7 December, 2016

NEWSLETTER 11: AIRCRAFT LEASING

Left holding the baby

Mark Webb

Don’t be tempted to buy into aircraft leasing businesses despite the recent flurry of IPOs. It is a bad industry and the only stocks to trade above book value are those with creative accounting or government subsidies. The prospect of rising interest rates and low oil prices means that the aircraft leasing cycle is turning down. This explains why everyone is trying to offload these assets. We think China Aircraft Leasing (1848 HK) might not survive the cycle. Don’t be left holding the baby.

A series of acquisitions and successful recent share listings have put the aircraft leasing industry back on investors’ radars. Aircraft lessors’ appeal is based on the rapid growth in Asian airline fleets and relatively safe income. Airlines rarely default on aircraft leases and even if they do, there is a globally established mechanism for securing the repossession of leased jets.

However, most investors are focusing on the wrong issues. While lessors face relatively low credit risks, another far more important factor drives economic returns in this industry – the value and lease rates for used aircraft. Indeed, the actual returns on an aircraft used in leasing are only known once the jet has been sold. In this area, risks are now rising considerably.

We believe the global industry cycle has peaked and is starting to turn-down. At the end of 2015, Delta’s CEO flagged a huge bubble in excess wide-body airplanes. In Asia, significant over ordering by ASEAN low cost carriers risks oversupply in the smaller narrow-body jets as well. Globally, the aircraft order backlog is at record levels and the fall in fuel prices cuts the incentive to scrap older jets. Manufacturers have responded by cutting the selling price of the latest generation aircraft by 10-15% and this plus oversupply is cascading through the market for older jets, cutting second hand prices and leasing rates. This cyclical downturn in asset values is being compounded by new entrants in aircraft leasing boosting competition among lessors.

Relative poor underlying returns in the leasing industry have also been masked by significant non-operating income, high levels of floating rate debt and aggressive accounting treatments. Depreciation is comfortably the biggest operating cost, but lessors depreciate their jets at far lower rates than the airlines they lease the planes to, which significantly inflates profits. Other tricks include using finance lease accounting despite keeping ownership of the jets, which front-loads profit.

As our recent report on aircraft leasing details, we believe China Aircraft Leasing (1848 HK) faces a difficult outlook, has weak underlying profitability and an over-leveraged balance sheet. Mediocre financial performance looks to have taken advantage of subjective accounting policies which allow the front-loading of profit. While BOC Aviation is much better placed, its returns are underwhelming and it may be under-depreciating its jets at a time when global oversupply starts to put downward pressure on aircraft values.

And finally, seeing that aircraft leasing is all about the accounting, here's our video of the day: