The State of the Aviation Industry
In a recent webinar, Naji Nehme, CEO and CIO at Petiole Asset Management AG, and Joe McConnell, Partner, Deputy Co-chief Investment Officer at the global alternative investment firm Castlelake, discussed the current state of aviation and the outlook for the sector. The full webinar can be viewed below. The text that follows is a summary of the main points by subject area.
Aviation’s long-term investment appeal
Over the past 70 years, the aviation sector (as measured by passenger traffic) has consistently increased by around 1.5 times global GDP growth, with supply and demand proving predictable. Despite all the volatility seen in the past couple of decades, related to geopolitics and the Covid-19 pandemic, that trend line has held steady.
Market trends – post-Covid boom
The industry has largely recovered from the Covid-19 crisis. Airlines have returned to profitability – global profits are forecast to be around US$10 billion in 2023 – and the number of passengers flying in North America is expected to exceed pre-Covid levels this summer. Passenger numbers in Europe are close to rising above those levels, and in Asia (excluding China) demand is nearing its pre-Covid peak. Overall, and anticipating a recovery in China, we expect global demand to return to pre-pandemic levels this year.
Aircraft demand exceeding supply
A lack of new aircraft is currently the key constraint on passenger growth. We believe that if airlines had been able to increase their capacity – through the acquisition of new aircraft – passenger volumes would already be significantly higher than in 2019. The lack of capacity is translating into much higher air fares – the increase averages 30% to 40% globally – and revenues are back to 2019 levels. Falling oil prices are also benefiting the industry.
The huge orders placed by IndiGo and Ryanair, which are among the lowest-cost, best-run airlines in the world, highlight the thirst for new aircraft. At the recent Paris Air Show, Airbus landed the biggest-ever order in the history of commercial aviation when IndiGo signed a contract for 500 of its A320 planes, to be delivered between 2030 and 2035. In May, Ryanair agreed to buy 150 new Boeing 737-10 aircraft, and took options on 150 more in a deal worth around US$40 billion at list prices.
These airlines use their scale to their advantage when ordering aircraft and typically do so at points in time when the macroeconomic environment isn’t particularly good, so that they can demand large discounts. Castlelake believes their motives are different this time round, and recent orders reflect the airlines’ optimistic view on the outlook for growth and consolidation within the industry. So, although IndiGo and Ryanair will undoubtedly receive discounts, their primary motive for placing these orders now is to lock in growth before other airlines boost their fleets.
Airlines struggling to meet demand
Meanwhile, the aircraft suppliers are facing significant challenges. These include meeting the technological advances in fuel efficiency they have promised in their cutting-edge aircraft. Some are struggling to do so – particularly in terms of engine and wings, which are requiring costly adjustments. There are also maintenance issues, some of which could take years to address.
The pandemic created a number of problems that have added to these difficulties – such as skills shortages – and hence Original Equipment Manufacturers (OEMs) are struggling to ramp up supply. The fact that the first airplanes ordered by Indigo from Airbus won’t arrive until 2030 reflects these supply issues.
Global shortage of aircraft
Castlelake believes the airline industry worldwide will be short of around 4500 aircraft between now and 2030. That reflects the supply-chain difficulties outlined above and other challenges. These include the fact that large numbers of older aircraft are being retired because they are costly to run, due to relatively low fuel efficiency. In other industries, new competitors might appear to increase supply, but the high barriers to entry in the aerospace industry make this unlikely.
Impact on ticket prices
These supply/demand imbalances should help support growth in ticket prices. For the past 25 years, average ticket prices have fallen and airlines have focused on reducing costs, so it is difficult to determine how high prices can go before demand starts to reduce. The best investment strategy, therefore, is to focus on the best-run airlines, which will be able to survive the next downturn when it inevitably comes. The weakest airlines always succumb first, so it is wise to focus on the strongest in any given region.
Attractive risk/reward profile
Since focusing on the strongest firms provides strong downside protection, returns are more attractive than in other, comparable assets, such as infrastructure, and it is possible to generate significant premiums over more liquid assets.
The impact of high interest rates
High interest rates typically reflect high inflation – and since these are inflationary assets, that should prove a supportive environment for investors. The OEMs are able to increase prices significantly and maintain profit margins since the industry is a duopoly, composed of Airbus and Boeing. Moreover, every new aircraft order contract includes an inflation adjustment in terms of residual values.
Balance sheets in the US and Europe
Consolidation is at a much more advanced stage in the US than in Europe. There are effectively just four major airlines left in the US, plus a number of low-cost carriers, and these businesses are largely faring well. The European market is much more diversified, and hence balance sheets are weaker. There is also much more scope for consolidation, with the low-cost carriers continuing to win market share from legacy airlines. Loyalty programmes are more significant in the US and represent a much higher barrier to competitors than in Europe.
Private markets exploiting closure of ABS finance
The asset-backed securities (ABS) market is closed and isn’t likely to reopen until interest rates fall significantly. Private markets are taking advantage with compelling financing terms, from both the investors’ and borrowers’ point of view.
The impact of climate change
While every airline wants to operate fuel-efficient aircraft, with the lowest possible carbon footprint, the reality is that the worldwide shortage of aircraft means that desire is pretty much irrelevant. For the reasons we highlighted earlier, that situation is unlikely to change over the next 10 years or so. Overall, the industry is focused on becoming carbon neutral by 2050.
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