SARS, with a death rate of approximately 2.1%. Historically, while global health epidemics have hurt aviation by reducing revenue passenger kilometer (RPK) growth in the short term, there have been no long-term effects for any epidemic of the last twenty years, including SARS, Avian Flu, Swine Flu, Ebola, or Zika on aircraft values or the aviation market as a whole.

The SARS outbreak could provide some insight as to how aircraft values and the aviation industry might be affected by the current Coronavirus. mba values research shows SARS disproportionately affected aircraft values. Typically, older vintage and out of production aircraft were hit the hardest after the SARS outbreak, showing the most value volatility in the following two years. Newer vintage and current production aircraft were significantly less volatile.

Market values for aircraft and Brent Crude prices have historically had an inverse relationship; in low fuel price environments, aircraft values tend to increase as aircraft become less expensive to operate, while market values decrease in high fuel price environments. This is especially apparent in older vintage and out of production aircraft, as they are less fuel efficient, and thus more sensitive to fuel price. However, 9/11 and the SARS epidemic broke the correlation between Brent Crude prices and market values, and this relationship does not recover until after the worst point of the SARS epidemic in 3Q 2003 for most aircraft types and classes. After the SARS outbreak, looking at narrowbody aircraft, the market value of a 1988 737-400 and A320-200 fell 14.8% and 42.0% respectively in 1Q 2003 from the previous quarter, while market values for a 1998 737-400 and A320-200 fell 15.1% and 16.7% respectively in 1Q 2003. Market values for a 1998 737-800, which technologically replaced the 737-400, dropped 11.2%. At the same time, Brent Crude prices fell 3.5% from the previous quarter during 1Q 2003.

Generally, narrowbody aircraft values recovered by 3Q 2004 and show no long-term effects from the SARS outbreak. However, there were only limited travel restrictions in place during the SARS outbreak, while travel restrictions in China and internationally during this Coronavirus outbreak have been significantly more extensive, potentially having a larger effect on RPKs than SARS. The immediate reduction in passenger demand caused by these travel restrictions will likely hit narrowbody values slightly less than widebody values, as carriers will rely more on their narrowbody fleets in the reduced-demand environment, particularly in the domestic Asia market.

Widebody aircraft in particular took the brunt of the value hit during the SARS epidemic, as they potentially will in the quarters following this Coronavirus epidemic as well. Like narrowbodies, widebody values recovered by 3Q 2004. The small to mid-sized widebodies such as the 767-300ER and A330-300 showed less volatility than large widebodies. Market values of older vintage aircraft, such as a 1988 767-300ER and a 1994 A330-300, were affected the most, falling 13.3% and 18.8% respectively in 1Q 2003. The newer 1998 vintage 767-300ER and A330-300 market values fell slightly less at 10.4% and 13.6% respectively. With the A330 currently in a soft market, all vintages, but particularly older vintages, could be vulnerable to further market value volatility, as the A330 is a popular widebody in the Asia/Pacific region. The 787, also a popular type in the Asia/Pacific region, could be vulnerable to market value volatility as concerns of overproduction combined with reduced passenger demand might lead to delayed or cancelled deliveries of the type in the near to mid-term.

Large widebodies, such as the 777-200ER and the 747-400 were also heavily affected by the SARS outbreak. Market values for the 1998 vintage 747-400 were hit the hardest by SARS in part because the type was nearing the end of its production run, falling 16.1% in 1Q 2003 while market values for a 1989 vintage only fell 7.7%. This time around, we could see softening of market values for older vintage 777-300ERs, or even the A350-900, as these types are popular on mid to long-haul routes in Asia.

Financial markets took an immediate hit with the shock of the epidemic after the Chinese New Year on January 27th, with the US’s S&P 500 and NASDAQ falling 1.6% and 1.9% respectively, and London’s FTSE 100 Index fell 2.3%. However, so far through the epidemic, the S&P 500 has only fallen 0.16% and the NASDAQ has actually risen 2.0%. Since the Coronavirus was announced, through the end of January, Hong Kong’s Hang Seng Index has fallen 6.7% and Shanghai’s SSE Composite Index has dropped nearly 10.0%.

International airline stocks were also affected, particularly airlines with large international presences and extensive Asian networks. China Eastern Airlines and China Southern Airlines’ stocks have been hit the hardest, both falling around 17.0% during the epidemic, as their networks rely heavily on international routes within Asia and around the globe. The following chart shows how several airlines were affected at various event dates throughout this epidemic, starting December 31, 2019 when China reported a new illness to the WHO, around the weekend of the Chinese New Year, and when the WHO deemed the Coronavirus to be an international public health emergency at the end of January.

Airlines are now more flexible than they were in the early 2000’s, becoming more savvy with capacity and revenue management, making changes to flight schedules just days after the start of the epidemic in response to anticipated drops in demand. Several airlines have cancelled their flights to China altogether, including British Airways, Lion Air, Lufthansa, Air France – KLM, Virgin Atlantic, Delta Air Lines, and American Airlines, with more expected to follow. While cutting flights to and from China might curb the spread of the illness, it could potentially have drastic effects for airlines’ financials. Research conducted by mba’s Forecasting and Modeling Group shows three of the top ten international routes from China to outside of the region by frequency are between China and the United States. United Airlines and American Airlines each serve two of those three routes, with Delta Air Lines serving one route, making them particularly exposed to the travel restrictions. United Airlines is also one of the top ten operators to China by frequency and has taken the largest hit to its stock price so far because of its exposure.

After the SARS outbreak, global financial markets fully recovered within one year, even while continuing to recover from the effects of the 9/11 terrorist attacks. This coronavirus hit during a long boom period for the financial and aviation markets, which may help to mitigate the financial effects of the epidemic on aviation, as most airlines are more flexible and financially fit, and thus more equipped to handle the reduction in passenger demand.  The coronavirus has also affected the manufacturers, as Airbus announced it has closed its final assembly line in Tianjin, China in response to the coronavirus. China’s importance to the aviation industry has grown tremendously since the SARS outbreak 18 years ago, and is essential to many global airlines’ growth horizons, which may make this epidemic that much more painful for the industry. The aviation industry’s fears of an economic downturn ahead combined with the potential severity of this epidemic is likely to perpetuate the rash of airline bankruptcies we saw in 2019, as some financially suffering airlines might not cope with the reduced demand. It would also be reasonable to see a slowdown in aircraft transactions and financings in the near to mid-term, though the ABS and EETC markets might hold solid, as they are more long-term instruments.

The timing of the outbreak is also unfortunate for the industry as the Chinese New Year January 25th, China’s largest travel holiday, was effectively cancelled by the outbreak. According to CNN, in 2019 the Chinese New Year accounted for around 73 million trips by air travel. According to IATA, at the worst of the SARS outbreak in May 2003, RPK’s dropped by about 35% with no travel restrictions by countries. Currently, with the travel ban within China and many other countries limiting travel to and from China, RPK’s are expected to take a sizeable hit. With economic growth slowed to 6.1% in 2019, and resulting reduced passenger demand growth in China over the past two years, if the Coronavirus lasts through the quarter, it could have long-term economic effects, unlike prior health epidemics, as Asia grows to be one of the largest aviation markets in the world.

Monetizing Slots, Gates and Routes

Slots, Gates and Routes – Monetizing Intangible Assets

Slots, Gates and Routes (SGR) are immensely valuable assets for airlines, referred to commonly as “intangible” assets for valuation and collateralization. For operators, SGR assets represent strategic long-term competitive advantages and their value helps to raise additional capital for airlines, predominantly based in North America. mba estimates that close to $8.0bn US of debt was outstanding as of December 2016 utilizing slots, gates and routes as collateral. Despite the numbers, large-scale collateralization of SGR to raise capital remains largely untapped in non-US markets.

The use of SGR as collateral for funding purposes relies primarily on lenders’ and investors’ confidence in the enforceability of the asset; concern is focused on such enforceability in the event of default, as well as maintaining contractually agreed-upon loan-to-value (LTV) ratios. Detailed in the contracts, an independent initial request to provide the appraised asset value serves the joint purposes of calculating initial LTV ratios and subsequent calculations of maintenance of these ratios.

SGR Defined – What Falls Into the Asset Class?

Slots

Generally speaking, the term airport slot covers the range of actions and access an operator may have at a given airport, including land and takeoff and use of related facilities on a schedule basis. The term slot is interchangeable with slot-pair as the use includes time scheduled to land and depart. The International Air Transport Association (IATA) defines an airport slot as “a permission given by a coordinator for a planned operation to use the full range of airport infrastructure necessary to arrive or depart at a Level 3 airport on a specific date and time.[1]” Airports are classified by IATA as a Level 1, Level 2 or Level 3 based on the capacity of the facilities and the demand for access or use. Level 1 airports’ capacity generally meet the demand at all times whereas a Level 3 airport’s demand for slots significantly exceeds the capacity at the airport and therefore slot allocation requires a coordinator out of necessity. Although most airports in the U.S. are categorized as ­Level 1 airports under the IATA Worldwide Slot Guidelines (WSG), the Federal Aviation Administration (FAA) has imposed Level 3 slot controls by rule at John F Kennedy International Airport (JFK), LaGuardia Airport (LGA), and Ronald Reagan Washington National Airport (DCA).

 

Routes

Routes are defined as the right to operate scheduled air service between specified airports. The route authority is governed by multilateral agreements between countries, and are subject to capacity restrictions at each airport and also between countries. In the United States, the Department of Transportation (DOT) processes requests by U.S. airlines for authority to serve foreign markets. If more carriers seek frequencies than are available, the DOT must allocate the frequencies among the U.S. carriers using comparative selection procedures.

A Brief Look at the Market

A vast majority of outstanding SGR secured debt consists of bank loans between airline and a lending bank. Although the use of slots, gates and routes as collateral in debt financing is common among large North American airlines, it still represents a minority share of total debt financing for these airlines, with the exception of Virgin Atlantic.

 

In December 2015, Virgin Atlantic used its slots at London Heathrow Airport (LHR) as collateral for a private placement bond, raising £225 million ($260 million US) of debt financing, the largest non-bank related debt financing arrangement with SGR as collateral, with proceeds used to finance new aircraft orders. In January 2017, Virgin Atlantic announced it had secured another £32 million ($40 million) of financing on the back off the same slot portfolio. The Virgin Atlantic deal represented the first, and (to this date) only, funding deal where slots outside of US airports were used as collateral in non-bank lending, although British Airways’ parent IAG previously attempted in 2012, but proved unsuccessful due to the timing issues, and that transaction’s  specific complexity.

In addition to providing an additional source of funding for airlines and thereby diversifying the funding base, the cost of SGR related debt is relatively beneficial compared with other common sources of aviation financing. The chart below depicts the average publicly disclosed interest rates on debt facilities secured by SGR collateral and the average LTV for the same facilities, in comparison to recent aircraft ABS and airline EETC transactions. On average, interest rates on SGR secured debt facilities are comparable to A-tranches in aircraft ABS and EETCs.

 

 

Regulatory Impact on SGR Assets

While investor confidence to enforceability plays a large role in arranging SGR debt financing, the regulatory environment in various jurisdictions often dictates the starting point for valuing SGR assets. Changes in regulations can have a significant impact on the value of these assets.

In the US, the Department of Justice (DOJ) can mandate divestitures when there are competition concerns as a result of mergers between airlines. Following their merger in 2013, US Airways and American divested a total of 17 slot pairs at LGA and 52 slot pairs at DCA to gain DOJ approval. Private auctions for these slots at LGA and DCA, respectively, were limited to Low-Cost Carriers. Ultimately, at DCA, Southwest Airlines won six pairs plus five pairs it was already leasing from American, while Virgin America won bids for six slot pairs. At DCA, Southwest Airlines won 28 pairs, JetBlue Airways won 12 pairs, plus eight they were already leasing, and Virgin America won four pairs.

The US Department of Transportation (DOT) also plays a role in the management of SGR. It granted antitrust immunity in 2016 for the proposed alliance agreements submitted by Delta Air Lines and Aeroméxico. This was on the condition that the carriers divest takeoff and landing slots to support 24 new daily transborder services from Mexico City and four new daily transborder services from New York JFK, to be operated by competing airlines. The American and Delta examples above illustrate the impact regulatory actions have on competitive environment and SGR values.

Beyond North America, regulation can, in addition to evaluating slots for competition, impact the distribution of trans-ocean routes. In December 2016, the DOT finalized its decision to award American Airlines route authority between Los Angeles and Beijing. Delta Airlines had also filed an application, however the DOT determined that American Airlines’ superior connectivity (resulting in a higher number of U.S. travelers benefitting from one-stop connections over Los Angeles) was significant enough of a factor to award the route to American.

Asset Enforceability and Transferability

As SGR is considered an intangible asset, establishing parties’ legal rights and generally market interests are together the center piece to demonstrate discernable value for the parties transacting, the relatively small number of completed sales transactions make benchmarking difficult, and attracting investment using these assets is complicated by lack of information. However, there are indicators of the inherent value, enforceability and transferability of the asset worth reviewing.

Although sales of SGR assets occur less frequently, several examples of slots and routes transactions are notable. The table below contains slot sales at London Heathrow Airport, LaGuardia Airport, and Ronald Reagan Washington National Airport over the past decade, their value being shown in the market demand.

 

Sales of routes occur less frequently than slots, however multiple transactions between 1982 and 1992 are informative to value and opportunity. Approximately $3.0bn worth of route transactions occurred during this period as shown in the following table. A majority of these sales were a result of bankruptcy proceedings.

The legal view of SGR collateral is equally up to benchmarking the asset value in the market, and the use of slots, gates and routes as collateral has been supported by several US courts. In the American Airlines bankruptcy case, the route authorities and gate leaseholds that had been used as collateral in certain of its lending agreements were deemed as valid. Ultimately, American Airlines prepaid these loans early and the creditors received full payout, with no impairment of their security interest. Another example where the validity of SGR assets was upheld in court is the case of Monarch versus Airport Coordination Limited. The court ruled that Monarch in fact had the right to its slots for the 2018 summer season at London Gatwick airport, despite having had its Air Operator Certificate revoked (see: How Monarch Monetized Gatwick Slots Post-Collapse). The right to sell an asset out of Bankruptcy as ruled by the court in the Monarch case provides further validity to the use of SGR assets as collateral.

Finally, even in instances where sales of SGR are prohibited by regulation and transferability of the asset cannot take place, there is inherent intangible value in the asset. This is because airlines can lease the asset to a partner airline rather than sell it in order to obtain long term rights to the slot. In fact, slot leasing is more common than slot sales as airlines prefer to retain the long term rights to the asset. Therefore, where sales are prohibited, it is possible to generate a return on the asset while maintaining long term ownership rights.

Conclusion

Large North American Airlines have successfully monetized their slots, gates and routes to raise financing. That said, SGR secured debt still represents a minority share of an airline’s overall debt funding and remains a relatively new concept among airlines outside of North America. The regulatory environment can have a significant impact on the value of SGR assets, as illustrated above. However, regulation tends to change infrequently and the long term nature of these assets means their value is less susceptible to short term fluctuations in the economic environment. Moreover, the validity of slots, gates, and routes as collateral has been upheld in several court cases predominantly in North America, but also more recently in the UK. While the Monarch ruling should improve investor confidence in SGR assets, large-scale monetization of slots, gates and routes outside of North America remains a significant source of untapped capital.

[1] https://www.hamburg-convention.com/en/hamburg/stories/iata-slots-conference