Posts

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.

Boeing MAX v Airbus Neo: An Evolving Rivalry

When Airbus launched the A320 to compete against the 737 family of aircraft in 1984, it was competing against a mature company with a distinct first-mover advantage. It took Airbus a good number of years to catch up to Boeing’s order books, cementing both the A320 and the 737 as two of the most successful aircraft of all time, in terms of orders.  With the advent of a new generation of aircraft, we have seen a slight advantage of one manufacturer moving ahead, though it is still early days for both aircraft families. As of November 2017, Airbus commanded a healthy lead with 5,254 neos on order compared to 4,065 MAXs on order and a first-mover advantage in the 200-240 seat segment with the A321neo edging out over the MAX9 and MAX10.

Since the launch of the 737 Next Generation (NG) and the A320ceo family, the preference in the narrowbody market has shifted and resulted in the changes culminating in the MAX and neo family of aircraft. The most distinctive shifts we have observed are the general upgauging of the aircraft and a greater sensitivity to fuel prices. The upgauging of aircraft has resulted in every version of the MAX being built larger than its predecessor. Additionally, we see an upward shift in market share of the 200-240 seat aircraft in the narrowbody market. The A321neo has increased its market share to 28% from the 22% the A321ceo held in the ceo family and the MAX 9 and MAX 10 aircraft command 14% of total MAX orders compared to 8% the 737-900 and 900ER held with the NG family.

Order Book Review

Source: mba REDBOOK STAR Fleet November 2017, Boeing.com, Airbus.com

The Impact of Rapid Economic Growth

A large part of this upgauging can be attributed to the rapid economic growth in Asia. IATA estimates that the region will grow 4.7% annually, with China set to become the world’s largest aviation market by 2024 and India displacing the UK as the third largest market in 2025. While the Asian carriers have been riding on the wave of economic growth in the region, the infrastructure has been struggling to cope with the surge in demand and is lagging behind the growth of the carriers it’s trying support. To overcome these infrastructure limitations, Asian carriers are relying on larger aircraft to fly higher-density routes. A great example of this is Vietnam Airlines which has seen strong growth over the last few years but has been limited by infrastructure growth in the region. The airline operates a modern mix fleet with the smallest aircraft outside of its turboprop fleet being the A321-200 with the intention to lease 18 A321neos from Air Lease Corp and Aviation Capital Group. With the MAX and neo, we see that Airbus has had greater success in Asia, with orders in Asia accounting for 46% of the neo backlog. Boeing has taken a more balanced approach with the bulk of its MAX orders concentrated in North America at 33% and Asia coming in a close second at 30%.

Regional Overview of the MAX/neo Order Books

Source: mba REDBOOK STAR Fleet November 2017, Boeing.com, Airbus.com

Comparing Cost Advantages

The general upgauging of the narrowbody segment has worked in Airbus’ favor allowing the A321neo to pull ahead of the 737 MAX 10 due to its first-mover advantage and seat cost advantage. However, as we move down the product line we see a reversal with the MAX having a seat cost advantage over its Airbus counterpart, with the MAX 8 and MAX 7 having a $20k seat cost advantage over the A320neo and A319neo respectively. While this may intensify the competition between the MAX 8 and A320neo, the lower seat cost of the MAX 7 may come at a cost to Boeing. The lower cost per seat on the MAX 7 is a result of increasing the capacity of the aircraft which may take away some of the advantages the 737-700 gave to its customers.  The segment in which the A319 and 737-700 operate is somewhat niche compared to the larger variants, where operators care more about “right-sizing” and operating an aircraft within a narrower band of operating economics in which the aircraft is viable.  Although the bulk of the sales are still expected to come from the A320neo and MAX 8, the lower end of the narrowbody segment where the A319 and 737-700 currently operate should not be neglected.  With over 1,440 A319s and 1,125 737-700s in operation; and the average age of the fleet being 11.76 years and 11.8 years respectively, the 100-150 seat market may prove to be a pivotal market to capture even if the orders are solely for replacement rather than growth. With the new family of E2 jets by Embraer and the marketing efforts of Airbus behind the Bombardier CSeries, we could see a dilution of market share and an end to the long standing duopoly in the segment.

Cost per Seat Based on mba’s Market Values as of 4Q17

Source: mba REDBOOK 4Q17

 

In most other aspects, the MAX and the neo share very similar operating economics. The projected maintenance cost for both the MAX and the neo are comparable in the mid to long run. However, due to a longer interval for the first heavy check on the MAX, the A320neo has a higher maintenance cost for the first seven years. The maintenance cost over time for the neo is more gradual with cost increasing steadily over time. With the MAX, we see a spike at the 9 year mark as the first heavy check comes due followed shortly by a landing gear overhaul which runs on a shorter interval compared to the neo. Past this point, both aircraft have very similar maintenance cost as the MAX returns to a 6 year heavy check interval with the exception being the landing gear check intervals which is 10 years for the max and 12 years for the neo. This results in a higher cost for the MAX at the end of 20 years but will even out at the 24 year mark once the neo is due for the second landing gear overhaul. The lower cost observed with the MAX 9 compared to the A321neo is mostly attributed to the same engine variant being used on the MAX 9 as the MAX 8 while the A321neo’s maintenance cost is valued using the more powerful LEAP-1A32 and PW1133G which has a higher maintenance cost. The spike in maintenance cost at 15 years for the GTF powered A321 is due to its second engine shop visit coming due before the LEAP powered A321, but the cost eventually evens out again at the 20 year mark with the GTF A321neo coming out slightly more favorable.

Scheduled Maintenance Costs Accumulated Over the Life of the Aircraft

Source: mba aircraft maintenance cost database[1]

In addition, if the economic value of the current generation of aircraft is any indication of the value of the MAX and neo, both aircraft will have a very similar residual value curve with the MAX slightly ahead in all but the 100-150 seat segment where it closely trails the A319.

Average Historical Market Value Depreciation

Source: mba REDBOOK Historical Aircraft Values

Fulfilling Engine Expectations

As previously mentioned, an observed change in the market is that operators are becoming far more sensitive to fuel prices compared to 30 years ago. With the current fuel prices hovering around US$50.00 a barrel, the need for fuel efficient aircraft is dampened, however it was due to a spike in fuel prices that led to the inception of the re-engined aircraft families currently entering the market.  A major draw of the MAX and neo is the promised fuel burn advantage over current generation aircraft. At the core of the advertised double digit fuel burn advantage touted by both plane makers is the new generation of engines.

On the power-plant manufacturing side we see little change as the two existing incumbent OEMs, Pratt & Whitney (P&W) and CFM, continue to be the majority providers of engines in the 75-240 seat segment. Outside of the V2500 engines, most of the other P&W powered aircraft are nearing retirement, as such P&W has hedged the company’s future in the commercial aviation market on the success of the geared turbofan. So far, both the CFM LEAP and PW1100G have delivered on its promise of lower fuel burn, lower life-cycle maintenance cost and good dispatch reliability. However, the introduction of the new generation of engines has not been without hiccups. The PW1100G had two main issues that plagued its entry into service, namely a fault with an air seal and a combustor issue that P&W claims is isolated to aircraft operating in India. To compensate, P&W has had to divert some of the engines to a spare pool.  This combined with supply-chain shortages has resulted in a failure to meet its scheduled deliveries.

At the same time, CFM’s LEAP engines have not had a trouble free introduction into service. During a borescope inspection, several LEAP engines were found to have premature deterioration of the ceramic matrix composite coating on the turbine module. While both engine manufacturers have promised fixes for the respective issues, there has been a slight order advantage for CFM engines which have received around half of the neo orders and is the sole engine provider for the MAX.

The low fuel price environment and abundance of capital looking for yield in the aviation sector has resulted in a slightly tempered response to the new generation of aircraft and lease rate ranges have been wide.  The sale-lease-back market has seen rates for A320neo and MAXs in the low $300k’s in some cases, trading closer to where one would expect last off the line ceos and NGs, but also up to $400k in others, with many lease rates falling in between. The 25% swing in lease rates can be attributed to other lease parameters such as the lessee’s credit, term, return conditions and multiple aircraft placement deals; however it also shows a fragmented market with some operators unwilling to pay a premium during low fuel prices, and lessors have been willing to bend to gain market share, and others desperate for new aircraft to support fleet growth. Keeping this in mind, it is important to note that the lower rates are more reflective of the state of the capital markets and not reflective of the technical performance of the future generation aircraft.

In Summary

Despite the engine setbacks during the initial entry into service and the entrant of new competitors, the MAX and neo families of aircraft look poised to become economic successes for Airbus and Boeing. Although there have been initial leaders in the segment so far, it will not be surprising to see the competitive landscape re-adjust itself to look like the current generation of aircraft with a few new partnerships in the mix.

 

[1] Maintenance cost projected using average utilization of 737-800 and A320ceo and current estimated maintenance cost. Maintenance costs and intervals likely to change as engines mature and additional in service experience is accumulated. PW1100G excludes gearbox overhaul costs.