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Maintenance Matters in Aircraft ABS Deals – Part 1

In this edition of mba Aviation’s Insight Series, the Forecasting & Modeling team looks at the way Maintenance is considered in Aircraft Securitizations.

Key Concepts:

  • Maintenance Value and Compensation are significant elements in Aircraft Asset Backed Securitizations (ABS)
  • The Maintenance Support Account of an ABS is used to fund all future maintenance events for the assets in the portfolio
  • Maintenance Value becomes a larger portion of the overall aircraft’s value as it ages

Maintenance value and the corresponding compensation, typically designated as “Supplemental Rent”, “Reserves”, or “End of Lease Compensation” within a lease agreement, contribute an essential element of value and liquidity within an Asset Backed Securitization (ABS) portfolio.

In an aircraft lease, lessors collect maintenance compensation for utilization on the individual components on each aircraft.  These typically include the airframe, landing gear, auxiliary power unit (APU), engines, and engine life limited parts (LLPS).  The chart below depicts a typical distribution of monthly maintenance reserves over each component, determined by cost and approximate interval of each relevant maintenance item on an A320-200.

Within an ABS deal, maintenance compensation collected from the lessees is funded into an aggregate Maintenance Support Account.  Whereas typical leases will divide reserves into individual accounts to be drawn down at the time each component undergoes maintenance, the Maintenance Support Account is used to reimburse all future maintenance events for the assets in the portfolio, and is only required to have funding over a predetermined “look-ahead period”, typically 12 months.

In addition to supplementing cash flows in a portfolio, maintenance adjustments, as calculated by the cost of a maintenance event and the position of the aircraft in its maintenance life cycle, are applied to each aircraft’s Base Value.  The maintenance adjusted values are then used to assess the overall value of the collateral pool and determine the loan-to-value (LTV) on each tranche of issuance.

As an aircraft ages, the overall value of the asset depreciates.  However, the cost to perform maintenance on each of its components increases over time with inflation.  Therefore, as the asset ages, the inherent value of maintenance in the aircraft becomes a larger portion of its overall value.

Based on the full life market value and the full maintenance value of the components on an aircraft, an approximate run-out value on each vintage of the aircraft can be derived.  The maintenance value to full-life value ratio illustrates how the value of maintenance in an aircraft encompasses a larger factor of the asset’s total value over time. The example below is an estimation of the reinvestment needed to bring an A320-200 back to full-life conditions.

As a result of the dynamic between aircraft depreciation and maintenance appreciation, we find two immediate impacts on ABS transactions over time: First, the inherent maintenance value become a larger component of each aircraft’s value and therefore the overall collateral pool. Second, as lease rates decrease with the decline in overall asset value, the maintenance-related cash flows become an increasing portion of the ABS’s liquidity.

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.

China’s Trump Card: The C919

The COMAC C919

China has long been recognized as an engine for growth in the aviation industry.  Its airlines are rapidly expanding and demand for air travel continues to skyrocket, for both domestic and international trips.  Not wanting to cede the entirety of the increased demand for aircraft to Airbus and Boeing, the Chinese Government launched The Commercial Aircraft Corporation of China (COMAC) in 2008.  COMAC has since launched the C919, a 168 seat aircraft which looks to break the Airbus and Boeing duopoly.  The Chinese are not the first to attempt to break into the narrowbody passenger aircraft market.  Some have been successful, like Airbus with the launch of the A320 in the late 1980s, while others have failed, like the Dassault Mercure in the mid 1970s. While the C919 will likely not reach the heights of the A320, the aircraft has the potential to be carried to moderate success by the domestic Chinese market.

Operating Characteristics

Although the C919 has the performance capabilities to meet the needs of virtually all of China’s domestic carriers, it cannot match its western counterparts particularly in regards to range. The C919 has a max payload range of only 1,350 nautical miles (nm), which is 1,200 nm less than the 737 MAX 8 and 650 nm less than the 737-800. When both aircraft are configured to hold 168 passengers, the C919 can travel 2,430nm, while the 737-800 can travel 3,100 nautical miles, assuming an average passenger weight of 190 pounds (lbs). This range differential is accounted by the C919 having an MTOW of 165,565 lbs, nearly 10,000 lbs lighter than the 737-800, but having an empty weight that is 2,000 lbs heavier than the 737-800.

While the Boeing 737 aircraft may have the range advantage over the C919, an analysis of the schedule of Chinese operators reveals that the C919 is well suited to domestic Chinese operations. mba performed an analysis of all Chinese domestic routes currently operated by the 737-800 or A320-200 and flown at least weekly.  The results showed that the C919 would likely be able to serve all of these routes, assuming the aircraft is operated in its standard 168 seat configuration. Depending on the C919’s take-off performance, the aircraft would likely take a seat penalty at some of China’s higher elevation airports such as Ürümqi. Additionally, the C919 as well as the 737-800 and A320-200 cannot operate in cities such as Lhasa, which has an elevation of over 11,000 ft. Due to these observations, Chinese operators would most likely not be concerned about the C919’s range limitations. COMAC official literature states that the company will launch a C919ER, which will bring the aircraft’s performance closer to that of the 737-800 and increase COMAC’s presence in the market. However, no information has been released regarding the variant’s launch date or how COMAC will achieve the performance upgrade.

The C919’s suitability for Chinese operations is further explained by China’s unique geography for a country of its size. Nearly all of China’s population centers hug its east coast, while the western part of the country is mostly empty, save for a few large cities in the Xinjiang province in the northwest of the country.  There are also several other countries whose geographies are similar to China’s in this regard, which would allow the C919 to operate successfully. Brazil, India, and most countries in South East Asia would all be suitable markets for the aircraft, but major airlines in these regions have substantial orders for A320neos or 737 MAX 8s. This market saturation for narrowbody aircraft makes it unlikely that carriers in these regions will place C919 orders.

Another disadvantage the C919 has versus its western counterparts is that it has a maximum seating capacity of only 174 seats. The 737-800 and A320-200 currently have a maximum seating capacity of 189 seats.  This seating limitation will be less attractive to low-cost carriers, which operate narrowbody aircraft at maximum capacity. The ideal customer profile for the C919 is a Chinese full-service carrier, which is reflected in the type’s order book, from which Chinese low cost carriers Spring Airlines and Lucky Air are notably absent.

Certification

COMAC faces an arduous road attaining type certification for the C919.  It took twelve years for COMAC’s first aircraft, the ARJ21, to attain type certification from the Civil Aviation Administration of China (CAAC). The C919 is expected to attain type certification from CAAC in 2020, which like the ARJ21, will be twelve years after the program’s launch. Another hurdle facing the C919 is type certification by western regulators such as the Federal Aviation Administration (FAA) in the United States and the European Aviation Safety Agency (EASA) in the EU. COMAC has applied with EASA for type certification for the C919, and in November 2017, the Chinese aviation regulator, the Civil Aviation Administration of China (CAAC) signed an agreement with the FAA which grants CAAC “comprehensive peer recognition” as an aerospace supplier.  All Chinese aircraft would still be subject to certification review with the FAA, but the agreement does open the door to further cooperation between the FAA and CAAC in the future.  These developments show that western certification of the C919 is not as far-fetched as believed when the program was launched. However, even if western type certification is received, it does not necessarily mean the aircraft will be purchased by western operators or lessors.

After Market Support

Potentially limited aftermarket support is another issue that may cause many non-Chinese operators to balk at purchasing the C919. It is unlikely that COMAC will be able to develop an efficient maintenance and spare parts distribution network for the aircraft.  Interjet, the sole North American operator of the Russian built Sukhoi Superjet, has had operational difficulties caused by Sukhoi’s similar supply chain issues. Engine maintenance delays have forced the grounding of several of Interjet’s Superjet aircraft, and some of the grounded aircraft are being cannibalized to keep the rest of the fleet flying.  Even though the Superjet’s sole engine option is a western built engine (the French built Safran PowerJet SaM146) the engine’s only application is the Superjet, limiting the amount of spares available. Should non-Chinese operators adopt the C919 they would likely face similar challenges as Interjet.  The C919’s saving grace in this area is that a large portion of the C919’s components are western built.  The APU is a Honeywell HGT750, and its engines, CFM LEAP-1C will likely have significant parts commonality with other CFM LEAP engines. However, this will probably not be enough to convince operators that maintenance can be completed on C919 aircraft in a timely and affordable manner.

New Entrant Competition and Pricing

Even if the C919 had performance figures equivalent to current generation Boeing and Airbus aircraft, it would still have a hard time securing any orders outside of its home market. Operators are often unwilling to be early adopters of an unproven manufacturer’s aircraft as seen in the order book for Russian built Irkut MC-21 and Sukhoi Superjet.  The MC-21 has performance figures much closer to the 737 MAX 8 than does the C919, but it has only managed to secure 205 orders, with Egyptian operator Cairo Aviation being the only customer outside of the Commonwealth of Independent States (CIS). Sukhoi has had similar challenges marketing the Superjet, with only two commercial operators of the aircraft (Mexico’s Interjet and Ireland’s CityJet) located outside of the CIS. Commercial challenges experienced by Russian manufacturers show that there is an uphill battle ahead for COMAC’s marketing team when they attempt to sell the C919 to non-Chinese operators. Granted, once all 205 MC-21 orders are filled, the aircraft will make up roughly 40% of all narrowbody aircraft operating for Russian airlines. Should the C919 achieve similar home market penetration, COMAC will receive around 1,000 orders for the aircraft.

Pricing of the C919 is difficult to pinpoint as no commercial terms have been agreed upon as of December 2017.  All orders currently consist of a “customer agreement” in which pricing and delivery schedules have not been discussed.  List price of the C919 has not been announced by the manufacturer although it is believed to be around $68.4 million.  If the same discount that manufacturers typically give to the A320-200 and 737-800 list prices is applied, the purchase price of a new C919 would be somewhere between $28.7 million and $32.1 million, placing the aircraft at around the same price as a new Embraer E-190. This pricing is a bargain for an aircraft of the C919’s size and the aircraft may win a few customers on price alone.  The Chinese Government is also likely to subsidize the purchase of the C919 for Chinese operators, increasing the likelihood Chinese airlines would select the aircraft over its western competitors.

Tariff Effects

On April 4th 2018, the Chinese government announced a 25% tariff on aircraft imported from the United States of America with an empty weight between 15,000 and 45,000 kilograms.  It is unknown how the Chinese will define empty weight, which is key to assessing the impact of the proposed tariff. The 737 MAX 8 has an operating empty weight of 45,070 kilograms, which would put it just above the tariff cut-off weight.  However, if the Chinese government defines empty weight as “manufacturer’s empty weight” which is the weight of solely the aircraft structure, the 737 MAX 8 will undoubtedly be subject to the proposed tariff. It is important to note that the tariff on aircraft is not likely to be implemented in the immediate future, but should it go into effect there would be significant consequences for both the Chinese and American aviation industries. The C919 would undoubtedly become more attractive to Chinese operators as the pricing versus the 737 MAX 8 would only become more competitive.  There are currently only 138 orders for the 737 MAX 8 from Chinese operators, but there are 1,079 737-800s currently operating in China that will need to be replaced at some point in the future.  Since Boeing would no longer be able to compete in this segment, COMAC and Airbus would undoubtedly look to fill this demand.  However, the 737-800 fleet in China is very young, with an average age of just under five years, so the tariffs would most likely be repealed once the fleet needs replacing in significant numbers.  The tariffs would also make it difficult in the short term for American operators to move used 737NGs, as the Chinese secondary market would effectively be blocked.  Should the tariff go into effect, both COMAC and Airbus could be winners, and the C919 program may get a much needed boost.

Looking Ahead

The C919 is a noble effort by the fledgling Chinese aviation industry. The aircraft is more than capable of serving Chinese airlines in their domestic operations, which is a sizeable and growing market. This combined with bargain pricing and Chinese government assistance may drive Chinese operators to the C919, cutting into a small yet noteworthy portion of both Boeing’s and Airbus’ Chinese business. Outside of China, the performance limitations of the aircraft will hinder the sale of the C919 and therefore COMAC does not currently pose a threat to the Boeing-Airbus duopoly. However, COMAC will certainly learn from its experience producing the C919 and will certainly produce more capable aircraft in the future. As a result, both Boeing and Airbus should take the Chinese aerospace industry seriously and implement strategies to counter their new competition.