Aviation Finance

 - September 28, 2006, 6:20 AM

A common admonition to investors is to regard a stock’s past performance as no guarantee of future results. On the macroeconomic level, however, general patterns prove more often true than not, especially over the long run.

Famed economist John Maynard Keynes coined perhaps the most memorable–and indubitable–of truisms, economic or otherwise: “In the long run, we are all dead.” (Keynes maintained that governments should try to solve short-term economic problems rather than wait for slow-moving market forces to fix them, because “in the long run….”)

The last 12 months have bolstered the validity of one well known, long-term economic truism relating to business aviation. “When Wall Street and the economy are doing well, business aviation benefits,” said Rudy Tenore, senior vice president of corporate aircraft finance for Banc of America in Providence, R.I. However, “the market is cyclical,” he said, and the opposite holds true as well: an economic slowdown is usually followed by a slowdown in the business jet market. During both upswings and downturns of the general economy, business aviation lags by about nine to 12 months, Tenore explained.

Thus, since the U.S. economy has “continued to expand at a brisk rate, on balance, over the first half of 2006,” as the Federal Reserve Board stated in its July 19 Monetary Policy Report to Congress, it should not be surprising that the General Aviation Manufacturers Association (GAMA) reported record-breaking shipments and billings during the same time frame. Shipments totaled 1,843 general aviation airplanes (including pistons and nonpressurized turboprops), a 19.1-percent increase over the same period last year, and industry billings rose 34.9 percent, to $8.8 billion.

“This,” said Pete Bunce, GAMA president and CEO, at EAA’s AirVenture in late July, “is the highest recorded billings for the first half of a year in general aviation’s history. With our manufacturers’ current backlog, we are confident that this trend will continue throughout the remainder of 2006.”

The overall upward trend in industry shipments was evident in all aircraft segments, GAMA reported. Shipments of piston-powered airplanes in the first six months of this year were up 17.4 percent from the same period last year, to 1,270. Turboprop shipments rose 12.1 percent, from 141 last year to 158 this year. And leading the pack was the business jet market, with a 27.7-percent increase in shipments, from 325 to 415 aircraft. This continues the upward movement that began in 2003.

But as Richard Ramsden, vice president of Wells Fargo Equipment Finance in Weston, Fla., pointed out, “The prosperous economy continues to be the main driver behind the new orders. The new jet activity we saw in the first half of this year was really last year’s orders based on the backlogs that existed in 2005. Given current backlogs, I see continued increases in 2006 deliveries. As the economy changes, however, so will the order book.”

As impressive and welcome as the GAMA numbers are, experts in aviation finance are quick to point to the past as an example of the cyclical nature of the business. “The question is really why did aircraft shipments drop in 2001 and 2002,” said Bob Kent, president of Scope Aircraft Finance in Columbus, Ohio.

“Aircraft unit shipments increased every year from 1994 through 2000. Then there was a drop in 2001 that coincided with the economic downturn. Real GDP [gross domestic product] was flat from 2000 to 2001 and began to recover only slightly in 2002, but did not even reach a 2-percent increase. By 2003 the GDP increase was more than 3.5 percent, and that year aircraft unit shipments resumed their rise,” he added.

David Davis, president of the aircraft division for 1st Source Bank in South Bend, Ind., said, “There still remains some pent-up demand from the slow market of a few years ago, and some of the aircraft currently being delivered were ordered more than a year ago. Of course, interest rates were at historic lows and, when viewed over the past two decades, are still relatively low. One additional factor in new aircraft sales is that used aircraft values have held steady or increased in the recent past and most aircraft owners are more willing to move to a new aircraft if they can obtain reasonable value for their existing equipment.”

Mary Schwartz, director and vice president for Citigroup Private Bank Aircraft Finance in New York, also sees other factors involved. “The corporate aircraft business was accelerating at a rapid rate until 9/11,” she said. “Certainly, immediately post-9/11 business aviation suffered, but in a relatively short period of time it started picking up again. Only this time it wasn’t just an improving economy, but the economy coupled with people of wealth not wanting to fly the airlines anymore. We became very conscious of terrorism, and it’s easy to see that, from a safety point of view, there’s nothing like having your own aircraft.

“Travel via private jet has become more of a global phenomenon,” Schwartz continued. “Wealth has been growing both in the U.S. and abroad, allowing more individuals into the market. Business aircraft have become a popular means of travel for executives and individuals alike and they are not frowned upon quite as much as they once were in many locations. Manufacturers have reported a huge increase in demand in Europe, Asia Pacific and elsewhere. In addition, companies have become more global and therefore have a greater need for convenient, safe travel.”

Dave Labrozzi, president of GE Capital Solutions, Corporate Aircraft in Danbury, Conn., agreed. “For companies, this upward trend [in business aircraft sales] can be attributed to the economy. For individuals it is due to growth of wealth. Many aircraft owners are ‘stepping up’ to larger, newer equipment. In addition, the airline experience and passengers’ safety concerns are likely contributing to the increased demand.”

Tenore of Banc of America said, “Low interest rates and new products offered by the OEMs helped fuel the current upward trend.”

And Nick Popovich, president of Valparaiso, Ind.-based Sage-Popovich, attributed the trend to “the combination of delays and other service issues with the airlines, along with the continuing terrorist threats, such as what we just saw in London [the August plot to blow up several airliners in flight]. Companies can no longer afford the loss of executive time and delays.”

Soft or Hard Landing for Business Aviation?
In its July 19 report to Congress, the Federal Reserve Board made this evaluation of the economy: “Taking a longer perspective, the U.S. economy appears to be in the midst of a transition in which the rate of increase in real GDP is moving from a pace above that of its longer-run capacity to a more moderate and sustainable rate.”

A survey of 51 professional forecasters in August confirmed this viewpoint, summarizing that the “growth in U.S. real output over the near term looks a bit slower and inflation a bit higher than they did just three months ago.” In other words, the economy is still growing but at a slower rate than last year.

Tenore said, “My feeling is that the market is slowing, and this trend may continue into next year and 2008. I don’t expect to see any major downturn, as we experienced in 2001 to 2003, but a slowdown in the rate of growth.” He called this “a market breather,” rather than a cause for major concern and expects the market to turn up again in 2009.

Labrozzi of GE Capital Solutions agreed. “For the next year-and-a-half, the market for new business jets will probably remain at the status quo as backlogs
exceed two years. The unknown factor involves manufacturer acceptance of potential order cancellations.”

But Chuck Dimeler, vice president/general manager for North American Aviation Finance in Lakeland, Fla., was more pessimistic. “The overall economy seems to be too volatile,” he said, warning that inflation and recession are possible. Because the economy “seems to lack any particular direction, many people and companies are in the wait-and-see mode,” he said.

Echoing this, Kent of Scope Aircraft Finance, said, “If real GDP continues its first-half-2006 slippage–a reduced rate of increase–I would anticipate a slowing
of aircraft shipments.”

As recently and frequently reported in the financial media, many people–economists, analysts and laymen alike–are concerned about the possibility of a recession, or “hard landing” for both the economy and the stock market, for a number of reasons.
These include, but are not limited to, the current, long-expected downturn in the U.S. housing market; the steady increase in interest rates over the last two years (until it took a pause in increases in August, the Fed had implemented 17 straight rate hikes since June 2004, raising the prime rate from 1 percent to 5.25 percent); higher oil prices (though the cost of crude dropped a bit in late summer); and the ever increasing national debt and budget deficit, accrued in large part to pay for the war on terrorism. People fear a worst-case scenario of both inflation (which the Fed’s interest-rate hikes are meant to curb) and recession.

Other people predict and hope for a softer landing–a slight downturn followed by a recovery, which would mean the Fed’s interest rate hikes worked.

Economic forecasting is not an exact science, and with due respect to Keynes, the actions a government can take to solve short-term problems don’t always work as expected. So predicting what the future of the economy will bring is a gamble, even for people who make their livelihoods in finance. But whichever landing the economy makes, the business aviation market will probably make a similar touchdown about a year later. That’s been the general pattern anyway.

Although the aviation lenders interviewed for this article mentioned a number of factors affecting aircraft sales in the near term, the rise in interest rates does not seem to be a major concern.

Joseph Dini, senior vice president of Sovereign Bank, Boston, said, “I do not see higher interest rates affecting sales. Published rates are not reflective of the rates being charged in the marketplace, as there still is an abundance of funds. Fuel is a wild card. It may motivate some owners to sell their older, fuel-inefficient aircraft. For others, it may cause them to stay put and fly less. All in all, fuel is an embedded cost and shows up in competitive modes of transportation. Not buying an aircraft will not necessarily save transportation costs.”

Kent of Scope Aircraft Finance said, “I would not focus on the runup in the target Fed funds rate, given that long-term rates remain extremely conducive to asset financing in general, and aircraft finance in particular. The five-year treasury rate was 5.07 percent in June. In the mid- to late 1990s, when aircraft shipments were going up every year, this rate averaged more than 6 percent.”

Davis of 1st Source agreed with Kent about the influence of interest rates, but disagreed about fuel and added another factor. “Interest-rate increases don’t seem to be holding purchasers back, as there are many willing lenders in the market who are offering rates that have not gone up at the same pace as many of the rate indices. Fuel costs are not a major factor when taken into consideration against a multimillion-dollar aircraft used for business or personal reasons. OEM backlogs are an issue, but many buyers can rationalize the wait for their new aircraft based upon the perceived greater value of something you have to wait for. I don’t believe any of these factors will slow down the market for new units.”

“Large-cabin jets will continue to do well because owners of this class of aircraft are less likely to be affected by interest rates and fuel costs,” said Citigroup’s Schwartz. However, she thinks backlogs might affect new aircraft sales, because “people do not want to wait three years for a new aircraft and might settle on a slightly used aircraft and forego the purchase of a new one.”

Pre-owned Predictions Vary
In 2002 the used business jet market reached its high-water mark of 2,059 aircraft for sale. The inventory hovered near that level for about a year, then began to decline as both new and used jet sales increased, dropping to a low of about 1,600 in December last year. This March the inventory climbed to more than 1,700 jets, where it has remained, reaching 1,771 in July before retreating to 1,762 in August. Average asking prices for some models, primarily newer, larger business jets, have risen. Though the new and pre-owned business jet markets are affected by the same economic factors, they sometimes react in different ways.

“The average age of the jet fleet in 2000 was well over 20 years, and with the slowdown in the 2001 to 2003 period it got older,” recalled Dini of Sovereign Bank. “The improved economic climate had motivated many to upgrade. Those orders are now being delivered. There is a dearth of good, late-model used aircraft for sale. As we say, ‘The only way to build a used aircraft is to deliver a new one.’ Therefore, there must be older used aircraft entering the market that were displaced by the upsurge in new deliveries. This trend will continue as long as owners of older aircraft compute the lower operating cost with new ownership–fuel efficiency along with cheaper maintenance.”

1st Source’s Davis said, “Better-quality used aircraft will remain in demand, in part because of the OEM backlogs. Purchase of a multimillion-dollar piece of equipment can be an emotional decision and many buyers want that big piece of metal (or composites) now, when they’ve made that decision. If they can’t have the new one, a good aircraft a few years old in like-new condition can be a very attractive alternative.

“Today, the inventory of used aircraft contains a better quality overall than it did in 2002. Most of the old, tired equipment has been washed out of the system. With so many new units delivering, the used inventory will increase. It’s likely that international purchasers will take many of those newer, good-quality used units.”
When asked if the used aircraft inventory would reach or surpass its current high-water mark, the lenders gave mixed responses.

 “It is not only likely but highly probable that at some time in the future–with the growing population of business jets and in connection with a market retraction–we will see inventories top the last peak of 2,059 aircraft,” said Tenore of Banc of America. “Regarding inventories for the balance of the year, we should see them remain fairly flat with the exception of some models where supplies will increase. In 2007, expect some upward pressure as the year progresses.”

“I can see used inventory rising to those levels, with older aircraft finally hitting the scrap heap,” said Dini.

Schwartz of Citigroup said, “I don’t think it will happen this year, but that is barring any unforeseen crises that might occur.”

“I think it will happen, but not yet,” Walter Horsting of Valley National Bank said. “As the VLJs hit the market, there is potential for the number of used business jets to increase significantly.”

WellsFargo’s Ramsden said, “I expect the level of inventory to stabilize at current levels and not go much higher. I do see some softening in prices, especially on older units. High-quality, ready-to-go airplanes are still in high demand and will be for the rest of 2006.”

Popovich of Sage-Popovich said, “With the latest round of terrorist activities and the airlines requiring passengers to arrive three hours before their flights, I think the universe of used aircraft is going to shrink once again. Prices will rise slightly as demand increases.”

‘In the Long Run…’
Last year’s report on aviation finance summarized, “Even if economic conditions cool in the coming months, lenders expect next year to be ‘reasonably solid,’ or even stronger than this year.” As we have seen, this year so far turned out to be even stronger.

The report concluded with the following statement, much of which still applies: “If the cost of oil levels or decreases, the Fed stops increasing the prime rate, the U.S. economy continues to grow without the threat of inflation, corporate profits remain high, more people continue to choose business aviation over airline travel, then the industry might just plow through the current cycle with nary a shudder.”

Considering all of the above, the market for new and used business aircraft looks to be on fairly solid ground for the next year or so and on even firmer ground thereafter. But as Citigroup’s Mary Schwartz pointed out, the future holds no guarantees: “In 2001 so many variables affected the market–the tech bubble bursting, 9/11, threats of terrorism, anthrax and the war–that it was inevitable there would be a downturn in the economy. This, in turn, caused the aircraft market to deteriorate. If we experience similar circumstances again, no one can begin to guess the impact it will have.”