s asian nsits - dbs bank airbus estimates that by 2035, the number of aviation mega-cities (which it...

DBS Group Research • April 2017DBS Asian Insights38n

um

ber

SECTOR BRIEFING

Asia Aviation SectorAircraft Leasing: Asian Players Taking Flight

19

DBS Asian Insights SECTOR BRIEFING 3802

Asia Aviation Sector Aircraft Leasing: Asian Players Taking Flight

Produced by:Asian Insights Office • DBS Group Research

go.dbs.com/research @dbsinsights [email protected]

Goh Chien Yen Editor-in-ChiefJean Chua Managing EditorGeraldine Tan EditorMartin Tacchi Art Director

Paul Yong CFA Equity Analyst DBS Group [email protected]

Singapore Research TeamDBS Group [email protected]

19


03

0406131924

44

27

47

32

50

Investment Summary

Global Air Traffic on Long-Term Growth Path

Aircraft Demand and Fleet Development

Aircraft Financing

Aircraft Leasing: Background

Strategies Commonly Employed by Top Lessors

Emergence of Aircraft Lessors in AsiaChinese Lessors to the Fore

Japanese Lessors: Emerging Once More

Other Non-Traditional Lessors

Hong Kong’s Tycoons Join the Party

Potential Transactions in Aviation Leasing Spac

Draw of Aircraft Leasing

Valuations and Equity Picks

Key Risk Factors

AppendixAircraft Leasing 101

What’s Driving the Popularity of Aircraft Leasing?

Critical Success Factors for Aircraft Lessors

Drivers of Aircraft Value

ccording to the International Air Transport Association (IATA), global air passenger traffic rose 5.9% year-on-year in 2016 and is projected to grow 5.1% in 2017. Based on Boeing’s estimates, global revenue passenger kilometres (RPKs) will almost triple by 2035 to reach 17,093 billion passenger-kilometres

(p-km), which represents a compound annual growth rate (CAGR) of 4.8% for a 20-year growth period from 2015 to 2035.

Looking ahead, the expanding middle class is expected to drive growth in global spending. The middle-class population is forecast to expand almost 73% from 2.8 billion in 2015 to 4.8 billion by 2035. Supported by firm global economic growth, a rising middle-class population, higher expected spending power, globalisation, and greater air connectivity, we expect trips undertaken per-capita (and thus propensity to travel) to remain on a steady uptrend over the long term, with strong growth driven by emerging markets such as China and India.

Based on Boeing’s estimates, the global fleet will more than double to 45,240 by 2035 to match increased aviation demand. Of the 22,510 in-service aircraft in 2015, 18,330 are slated to be retired from service while another 1,440 are expected to be converted to freighters to further extend their useful lives. This means that Boeing expects about 39,620 new aircraft to be delivered between 2015 and 2035, and would require financing of at least US$3 trillion in 2015 dollar terms.

From less than 1% share in the 1970s, aircraft leasing has since grown its market share of the global fleet to over 40% and has held steady at around 42% in the last decade. Aircraft lessors play an important role in financing the substantial funding requirements for aircraft, and distributing aircraft capacity more efficiently globally.

Today, five of the 12 largest aircraft lessors hail from Asia, and a sixth is from Australia. Most of their growth were through the acquisition of another leasing company, and in the case of HNA Group’s, two – Avolon and CIT. Chinese lessors figure prominently among the top ten, including the largest player Avolon/CIT while Japanese lessor SMBC Aviation is also among the top five lessors globally.

Asian lessors are being linked to all manner of activity in the sector, including 1) acquisition of aircraft portfolios such as AirAsia’s leasing arm and Ansett Worldwide Aviation Services (AWAS), and 2) potential initial public offerings of lessors such as Minsheng Financial Leasing or the leasing arms of the Chinese banks, following the listing of CDB Financial

Investment Summary

ARising global air passenger traffic

Growing middle class driving demand

Robust demand for new aircraft

Asian lessors join the fray

Buoyant deal activity


Leasing and BOC Aviation in Hong Kong. Meanwhile, even Hong Kong’s tycoons such as Cheong Kong’s Li Ka-shing and Chow Tai Fook’s Dato Dr. Cheng Yu-tung have amassed aircraft-leasing assets in recent years, and are looking to grow their aircraft portfolios.

Listed aircraft lessors are trading at an average of 8.9x (consensus) current earnings, declining to 7.7x forward earnings. BOC Aviation is the cheapest in terms of price-to-earnings at 7.7x currently. Other than China Aircraft Leasing (CALC), which is trading at 1.9x current price-to-book value (P/B), against a projected current return-on-equity of over 22%, the rest of the Hong Kong-listed aircraft lessors are generally trading at around 1x current P/B. While on average the sector only offers a dividend yield of 2.5%, both CALC and BOC Aviation are offering higher–than-average prospective dividend yields of over 6% and 3.8%, respectively.

Our top pick is BOC Aviation (Buy, target price of HK$54.10) and we also recently initiated coverage on CALC with a Buy call and current target price of HK$12.

The most common concern for investors seems to be that of aircraft oversupply. Our view is that given the duopoly in aircraft manufacturing, aircraft supply-demand should be balanced in the long term as it is in the interest of the original equipment manufacturers (OEMs) to promote such a situation. In the short term, we also see the aircraft supply-demand environment as relatively benign as 1) global load factors are near historic highs; 2) OEM production growth rate is matching expected demand growth; 3) order books are strong; and 4) aircraft storage/retirement are already at low rates.

The next common concern – interest-rate risk. A key feature or driver of an aircraft lessor’s earnings is the net spread (the difference between average yield on aircraft portfolio and average cost of debt) that a lessor earns. In an environment of rising interest rates, investors may have reason to fret. Generally speaking, aircraft lessors are well aware of this risk and manage it via 1) natural hedging where fixed-rate leases are funded by fixed-rate debt, and floating-rate leases are matched with floating-rate debt; 2) active interest-rate hedging using derivatives such as caps and swaps; and 3) trading (sale) of aircraft in the portfolio.

Key risks


05

ccording to the International Air Transport Association (IATA), global air passenger traffic rose 5.9% year-on-year in 2016 and is projected to grow 5.1% in 2017. Based on Boeing’s estimates, global revenue passenger kilometres (RPKs) will almost triple by 2035; reaching 17,093 billion passenger-kilometres

(p-km) which represents a compound annual growth rate (CAGR) of 4.8% over a 20-year growth period from 2015 to 2035.

Key drivers of air traffic demand:

1. Prevailing economic conditions, which dictate travel demand needs.

2. Improving inter- and intra-region route connectivity, helped by liberalisation of airspace and low-cost carriers.

3. Favourable demographic trends (i.e. population growth, rising middle-class population, and higher discretionary spending).

Rosy outlook for global aviation

Global Air Traffic on Long-Term Growth Path

A


Diagram 1 : World traffic flow forecast (RPKs in billions) for the next 20 years

Source: Boeing, DBS

Anticipating a world GDP growth rate of 2.9% per annum (p.a.) over the next two decades – which should help spur trade flows, human capital movement, tourism, and ultimately, demand for global air travel, Boeing predicts air passenger traffic will grow at an average of 4.8% p.a. into 2035. This is supported by historical trends, where global air travel has consistently outpaced world GDP growth at 1.5x to 2x.

Between 2016 and 2035, global growth is expected to be largely driven by the Asia-Pacific region, which is poised to log an annual GDP growth rate of about 4.1%, far exceeding the global average of 2.9%. Following closely behind are the Middle East’s estimated 3.8% and Africa’s 3.7%.

The gradual liberalisation of airspaces through open skies and bilateral air transport agreements, coupled with the expansion of low-cost carriers, have played a central role in driving inter- and intra-region air connectivity and the formation of new mega aviation hubs.

Asia-Pacific to drive global growth

Better connectivity, more mega hubs


07

Diagram 2 : Drivers for air traffic and aircraft fleet growth

Diagram 3: Breakdown of global annual GDP growth forecasts by region (2015-2035)

Source: Airbus, DBS

Source: Boeing, DBS

Increased Demand for

Fleet

To illustrate, Shanghai Pudong Airport is now ranked the eighth busiest airport (by passengers) in 2016 from the 34th position in 2009 after passenger traffic more than doubled from nearly 32 million in 2009 to over 66 million in 2016. Over this period, the market shares of low-cost carriers in China also strengthened significantly from around 8% in December 2009 to more than 20% in December 2016.

Airbus estimates that by 2035, the number of aviation mega-cities (which it defines as cities with more than 10,000 daily long-haul passengers) will rise to 93, from 55 in 2015.

Looking ahead, global spending power will largely be driven by the growing middle-class population, which is forecast to expand by almost 73% from 2.8 billion in 2015 to 4.8 billion by 2035. Based on estimates by Airbus and Oxford Economics, the middle-class population will likely account for over 55% of the world’s total population by 2035 – the bulk of which should stem from emerging economies.

Based on estimates by Airbus and Oxford Economics, discretionary spending globally will rise from US$8 trillion to US$13.2 trillion by 2025, driven by higher spending in emerging economies. The share of discretionary spending by emerging economies is expected to expand from 39% in 2015 to 46% by 2025.


Banking on the middle class

Strong growth in discretionary spending

Diagram 4 : Burgeoning middle-class population (in millions) between 2015 and 2035

*Households with yearly income between $20,000 and $150,000 at purchasing power parity (PPP) in constant 2014 prices

Source: Airbus, Oxford Economics, DBS


09

Diagram 5 : Discretionary spending in 2015 versus 2025

Diagram 6: Expect higher propensity to travel over the next 20 years

*Spending on recreational goods and services (2010 US$, PPP)

Source: Airbus, Oxford Economics, DBS

Source: Airbus, Boeing

Narrowing travel demand gap

Thanks to firm global economic growth, rising middle-class population, higher expected spending power, globalisation, and greater air connectivity, we expect trips undertaken per capita (and thus propensity to travel) to remain on a steady uptrend over the long term.

In 2015, average trips undertaken annually per capita in mature regions such as North America and Europe stood at 1.8 and 1.2, respectively, far above that observed in emerging economies such as China’s 0.3 and less than 0.1 for India.

Airbus forecasts the travel demand gap between mature and emerging markets will narrow by 2035 on the back of rapid economic growth, with China set to see a multi-fold increase in air travel to 1.3 trips per capita. In absolute terms, given its population of over 1.37 billion, China’s air travel market holds vast potential. Similarly, India is also poised to deliver significant trip-per-capita growth, albeit on a smaller scale.

Home to approximately 4.4 billion people in 2015, Asia-Pacific accounts for almost 60% of the world’s population but only represents around 30% of global RPK.

Continued growth in China’s domestic aviation sector could see the mainland overtake the United States’ as the single largest aviation market by 2030.

Mostly driven by strong demand in China and traction in other fast-growing Asian economies (such as India), Airbus believes that air traffic in Asia-Pacific will grow at 5.7% CAGR, to represent 36% of global RPK by 2035.


Source: Airbus, DBS

Diagram 7: Trips per capita for selected countries and regions (2015 versus 2035)

Asia-Pacific leading global air traffic

China


11

Ranked the second- and third-largest aviation markets by RPK in 2015, the European and North American regions represented 25% and 24% of global RPK, respectively. With 20-year growth expected to steady at 3.5% CAGR for Europe and 2.9% for North America (both below the global average of 4.5%), Airbus estimates that their global shares will taper slightly to 22% and 19% respectively, by 2035.

Leveraging its geographical advantage and the gulf carriers’ rapid expansion, Airbus expects the Middle East to deliver 20-year traffic growth at 5.7% CAGR, to grow its share of global RPK from 9% in 2015 to 11% by 2035.

But emerging and developing economies are the ones to watch. Air-traffic growth in emerging and developing economies - representing nearly 86% of the global population, or 6.2 billion people - is expected to surpass that in advanced economies as (1) the former’s living standards improve, (2) more air travel infrastructure is put in place, and (3) as new routes (especially between secondary cities) are formed.

Source: Airbus, DBS

Diagram 8 : Global air traffic to grow at 4.5% CAGR into 2035

China’s domestic aviation sector could overtake the US’ as the single largest aviation market by 2030

Regions % of 2015 World’s RPK

% of 2035 World’s RPK

20-year CAGR

Asia-Pacific 30% 36% 5.7%

Europe 25% 22% 3.5%

North America 24% 19% 2.9%

Middle East 9% 11% 5.7%

Latin America 5% 5% 4.8%

CIS 4% 4% 4.1%

Africa 3% 3% 4.5%

Global Average 4.5%


Diagram 9: Emerging/developing economies’ RPK growth prospects

Source: Airbus, DBS

Economies Countries & Region Population(2015)

RPK CAGR

Emerging/ Developing

• Asia

• China

• India

• Middle East

• Africa

• CIS

• Latin America

• Eastern Europe

6.2bn c.5.6%

Advanced

• Western Europe

• North America

• Japan

1.0bn c.3.7%

Aircraft Demand and Fleet Development

B


13

oeing estimates there were approximately 22,510 passenger aircraft in service globally in 2015. Of which, North America had the largest fleet share of about 31% or 6,910 aircraft. The second-largest fleet was found in Asia-Pacific with 6,350 aircraft, which represented about 28% of the global fleet. Europe, with

about 4,610 aircraft and a 20% share, ranked third.

According to the fleet database from the Centre for Aviation (CAPA), the North America region is currently home to some of the world’s oldest passenger fleet, with an average fleet age of about 18 years. Meanwhile, the youngest stems from Latin America, with average fleet age of about 9.1 years.

While fleet age is viewed as a lagging indicator, it can still provide insight into varying demand trends across regions and direction with regard to fleet renewal.

Source: Boeing, DBS

Diagram 10: Average passenger fleet age by region (as at 8 August 2016)

Age

-

Similarly, Boeing forecasts traffic (RPK) growth of 4.8% CAGR between 2015 and 2035, and believes that global passenger fleet should grow at 3.6% CAGR to satisfy this growing demand for air travel.

Given the Asia-Pacific region’s strengthening economy, improving air transport connectivity, and with over 100 million new passengers set to enter the air travel market each year, it is poised to see the largest fleet growth (at 5% CAGR) among peers.

Meanwhile, the Middle East is expected to expand its fleet by 4.8% per year, in line with expected RPK growth of 5.9% CAGR, and Latin America by 4.4%. As such, fleet growth in advanced markets such as Europe and North America will likely be outpaced by that of emerging and developing markets.

Diagram 11: Global fleet growth (2013-2017F)

Diagram 13: Fleet growth rate by region between 2016 and 2035

Source: CAPA, DBS

Source: Boeing, DBS


Asia-Pacific to log largest fleet growth

Diagram 11: Global fleet growth (2013-2017F)

Diagram 13: Fleet growth rate by region between 2016 and 2035

Diagram 14: Global fleet could double by 2035

Source: Boeing, DBS

Source: Boeing, DBS

Based on Boeing’s estimates, global fleet will more than double to 45,240 to match increased aviation demand. Of the 22,510 in-service aircraft in 2015, 18,330 are slated to be retired from service while another 1,440 are expected to be converted to freighters to extend their useful lives and are likely to be narrow-body aircraft. Boeing also expects about 39,620 new aircraft deliveries to be made between 2015 and 2035.

Of the 39,620 new aircraft deliveries expected into 2035, Asia will likely account for around 38% or 15,130 aircraft. This is followed by the North American (21%) and European (19%) regions which account for 8,330 and 7,570 aircraft, respectively. We see this as largely in line with their respective future air traffic demand needs, and as they seek to replace ageing fleet with newer technologies which are often more fuel-efficient to optimise operating costs.


15

More than double

Asia to account for the bulk

Diagram 15 : Global new deliveries by region


Broadly speaking, there are three distinct aircraft types:

1. Wide-body: Typically larger commercial aircraft with twin aisles typically with medium to long range and can have passenger capacity from 160 to upwards of 480. Such aircraft can have 2-4 engines and be rated transatlantic or transcontinental. At list prices, a wide-body such as a B787-8 cost about US$224.6 million.

2. Narrow-body: They are smaller aircraft with a single aisle configuration with a passenger capacity of up to 200 and mainly ply short- to medium-haul routes. At list prices, a narrow-body B737-700 cost about US$80.6 million.

3. Regional jets: Regional jets can be defined as a set of narrow-bodies typically with passenger capacity up to 100 and are mostly used for connecting regional hubs and with a shorter range. These can include turboprops aircraft.

Of the new aircraft to be delivered by 2035, approximately 71% (or 28,140 hulls) will be narrow-bodies, while 23% (9,100 aircraft) will be wide-bodies. The remaining 2,380 are regional jets. The popularity of narrow-bodies among carriers is largely attributable to:

1. Cost efficiency: Narrow-bodies tends to come with shorter, lighter engines which are typically more fuel efficient.

2. Route flexibility: Narrow-bodies provide carriers – especially those who are also looking to operate new complementary short-haul routes, with wider redeployment opportunities. Additionally, as these routes typically involve smaller hubs with lower passenger traffic, carriers run a lower risk of unfilled seats.

The popularity of narrow-bodies

Diagram 16: Breakdown of global deliveries by aircraft type

Source: Boeing, DBS

-

-


17

Replacement needs, tighter regulations

Emerging markets contributing the lion’s

share

Travel demand aside, replacement needs and emergence of new regulations may also drive demand for newer aircraft. As compared to older models, newer aircraft offer the advantages of: (i) Lower operating costs, especially improved fuel burn (the best way to hedge fuel cost exposure) and lower maintenance costs; (ii) improved payload and range capability (important for opening new markets) and despatch reliability; (iii) advanced cockpits and cabins (weight savings either reduce costs or offer greater revenue potential from increased seat density. Often, older aircraft are uneconomic to refurbish); and (iv) availability (the option to upgrade an older aircraft is driven by available supply of new aircraft).

The airline industry is also subject to regulations, particularly on the safety and operational axes. The latter may impact fleet strategy and aircraft values. Another form of regulation which can potentially impact aircraft liquidity is aircraft importation age restrictions, which are used in certain countries to prevent the import of aircraft older than a certain age (typically ten, 15 or 20 years). According to aviation consultant Ascend, such regulations can be found in approximately 44 countries today, but only half of these are currently in effect.

We estimate that the order backlog of passenger aircraft from Airbus and Boeing totalled 9,676 as at 6 February 2017.At present production/delivery rates, this is equivalent to approximately ten years’ worth of deliveries and represents about 54% of the current installed fleet.

With the exception of Africa, emerging and developing markets such as Asia-Pacific and the Middle East, generally have higher backlog-to-current fleet ratios relative to their mature counterparts (Europe and North America). While order backlogs in North America and Europe only represent 36% and 42% of their respective fleet, the respectively, they absolute aircraft or order remains substantial at 1,501 and 1,978 aircraft respectively.

With majority of the order backlog already firmly committed towards airline’s fleet growth plans and replacement needs, both Airbus and Boeing have announced plans to lift production rates for the Airbus A320 and Boeing 727 families of aircraft to capitalise on the strong demand for passenger jets. Separately, based on CAPA’s fleet data, we also estimate that around 27.5% or 2,660 of the current order backlog actually accrue to lessors.

Expected to be delivered through 2025, we believe the firm backlog of nearly 10,000 aircraft from Airbus and Boeing alone, demonstrates the robust long-term demand for new commercial jet airliners.

Replacement needs and emergence of new regulations also drive demand for newer aircraft


Diagram 17: Order backlog (as disclosed by customers) as at 6 February 2017*

Region Africa Asia-Pacific Europe Latin America Middle East North America

Order Backlog

190 4,006 1,978 719 1,282 1,501

% Share 2% 41% 20% 7% 13% 16%

Current Fleet 587 6,240 4,708 1,130 1,127 4,114

Backlog as % of Current Fleet

32% 64% 42% 64% 114% 36%

Airbus and Boeing’s firm backlog of nearly 10,000 aircraft demonstrates robust long-term demand

for new commercial jet airliners

*for Airbus and Boeing passenger aircraft onlySource: CAPA, DBS

Aircraft Financing

B ased on the 39,620 new fleet deliveries number between 2016 and 2035 as estimated by Boeing, the total value of aircraft based on list prices would be worth at least US$5.96 trillion in 2015 dollar terms, but closer to US$3 trillion in reality.

In the next two decades (2016-2035), in line with the expected fleet expansion and deliveries, Asia will bear the bulk (approximately 40%) of actual fleet delivery costs, which is typically at a discount to list price and estimated overall costs is around US$1.195 trillion. Europe is expected to have a 19% share or about US$570 billion of actual fleet value, while the North American market will contribute a further 17%, which represents an actual fleet value of approximately US$524 billion.

According to Boeing, Latin America, Africa, and the Commonwealth of Independent States (CIS) will likely account for around US$178 billion (6%), US$86 billion (3%), and US$72 billion (2%) of actual fleet delivery costs, respectively. We believe that this is mainly a result of reflection of their preference/demand for secondary purchases of older aircraft (usually from developed markets), as opposed to outright purchases of newer models.


19

Diagram 18: Percentage of aircraft type by delivery value (2015 versus 2035)

Source: Boeing, DBS

Asia to bear bulk of fleet delivery costs

-

-

- -


To support the strong demand for newer technologies and fuel-efficient aircraft going forward, we anticipate that the aviation industry would require even larger amounts of funding – above and beyond that in 2015, which Boeing estimates to be in excess of US$100 billion p.a. According to their projections, annual aircraft financing required for new deliveries alone will likely reach US$172 billion by 2020, which represents a CAGR of 5.9% between 2015 and 2020.

Diagram 19: Aircraft delivery value by region from 2016-2035 (List prices)

Diagram 20: Growth of aircraft financing needs (2015-2020F)

Source: Boeing, DBS

Source: Boeing, DBS

Growing need for aircraft financing

USD (bn)

Of the US$127 billion in new aircraft financing estimated for 2016, a majority (87%) will be attributable to capital markets, bank debt, and cash. Capital markets will likely serve as the single largest source of financing, satisfying about 36% of new aircraft financing needs. Bank debt and cash will likely represent 27% and 24%, respectively.

Meanwhile, export credit provided by export-import banks and tax equity should account for the remaining 13% for new aircraft financing. Given ample liquidity in commercial markets, the popularity of export credit as a source of financing has diminished over time, but remains a key source of financing in emerging markets.

Capital markets play a huge role in aircraft financing. The largest users have been aircraft lessors, who have the financial sophistication and experience. In 2015, aircraft leasing companies tapped the capital markets frequently and accounted for a 45% share of capital market financing. The second-largest user of the capital markets for aircraft financing has been the US airlines as it is a cheaper source of financing than traditional commercial loans. Non-US airlines form the other bulk of the main user of capital markets.


21

Diagram 21: Sources of aircraft financing sources in 2016F

Source: Boeing, DBS

Capital markets – aircraft lessors’ preferred choice


The largest players that provide commercial lending are led by China and Japan, who have been extremely active and aggressive in the space. China accounts for almost 29% of commercial lending for aircraft financing. Japan is the second-largest lender at 15% globally.

Diagram 22: Users of capital market for aircraft financing

Diagram 23: Commercial bank debt by country for 2016F

Source: Boeing, DBS

Source: Boeing, DBS

Airlines are growing to meet the continued aviation transport demand globally, particularly new players such as the low cost carriers (LCCs) and start-up airlines in Asia. However, new aircraft are expensive and ties up large part of a carrier’s balance sheet as its fleet expands. Hence, aircraft leasing companies will continue to support and play a big part in financing new commercial aircraft deliveries through direct purchases and purchase-and-leaseback agreements as they assist airlines in growing their fleet.

Aircraft leasing companies use a wide range of financing tools such as asset-backed securities, debt capital markets, unsecured borrowings, etc. From the time series, it is evident that lessors are tapping more and more of the capital market – from 36% of all lessor deliveries in 2012 to 53% in 2015.


23

Diagram 24: Share of funding for aircraft lessor deliveries

Source: Boeing, Company filings, DBS

Aircraft leasing companies play a big part in financing new commercial aircraft deliveries, assisting airlines in

growing their fleet


ircraft leasing started almost five decades ago in the 1960s, just as commercial aviation was taking off. In 1968, airframe maker McDonnell Douglas was the first to introduce a vendor aircraft finance business solution to support its aircraft sales in an attempt to compete with its rivals. This eventually led to the

founding of modern day aircraft lessors Guinness Peat Aviation (GPA) in 1975 in Ireland and International Lease Finance Corporation (ILFC) in 1973.GPA and ILFC were eventually respectively taken over by General Electric Capital Aviation Services (GECAS) and AerCap, who are currently the world’s top two lessors.

From less than a 1% share in the 1970s, aircraft leasing has since grown its market share of the global fleet to over 40% and has held steady at around 42% in the last decade while the global fleet continued to grow. (For more on the basics of aircraft leasing, please refer to the appendix.)

While there are over 160 operating lessors globally, the sector is dominated by players with 50 or more aircraft in their portfolios. Among these, AerCap and GECAS dwarf their peers with over a thousand aircraft each, while the next closest player would be the Avolon/CIT Group (acquisition in-progress) with around 600 aircraft. Of the top 12 lessors currently, four are from China, whereas there were none just ten years ago.

Source: Bloomberg Intelligence, DBS

Aircraft Leasing: Background

A

Diagram 25: Top global aircraft lessors (>100 seats)

Lessor In-service On order Total

AerCap 1,127 408 1,535

GECAS 1,203 256 1,459

HNA/Avolon/CIT 593 262 855

Air Lease Corp 276 373 649

SMBC Aviation Capital 389 201 590

BOC Aviation 272 216 488

ICBC Leasing 279 133 412

BBAM LLC 389 0 389

Aviation Capital Group 248 101 349

AWAS 233 15 248

Macquarie AirFinance 198 40 238

CDB Leasing 158 54 212

Currently, there are nearly 800 airlines in about 160 countries operating almost 20,000 passenger jets of 100+ seats and their freighter equivalent. According to data from CAPA, the global airline fleet is currently dominated by the Asia-Pacific region with a 34% market share as at 7 February 2017. Europe follows with 26% and North America with 23%. A breakdown of the global leased fleet shows similar trends, with Europe and Asia-Pacific holding higher shares of around 30% each, and a lower share in North America of less than 20% – which indicates that the core aircraft operating lease markets are in Asia-Pacific and Europe, while the tax regime in North America encourages profitable airlines to own aircraft on their balance sheet.

Based on Air Finance data, the largest lessees by number of aircraft are from the European and Asia-Pacific regions. The single largest carrier lease is American Airline that accounts for almost 430 aircraft. Coming up in second is Air-France KLM as well as the International Airline Group (IAG), which includes British Airways, Aer Lingus, Iberia, Vueling airline brands under its umbrella.

From Asia-Pacific, the Chinese airlines dominate the lessee space. China Southern leads with 195 aircraft on lease, followed by Air China with 168 aircraft, Garuda Indonesia with 158 aircraft, China Eastern with 157 aircraft, and lastly, Jet Airways from India.


25

Source: Ascend, DBS

Core markets for aircraft leasing

Diagram 26: Breakdown of global fleet as at 7 February 2017


Diagram 27 : Top lessees by fleet (January 2016)

Source: Air Finance, DBS

From less than a 1% share in the 1970s, aircraft leasing has since grown its market share of the

global fleet to over 40%

ased on CAPA’s fleet database, we infer that nearly 60% of the global in-service passenger fleet owned by lessors as at 7 February 2017 are narrow-bodies. Offering better cost-efficiency and route-flexibility relative to wide-body aircraft, narrow-bodies are highly sought-after by airlines, particularly in Asia where LCCs

have been rapidly gaining market share as they continue to drive regional connectivity through fleet expansion and the launch of new short–to-mid-haul routes.

Given the above, it is unsurprising that narrow-bodies are able to tap a bigger market – and are thus generally more liquid, which helps support secondary market values – and are often easier placed out than wide-body types.

But evolution of wide-body jets could help lift proportion of wide-bodies from 13% currently. Helped by technological shifts, new-generation wide-body aircraft, such as Boeing’s 787 Dreamliner as well as Airbus’ A350 and A330neo, offer improved cost economics, performance, and operational flexibility than previous generations’ (such as the Boeing 747 and Airbus A340) – and at a fraction of the cost.

With the ability to conform to a wide range of carriers’ business models, these new-generation wide-body types could play a bigger role in lessors’ portfolios going forward.


27

Diagram 28: Global in-service leased fleet by type (as at 7 February 2017)

Source: CAPA, DBS Bank

Strategies Commonly Employed by Top Lessors

BNarrow-bodies generally preferred

Evolution of wide-bodies could change

things

-

-


We estimate that the top ten players hold well over 40% of the global leased narrow-body fleet. Among the top ten, data from CAPA as at 7 February 2017 also suggests that the narrow-body space is mostly dominated by long-standing industry leaders, GECAS and AerCap. With a fleet of 905 and 730 narrow-body aircraft in their respective portfolios, GECAS and AerCap’s current scale in the narrow-body leasing market significantly eclipses that of their next closest rivals’.

Similar to trends in the global narrow-body leasing market, both AerCap and GECAS also appear to dominate the wide-body leasing market, with estimated market share of 14.9% and 5.9%, respectively.

Meanwhile the top ten players jointly hold about 40% of the global leased wide-body fleet, with Aercap having a larger proportion of wide-body aircraft in their portfolio relative to other top-tier lessors.

Diagram 29 : Top 10 lessors for narrow-bodies by fleet size (as at 7 February 2017)*

*excludes Avolon/CIT merger data Source: CAPA, DBS Bank

Aircraft lessors generally acquire aircraft through a) ordering and purchasing new aircraft directly from manufacturers, b) purchase and lease-back transactions with its airline customers, or c) acquiring aircraft from other lessors or even the entire portfolio/platform.

Based on data from CAPA, we estimate that the average fleet age of the top ten aircraft lessors’ (by in-service narrow- and wide-body fleet size as at February 7 2017) is approximately 7.4 years.


29

Diagram 30: Top 10 lessors for wide-bodies by fleet size (as at 7 February 2017)*

Diagram 31: Average fleet age of top 10 aircraft lessors (as at 7 February 2017)*

*excludes Avolon/CIT merger data Source: CAPA, DBS Bank

* includes in-service narrow-body and wide-body fleet onlySource: CAPA, DBS Bank


Lessors with older planes tend to enjoy higher yields, and vice versa. In the event of overcrowding in the secondary market, however, lessors with an ageing fleet could be faced with higher residual-value risks, which may put pressure on their credit rating and financing costs. As such, a strong risk-management framework is necessary to help balance the benefits of an older fleet against possible longer-term risks.

Operating ModelsWhile the actual operating model pursued tends to differ among the tier-1 lessors, their underlying business strategy may be broadly classified under either of the following categories: -

1. Young fleet: Under this strategy, lessors typically manage newer aircraft that are still in the first aircraft life-cycle and are thus less subject to residual value risk and substantial maintenance capex needs. Lessors employing this strategy include ICBC Leasing, Avolon, BOC Aviation, and Air Lease, which have average fleet ages between 3.8 and 5.1 years.

2. Yield-focused: Lessors such as Aircastle and AWAS operate in a niche space which is more agnostic (on a relative basis) to fleet age and instead, is focused on extracting yield and further value from their fleet.

3. All-rounders: Armed with specialty knowledge and extensive technical expertise, lessors such as GECAS and AerCap are well able to manage aircraft across ages and life-cycles. Their higher fleet ages of 11.3 years and 11.6 years, respectively, are reflective of this strategy.

Managing fleet age against risks


31

Diagram 32: Comparison of key metrics of selected aircraft leasing companies

As at end 2015 (US$m)

AerCap Air Lease Air Castle FLY Leasing CALC BOC Aviation

Total assets 43,914 12,355 6,570 3,417 3,090 12,474

Aircraft net book value

32,219 10,813 5,867 2,663 311 9,476

ROE (%) 13.8% 11.0% 6.9% 13.0% 19.5% 15.1%

Owned fleet 1109 240 162 80 63 227

Aircraft on order 447 389 35 n.a. 129 241

Weighted average age (years)

7.7 3.6 7.5 6.6 3.5 3.3

Average lease remaining (years)

5.9 7.2 5.9 6.5 10 7.4

Cost of debt funding (%)

3.70% 3.70% 5.20% 5.40% 4.10% 2.00%

Debt to equity (x) 3.5 2.6 2.3 3.7 9.5 3.7

Number of aircraft lessees

218 89 61 65 11 62

Number of countries

90 50 37 36 3 30

Manufacturer bias (existing fleet)

Airbus (53%) Airbus (40%) Boeing (56%) Boeing (57%) Airbus (92%) Airbus (51%)

Geographic concentration (by NBV)

Europe (35%),AP

(32%)

Asia (47%), Europe (34%)

Asia (42%), Europe(28%)

Europe (41%), Asia (31%)

Asia (100%) Asia (54%), Europe (23%)

Largest three customers

American Airlines (11%),

Diversified client base

S. African Airways (~7%)

Diversified client base

China Eastern (17%)

Cathay Pacific (~7%)

Aeroflot Russian

Airlines (~7%)

Thai Airways (~7%)

Chengdu Airlines (15%)

Iberia (~6%)

Virgin Atlantic Airways (~6%)

Martinair (~6%)

China Southern

(14%)

Qantas(~6%)

Source: Company filings


hile aircraft leasing has traditionally been dominated by American or European firms, Asian lessors have been catching up in a big way – beginning with the founding of Changjiang Leasing and ORIX Aviation in 2000. Today, five of the 12 largest aircraft lessors hail from Asia, and a

sixth is from Australia. Most of these have prominently grown through the acquisition of another leasing company, sometimes two.

Approximately a year after HNA Group completed the acquisition of Avolon and merged it with its own aircraft-leasing arm Hong Kong Aviation Capital, it sealed a deal in October 2016 to acquire CIT’s aircraft-leasing arm – forming the world’s third-largest lessor. In 2012, SMBC Aviation acquired RBS Aviation Capital, and BOC Aviation was formed following the Bank of China’s acquisition of Singapore Aircraft Leasing Enterprise from Singapore Airlines (and other investors) in 2006.

Meanwhile, Asian lessors have also grown organically from deliveries from OEM manufacturers, primarily Airbus and Boeing. As it stands, Avolon/CIT, SMBC, CDB Leasing, BOC Aviation, and ICBC Leasing all have order books of over 100 aircraft, which should help drive double-digit growth in their portfolios in the coming years. And this does not take into account the purchase and leasebacks of aircraft they will enter into. All this implies that the largest Asian lessors will continue to grow at a pace that is above industry average.

Inorganic growth a key driver

Organic growth has also helped

Emergence of Aircraft Lessors in Asia

W

*As at June 2016Source: Bloomberg Intelligence, DBS

Diagram 33: Top global aircraft lessors (>100 seats) – November 2016

Lessor In-service On order Total

AerCap 1,127 408 1,535

GECAS 1,203 256 1,459

HNA/Avolon/CIT 593 262 855

Air Lease Corp 276 373 649

SMBC Aviation Capital 389 201 590

BOC Aviation 272 216 488

ICBC Leasing 279 133 412

BBAM LLC 389 0 389

Aviation Capital Group 248 101 349

AWAS 233 15 248

Macquarie AirFinance 198 40 238


33

Source: AirFinance, CALC, DBS

Diagram 34: Timeline – The emergence of the Asian players

Chinese Lessors to the Fore

After the China Banking Regulatory Commission (CBRC) relaxed regulations on aircraft leasing in 2007, many financial institutions, led by China’s big banks such as Industrial and Commercial Bank of China (ICBC), China Construction Bank (CCB), China Development Bank (CDB), Minsheng, China Merchants Bank (CMB), and Bank of Communications, started building up their aircraft-leasing arms and developing their own capabilities and scale in this segment.

According to Boeing, China will take delivery of nearly 6,000 new jets worth US$780 billion between 2015 and 2035, as its domestic market is projected to be the world’s largest by 2030. Chinese lessors have been growing their share of the domestic aircraft-leasing business aggressively through acquisitions from other aircraft leasing companies as well as through purchases and leasebacks from Chinese airlines. By 2018, according to industry consultant Ascend, Chinese lessors will capture 55% of the aircraft-leasing market, from 38% in 2013, and nearly zero a decade ago. It is estimated that Chinese lessors now handle 80% or more of new domestic leasing transactions in China.

In 2013, China’s central government spoke of their desire for local lessors to expand outside their domestic market, given the huge potential growth in aviation traffic in the next decades. Prior to this, only a handful of Chinese lessors, namely BOC Aviation, CDB Leasing, ICBC Leasing, and Hong Kong Aviation Capital had significant operations outside China. We have since then seen Chinese lessors participate more actively in the international markets, and many of them are now actively linked to transactions outside China.


Diagram 35: Top Chinese aircraft lessors (In no particular order)

CDB Leasing

ICBC Financial Leasing

BOC Aviation

CALC

Minsheng Financial Leasing

CMB Financial Leasing

Bank of Communications Financial Leasing

CCB Financial Leasing

ABC Financial Leasing

AVIC Leasing

Avolon/CIT (HNA Group)

Source: Airfinance, DBS

Fast-growing domestic aviation pie

Going international


35

Most of China’s top aircraft lessors are supported by the country’s top banks. Examples of these are:

• China Development Bank (CDB) Leasing (Listed in the Hong Kong Stock Exchange in July 2016)

• Industrial and Commercial Bank of China (ICBC) Financial Leasing

• Minsheng Financial Leasing

• China Merchants Bank (CMB) Financial Leasing

• Bank of Communications Financial Leasing

• China Construction Bank (CCB) Financial Leasing

• Bank of China (BOC) Aviation (Listed in the Hong Kong Stock Exchange in June 2016)

• Agricultural Bank of China (ABC) Leasing

We profile some of China’s top, and up-and-coming aircraft lessors:

HNA Group: In January 2016, HNA Group, via its subsidiary Bohai Leasing, completed the acquisition of Avolon – then a top ten aircraft lessor globally – and merged its existing aircraft-leasing arm Hong Kong Aviation Capital under Avolon to form a top eight aircraft lessor.

This was sensationally followed by an agreement reached in October 2016 by Avolon to acquire the aircraft-leasing business of CIT Group for US$10 billion – which will form a combined business that will have an owned, managed and committed fleet of 910 aircraft valued at over US$43 billion, – placing the combined entity well ahead of SMBC Aviation and Air Lease as the third-largest aircraft leasing business in the world.

We expect that Avalon, having achieved its ‘medium-term target’ in less than a year after it was bought by Bohai Leasing, will continue to be active in acquisitions and transactions as it seeks to narrow the gap between itself and the two big boys, GECAS and AerCap, and to perhaps one day even surpass them.

BOC Aviation: Bank of China acquired Singapore Aircraft Leasing Enterprise (SALE) from Singapore Airlines and other shareholders in 2006, and subsequently became known as BOC Aviation. Since then, BOC Aviation with Bank of China’s support, has grown to be among the top aircraft leasing companies globally and was a top-5 player globally when it successfully completed its initial public offering (IPO) in HK in June 2016.

Bank-backed

Having been nudged out of the top five by Avolon’s acquisition of CIT, prospects for BOC Aviation remains bright as it is looking to leverage on new equity raised from its IPO to more aggressively growth its business.

ICBC Leasing: The leasing arm of China’s ICBC Bank, ICBC Leasing is one of China’s largest aircraft lessors with an owned, managed and committed aircraft portfolio of over 400 aircraft. The portfolio is primarily made up of Boeing and Airbus aircraft, with a spattering of Embraer and Bombardier planes. According to its website, ICBC Leasing has 48 airline customers in South America, Europe, Africa, the Middle East, and Asia.

With over 100 aircraft on order, ICBC Leasing is well positioned to continue growing and remain one of the country’s and world’s top lessors.

CDB Leasing: The leasing arm of the China Development Bank, CDBFL focuses on aircraft and infrastructure leasing mainly in China. As at end June 2016, CDB Leasing had a portfolio of 184 owned aircraft, 11 managed aircraft and 214 committed aircraft. This consisted mainly of narrow-body aircraft, such as the A320 family and B737-800, and wide-body aircraft including the A330 and B777. CDB Leasing had 41 airline clients in 22 countries.

With committed aircraft that is well over its current owned portfolio, CDB Leasing is positioned to grow firmly in the years ahead.

China Aircraft Leasing: Established in 2006, China Aircraft Leasing (CALC) had grown its fleet to 81 aircraft by end 2016, leased to 16 airline customers in Asia and Europe. With a firm order book for 92 aircraft from Airbus and potential for more from pop-ups and purchase & lease-backs, CALC is well poised to grow its fleet to at least 173 by 2022.

CALC has also been growing its earnings through the sale of its finance lease receivables to recycle its capital and grow its business, and also has a 49% stake in an aircraft disassembly business based in Harbin that is slated for commencement in 2017. This could help push CALC to become a true full value chain aircraft solutions provider.

Ping An International Financial Leasing: Ping An International Financial leasing company was founded in 2012 is a wholly owned subsidiary of Ping An Insurance Group – which is China’s largest non-state owned company. It has made sizeable orders and has been active in the secondary markets for purchase-and-leaseback deals to build up its portfolio, and has also been linked with M&A deals in the sector.



37

Diagram 36: Selected Chinese aircraft lessor activities (2015 -2016)

Source: Company filings, DBS

Timeline Activities

February 2015 Commencement of trading for Rongzhong International Financial leasing

July 2015 CALC’s US$94 million Hong Kong IPO - Asia’s first publicly traded aircraft lessor

July 2015 Newly set up Ping An International Financial Leasing aviation business

July 2015 Two new lessors entered the market

Hong Kong Financial Group Bridge Partners opened an aviation division

Astro Aircraft Leasing launched

September 2015 Bohai Leasing; a subsidiary of HNA Group acquired Avolon (the world’s third largest aircraft lessor at that point of time)

June 2016 BOC Aviation, an arm of Bank of China, started trading on the Hong Kong Stock Exchange with a US$1.1 billion IPO

July 2016 China Development Bank Leasing (CDB) Hong Kong’s US$800 million IPO

October 2016 Avolon agrees to acquire CIT’s aircraft leasing business for US$10 billion

Japanese Lessors: Emerging Once More

The Japanese were one of the earliest players in aircraft leasing, with the establishment of Showa Leasing in 1969. In the 1980s, the Japanese were a major source of aviation financing.

While Japanese banks have always figured strongly in domestic aviation financing, they have re-emerged in recent years in the global aviation market, as they seek higher returns and lower risk than traditional corporate lending. With the purchase of RBS Aviation Capital by Sumitomo Mitsui Financial Group (SMBC Aviation) and Mitsubishi UFJ’s acquisition of Jackson Square Aviation, Japanese lessors have once more returned to the fore.

The Japanese have been prominent in aircraft leasing since the 2000s, helped by their very own Japanese operating lease with call option (JOLCO) or Japanese operating lease (JOLs). A JOLCO is an operating lease fully or partially funded by a Japanese-domiciled source of funds. Under this structure, Japanese investors would plough back profit into financing aircraft purchases in exchange for tax benefits and depreciation-allowances claims It typically takes the form of an SPV with equity provided by Japanese equity investors (typically 20-30%) and the remainder financed by debt.

JOLs or JOLCOs are essentially like conventional operating or finance leases but the depreciation benefits that allow Japanese investors to decrease the taxable part of their funds end up being shared by lessor and lessee (in the form of lower lease rates). Since JOLs or JOLCOs are also available to foreign lessees, the availability and benefits offered by JOLs and JOLCOs have helped Japanese lessors become significant players in the aircraft-leasing space.


Japanese financing structure

Diagram 37: Top Japanese lessors

SMBC Aviation Capital

ORIX Aviation

Jackson Square Aviation

MC Aviation Partners

Century Tokyo Leasing Corporation

Showa Leasing

Mitsui Bussan Aerospace

Source: Airfinance Journal, DBS


39

Profiles of selected top aircraft lessors in Japan:

SMBC Aviation Capital (SMBC): It was established as a result of a US$7.3-billion acquisition of Royal Bank of Scotland’s aircraft-leasing business by leading Japanese institution Sumitomo Mitsui Banking Corporation. SMBC Aviation Capital is based in Dublin, Ireland. It is today among the world’s top five aircraft-leasing companies, with 669 owned, managed, and committed aircraft in its portfolio as at the end of September 2016.

ORIX Aviation: Founded in 1991 as part of ORIX Corporation, a Japanese financial conglomerate with businesses in asset lending rentals, property leasing, insurance, and investment management. It has presence in 30+ countries, with 60+ lessees.

Jackson Square Aviation: A San Francisco-based lessor which was acquired for about US$1.3 billion in 2013 by Mitsubishi UFJ Lease & Finance (MUL), one of the largest leasing companies in Japan by assets.

MC Aviation Partners (MCAP): Founded in 2008 as the wholly-owned leasing-and-trading arm of Mitsubishi Corporation, and currently owns and manages a fleet of over 100 aircraft.

Century Tokyo Leasing Corporation (TC Lease): The company was established in 2009 via a merger of Century Leasing System, Inc. and Tokyo Leasing Co., Ltd.

Showa Leasing: Founded in Tokyo in 1969 as a general leasing company, Showa is Asia’s first aircraft leasing firm. It was subsequently acquired by the Shinsei Bank Group in 2005 and is now the financial and operating leasing arm of Shinsei Bank.

Other Non-Traditional Lessors

The first airline-lessor was run by the now-defunct Ansett Australia, which established its leasing arm Ansett Worldwide Aviation Services in 1985. It was later sold to Morgan Stanley Dean Witter in 2000 for US$600 million and rebranded in 2004 as AWAS – one of the top ten aviation lessors by fleet size. Similarly, Singapore Airlines also set up a leasing arm known as Singapore Aircraft Leasing Enterprise (SALE) – jointly with Boullioun Aviation Service (in 1993) – which was sold to Bank of China in 2006 for US$965 million; SALE has become one of the world’s largest aircraft-leasing companies.

We have seen in recent years a number of airlines setting up their own leasing arms which, in addition to leasing to their own affiliated airlines, also lease to third-party airlines. The more prominent names include Indonesia’s Lion Air, Malaysia’s AirAsia, and Norway’s Norwegian Air Shuttle. We believe there are three main reasons for this phenomenon:

1. Seeking a higher, stable, and more diversified income stream. The airline business is cyclical, highly dependent on oil prices and global GDP growth, and hence on passenger demand. The leasing business enables airlines to build a new, more stable, and diversified revenue stream which also hedges against volatility in the US dollar. To quote Norwegian Air Shuttle’s chief executive Bjorn Kjos, “They (aircraft lessors) have a fantastic bottom-line. They earn all the money the airlines should have earned.”

2. Bulk discount. It is an open secret that the more planes you order from the OEMs e.g. Airbus and Boeing, the larger the discount. Having a leasing arm to place the planes helps an airline place larger orders and hence obtain a larger discount, which ultimately boosts profits.

3. Redistribute surplus aircraft. Having a leasing arm could also help an airline place out surplus aircraft in times of lower demand, though this would be less true in the event of a downturn in global air travel demand.

Challenges facing airline-lessorsGiven their association to particular airlines, airline-lessors are generally less successful in diversifying their customer concentration as compared to non-airline lessors (i.e. independent or bank-backed leasing companies), and thus face greater difficulty in accessing maintenance and other relevant records pertaining to the leasing business.

Secondly, the business of aircraft-leasing requires highly technical skills that are different from running an airline and which carriers do not typically possess; they include building infrastructure that supports remarketing and sales, contracting, configuration, and strong technical management of the assets to extract the most value from the aircraft.

And lastly, airline-lessors may not have the cost-of-funding advantage that many large or bank-backed lessors have.

Profile of three prominent airline-lessors that collectively have over 1,000 aircraft committed for delivery:

AirAsia’s wholly owned Asia Aviation Capital (AAC). Asia Aviation Capital based in Labuan, Malaysia was primarily set up as a wholly-owned subsidiary with the objective of providing aircraft-leasing services to low-cost carrier, AirAsia Group. AAC is responsible for acquiring, financing, leasing, remarketing, and selling aircraft for and on behalf of AirAsia Group’s affiliates outside Malaysia. Recently, AirAsia said that an undisclosed firm had made a US$1-billion offer for AAC and the group has appointed bankers to explore the sale of a stake in AAC.



41

Lion Air’s Transportation Partners (TP). Transportation Partners was set up in 2011 in Singapore as a company primarily involved in the leasing of aircraft and related services to Lion and Lion-affiliated airlines, as well as to external customers. Its first inroad into external aircraft-leasing was in 2014, when it signed a deal to lease three B737s to China’s 9 Air (subsidiary of Juneyao Airlines). In 2014, Indonesia’s largest privately-owned airline had a backlog order of 500 aircraft worth over US$20 billion, with deliveries over ten years. Focusing on both growth markets (China, India) and developed aviation markets such as USA and Japan, Lion Air hopes to further expand its scale in third-party aircraft leasing beyond its fleet of six aircraft as at 2015.

Norwegian Air Shuttle. The Oslo-based carrier set up a leasing arm based in Ireland, and in 2012, placed orders for more than 200 planes to be delivered by 2020. It has already leased 12 aircraft to Hong Kong-based HK Express, among others. As with other airline-lessors, Norwegian’s leasing entity will develop its own fleet by selling or leasing surplus aircraft to third parties while renewing the fleet and enabling high utilisation via their leasing operations. The subsidiary in part would also enable Air Shuttle to manage its currency-mismatch exposure: Loans denominated in the US dollar and aircraft balance-sheet values which are translated into the Norwegian krone.

In February 2016, it was reported that Norwegian Air Shuttle will look into spinning off this business, including the possibility of listing it or selling a stake.

Hong Kong’s Tycoons Join the Party

The wholly-owned aircraft-leasing arm of Li Ka-shing’s CK Hutchison Holdings, Accipiter, was established in 2014 and reportedly bought 18 planes from units of GE Capital Aviation Services for around US$714.8 million in the same year to kick-start its business. Accipiter currently owns 43 planes.

Cheung Kong Holdings, also owned by Li, was reported in 2014 to have formed a joint venture, Vermillion Aviation, with Mitsubishi Corp’s MC Aviation Partners to buy planes with a combined appraisal value of US$800 million; they have plans to grow the venture’s assets to US$5 billion within a few years.

In December 2016, Cheung Kong Holdings announced it would be buying Accipiter (CK Capital) from CK Hutchison for HK$7.6 billion. This is probably to consolidate the aircraft-leasing business under Cheung Kong Holdings.

Dato Dr. Cheng Yu-tung’s Chow Tai Fook Enterprises invested in its first aircraft-leasing joint venture Goshawk Aviation in 2013 with Investec and the Cheung Kong Group. After further restructuring, Chow Tai Fook Enterprises and NWS Holdings (both owned by Cheng) now own 50% each of Goshawk. Goshawk focuses on younger, narrow-body

commercial aircraft for leasing to international airlines. As at 30 January 2015, Goshawk’s portfolio consists of 27 aircraft.

In 2016, Chow Tai Fook Enterprises and NWS Holdings started their second aviation concern by forming a three-way joint venture with Aviation Capital Group. Chow Tai Fook and NWS will each own 40 % of the aircraft-leasing investment company, Bauhinia Aviation Capital, while Aviation Capital will have the remaining 20%. Bauhinia Aviation seeks to expand its aircraft portfolio to 50 narrow-bodies with an initial capital commitment of US$600 million from the shareholders.

Potential Transactions in Aviation Leasing Space

We are likely to see more deals and transactions in the aircraft leasing segment globally, with Asian lessors in the mix.

1. AirAsia’s leasing arm - Asia Aviation Capital. Bloomberg reported in December 2016 that AirAsia had received a dozen bids for its aircraft leasing unit, mostly from Chinese leasing firms, which included the leasing arms of China Merchants Bank and Ping An Insurance. According to the report, AirAsia is seeking buyers for a majority stake in Asia Aviation Capital, which it has valued at about US$1 billion.

2. Asian lessors’ interest in AWAS. According to a December 2016 Bloomberg report, Dublin-based AWAS has been put up for sale by its private equity owner Terra Firma, that could value the transaction, including debt, at US$7 billion. According the report, interested parties include Li Ka-shing, Ping An Insurance, as well as other Asian lessors, mostly Chinese. In March 2016, it was reported by Reuters that Terra Firma had rejected two bids from HNA Group for AWAS, and in 2015, AWAS had already sold a portfolio of 90 planes to Macquarie Group.

3. Potential listing of Aviation Capital Group (ACG). Privately held ACG, which is a wholly-owned subsidiary of Pacific Life Insurance Company, announced that it was considering an IPO back in December 2015 which would allow the aviation leasing arm to gain access to additional capital in order to pursue its growth and expansion strategy.

4. Minsheng Financial Leasing Co. Minsheng Financial Leasing Co. Ltd, which controlled by China’s Minsheng Bank, has publically stated that it could look to go public in Hong Kong and/or Shanghai by 2018.

5. Listing of other Asian lessors. We believe that there are other Asian lessors, besides CALC, BOC Aviation, and CDB Financial Leasing, that could look to list their business to tap new equity to fund their growth.



43

Draw of Aircraft Leasing

Ascend created the Ascend Aircraft Investment Index (AAII) that simulates the way an aircraft operating leasing portfolio functions and its respective unlevered returns over the period of measurement. The underlying model’s inputs are based on Ascend’s historical Current Market Values and Current Market Lease Rates (CMLR) to mirror past circumstances. When calculating the monthly returns from the portfolio, the model includes factors such as asset appreciation/depreciation, lease cash flow, lessor fees, capital expenditure for new acquisitions and capital gains from asset disposals (if any).

The AAII demonstrates achievable annual core unlevered returns of 6.4% for the 1991-2015 period, with a return volatility of 5.5%. The remarkably smooth shape of the AAII curve contrasts with the more volatile lines for the other benchmarks. The dips in the AAII curve after the recessions of 2001 and 2008 are small compared with the steep falls for other indices, while the growth for the rest of the period is noticeably stable and devoid of any sudden rises, which suggests a low volatility of returns provided by the underlying aircraft operating lease portfolio in our view.

The business of aircraft operating leasing offers investors predictable and stable cash flows, given that leases typically have a very long tenure (10-12 years for new aircraft) at a predictable rate (either fixed or floating with reference to London interbank offered rate or Libor). With aircraft usually placed out 12-18 months in advance, this further enhances earnings and earnings growth visibility for lessors.

For investors who crack the high barriers of entry of capital and technical expertise needed to manage an aircraft leasing business well over a sustained period, it has been shown to offer a higher and more consistent return-on-equity (ROE) than running an airline business (well).

Firm returns with relatively low volatility

Stable and predictable cash flows

Higher and more consistent profitability

Diagram 38: Singapore Airlines’ ROE versus BOC Aviation’s ROE (10-year)

*FYE MarchSource: DBS


PE ValuationsListed aircraft lessors are trading at an average of 8.9x (consensus) current earnings, declining to 7.7x forward earnings, with the range being fairly tight for the seven companies in the peer group. BOC Aviation is the cheapest in terms of price-to-earnings ratio (PE), trading at 7.7x current PE, declining to 6.6x PE – substantially below the peer average. Meanwhile, CDB Financial Leasing is the most expensive of the trio in HK – at 10.2x current PE, declining to 8.7x forward PE.

PB ValuationsOther than CALC, which is trading at 2.1x current price-to-book ratio (P/B), against a projected current ROE of over 22%, the rest of the aircraft lessors are generally trading at around 1x current P/B. In terms of P/B versus ROE, BOC Aviation seems to offer more value, as it is trading at a similar P/B to CDB Financial Leasing despite generating higher ROE.

Dividend YieldsHK aircraft lessors offer a dividend yield of 4.4% on average. Based on consensus estimates, there are two names that offer a decent yield. Falling at the higher end of the spectrum, CALC offers a prospective yield of 6%, whilst BOC Aviation offers a fairly decent yield of 3.8%. Apart from an industry-leading ROE, we observe that the fairly attractive yield on offer for CALC is also a probable reason why it trades at a higher P/B versus the ROE it generates.

Valuations and Equity Picks

Diagram 39: Current P/B versus Current ROE for aircraft lessors (as of 31 March 2017)

Source: ThomsonReuters, DBS

Stock PicksBOC Aviation is our top pick BOC Aviation offers investors a firm alternative to airlines to the continued growth of air travel globally and in particular Asia, as the region’s largest listed player. BOC Aviation’s earnings and cash flows are highly stable and predictable, and the group also possesses strong competitive advantages such as low cost of funding, strong track record (22 years of continuous profit), and an experienced management team.

We like BOC Aviation for 1) its size and scale (top five aircraft lessor by fleet size, including order book, globally), 2) attractive portfolio characteristics (well-diversified customer base, average fleet age of just 3.2 years with average remaining lease of 7.3 years), 3) firm earnings outlook (18.4% earnings per share CAGR over 2016-2018F) backed by a large order book of 232 aircraft (at end-1Q16) to be delivered over the next few years. At 7.7x FY17F PE, declining to 6.65x FY18F PE, and trading at just 1x FY17F P/B with 13.6% ROE, which is set to improve as the group increases its leverage post-IPO, current valuations are attractive.


45

Diagram 40: Aircraft lessors in US and HK (Prices as of 31 March 2017)

PER

31 March 2017 Mkt Cap

Price-to-Book ROE CrntYield

Company Last Px US$m Hist Crnt Forw Hist Crnt Hist Crnt Yield

AerCap Holdings NV

USD 45.91 8,092 7.3 7.6 6.6 0.99 0.86 13.5% 11.3% 0.0%

Air Lease Corp

USD 38.85 4,002 11.4 10.6 9.1 1.20 1.09 10.6% 10.3% 0.6%

Aircastle Ltd

USD 24.19 1,900 13.8 10.1 9.6 1.04 0.98 7.6% 9.7% 4.3%

FLY Leasing Ltd

USD 13.04 421 7.7 7.4 5.9 0.61 0.60 8.0% 8.0% 0.0%

CALC HKD 9.62 844 9.6 8.8 7.3 2.24 1.89 23.3% 21.5% 6.1%

BOC Aviation

HKD 41.45 3,703 8.6 7.7 6.6 1.11 1.00 12.9% 13.0% 3.8%

CDB Financial Leasing

HKD 1.98 3,287 10.7 10.0 8.5 1.02 0.92 9.5% 9.2% 3.1%

Average 9.9 8.9 7.7 1.20 1.05 12.2% 11.9% 2.6%

Source: ThomsonReuters (Consensus estimates)


Initiate coverage on CALC with a BUY, TP HK$12 Established in 2006, CALC has grown its fleet to 81 aircraft by end-2016, leased to 16 airline customers in Asia and Europe. With a firm order book for 92 aircraft from Airbus and potential for more from pop-ups and purchase & lease-backs, CALC is well poised to grow its fleet to at least 173 by 2022. Hence, CALC’s lease income is projected to grow steadily over the next few years, which is further supplemented by gains from the sale of its finance lease receivables. CALC also has a 49% stake in an aircraft disassembly business based in Harbin that is slated for commencement in 2H17 and targets to disassemble up to 20 aircraft p.a. in 2018. If successfully executed, this could provide further earnings and share price upside.

We value CALC based on a blend of 10x FY18 P/E and 2.2x FY18 P/B to derive a 12-month target price of HK$12. The higher than peer average target P/B multiple of 2.2x reflects the group’s industry-leading ROE of over 22%.

CDB Financial Leasing – China’s largest diversified lessorThe leasing arm of the China Development Bank, CDB Financial Leasing (CDBFL) focuses on aircraft and infrastructure leasing mainly in China. The company experienced significant impairment losses in 2015 as a result of the economic slowdown but managed to stay profitable nonetheless. With the focus on filtering of risker clients, and on the aircraft leasing and infrastructure segments, profitability should improve ahead.

With profitability set to improve for 2016 and in 2017 on lower impairment losses, we see the stock’s fair value at 1x P/B, or HK$2.01, against a projected ROE of 9.8% for 2017F.

n our view, the key factor that drives returns in aircraft leasing, in both the short term and long term, is the aircraft supply-demand dynamics. The most widely and commonly used aircraft types that carry the vast majority of today’s air traffic are mainly produced by Airbus and Boeing. According to CAPA, nearly 89% of the seats in the global fleet in service today

are attributed to Boeing and Airbus. The market for aircraft (passenger and freighter equivalent of 100 seats or more) has gradually evolved into a duopoly of Europe’s Airbus Group and US-based Boeing. Several smaller players (Fokker, British Aerospace, and Lockheed Martin) have exited the market over the years, and Boeing took over long-time rival McDonnell-Douglas (MDC) in 1997. Airbus and Boeing today account for 98% of deliveries in the market for 100+-seat passenger jets and freighter variants. While Embraer and Bombardier have a small share of this market, they pose a challenge only to the smaller players.

Meanwhile, COMAC of China and Irkut in Russia are developing new 150-seater single-aisle programmes, the C919 and MC-21, respectively, that may challenge this duopoly to some extent. However, the success of these programmes, in terms of both development and acceptance by the market, remains to be seen.

The most common concern for investors seems to be that of aircraft oversupply. Keen competition among airlines and strong order books at OEMs Airbus and Boeing, along with news that both manufacturers are ramping up production, worry investors.

Our view is that given the OEM duopoly in aircraft supply, aircraft supply-demand should be balanced in the long term as it is in the OEM’s interest to promote a balanced situation. A stable supply-demand picture helps aircraft retain value, which is positive for airlines, lessors as well as the OEMs themselves.

In the short term, we also see the aircraft supply-demand environment as relatively benign as 1) global load factors are near historic highs, 2) the growth rate of OEM production matches growth of expected demand, 3) order books are strong, and 4) storage/retirement is already at low rates.

A key feature or driver of an aircraft lessors’ earnings is the net spread (the difference between average yield on aircraft portfolio and average cost of debt) that a lessor earns. This means that aircraft lessors have interest-rate risk. In an environment of rising interest rates, investors may have reason to fret.

Generally speaking, aircraft lessors are well aware of this risk and manage it via 1) natural hedging where fixed-rate leases are funded by fixed-rate debt, and floating-rate leases


47

Key Risk Factors

IAirbus and Boeing duopoly

Oversupply worries

Interest rate exposure


have floating-rate debt, 2) active interest-rate hedging using derivatives such as caps and swaps, and 3) trading (sale) of aircraft in the portfolio with interest-rate exposure.

Furthermore, with demand for popular aircraft types being robust and the backlog for such aircraft being large – along with healthy airline profits generally – lessors should have some pricing power in terms of lease rates for new aircraft.

As a result, we believe that lessors’ earnings should not be impacted much by rising interest rates, unless the pace is sudden and/or the quantum of the hike is large.

We believe that lessors without a substantial order book to drive its organic growth could face lower returns if it can only look to grow via acquisition of aircraft from other lessors or through purchase and leasebacks from airlines. This is given the intensifying competition from new entrants into the aircraft-leasing space. Paying a premium for such assets would result in lower returns for the lessor.

We are currently in a period of low fuel prices. While Brent crude has rebounded from a low of less than US$40 a barrel a year ago, it remains relatively cheap currently. This has helped boost airline profitability, and in this buoyant environment for airlines, demand for leasing of aircraft (new or used) as well as lease rates have remained firm. Low oil prices have also reduced the risk of airlines defaulting on their lease payments.

On the other hand, the low-fuel-price environment means that older, less fuel-efficient aircraft are now more attractive or viable to operate. With aircraft being brought out of storage and a lower rate of aircraft retirement, demand for new aircraft may be affected. However, we do observe that orders for new aircraft and OEM order books, especially the variants with newer technology and are more fuel-efficient, remain robust and most lessors have also generally placed out their new aircraft 12 months or more in advance.

A lessor business is almost entirely dependent on the willingness as well as the ability of airline customers to enter into new aircraft operating leases and to pay and perform their obligation leases. During a downturn, the lessee may find it difficult to honour cashflow commitments, leading to delays in payments, and in the worst case, could face bankruptcy. Geopolitical risks, war, acts of terrorism, epidemics, and natural disasters could also impair the lessees’ ability to honour their lease terms. Increasing competition in the leasing space, high fuel costs, and worsening labour conditions are some other factors.

A lessor’s efficiency in obtaining funds is crucial to its operating business model. Its ability to borrow and the cost of funds hinge strongly on its balance-sheet strength and credit ratings; should a lessor’s credit rating be downgraded for whatever reason, there could be some serious consequences on its cost of funding and/or ability to borrow and refinance its loans as well as ability to compete.

Overpaying for aircraft in the secondary

market

Low fuel prices: A double-edged sword

Cyclical industry

Downgrade in credit ratings

The key value-generating asset is the aircraft itself. Under each lease agreement, the lessee is primarily responsible for maintaining the aircraft and complying with all regulations on aviation safety and airworthiness. If the lessee fails to properly maintain the aircraft, this could impact the sale value or re-lease value of the aircraft at the expiry of a lease, which imparts residual risk and could affect its overall fleet portfolio values.

For most traditional lessors who place their orders directly with the OEMs, the manufacturers’ ability to deliver the aircraft on time is of utmost importance. Failure to deliver or a delay – which are commonplace for aircraft with new technology – could result in lost or delayed revenues and brand equity with airline customers.

The introduction of new technology could affect the values of older aircraft in the long term, which would impact returns. The impact varies for different aircraft types, and is largely dependent on operator base, fleet size, production run and order backlog. The larger the operator base, existing fleet size, production run, and order backlog, the better the mitigation. A good example of this would be the next-generation A320neo and Boeing 737 MAX aircraft that have recently entered (in the case of the neo) or are soon to enter (the MAX) the market. It will take many years of strong production of these two latest models to challenge the existing fleet size of their predecessors. According to CAPA, there are currently over 6,700 of the A320 family of the aircraft in service and over 6,800 of the B737 family of the aircraft in service.

Aircraft lessors manage this risk by 1) mainly focusing on popular in-demand aircraft types with a large operator base, 2) ordering new generation aircraft, and 3) trading and selling of aircraft.

Aircraft lessors’ success hinges highly on access to debt and capital markets as well as liquidity. A market shock with the magnitude of the 2008-2009 global financial crisis, which led to the drought of liquidity, could paralyse the capital-intensive and high-gearing business model of aircraft lessors.

Come January 2019, IFRS 16 ‘Leases’ will be rolled out and it will bring most leases on lessees’ balance sheet. For airlines, this means that operating leases will have to be recognised on the balance sheet and will have an impact on gearing ratios, asset return metrics, and also potentially impact reported net profits.

While IFRS 16 should not result in substantial changes in accounting for lessors, there could be an impact on their business models and how the leases are structured, given the significant accounting impact that IFRS 16 would have on the lessees (airlines). For example, we could see lease periods being shortened.


49

Lessees may fail in maintenance

obligations

Delivery issues

Newer technology

Liquidity shock

IFRS 16 ‘Leases’


Aircraft Leasing 101

Leasing is a form of asset financing often used by businesses, which allows the lessee to make periodic payments in exchange for the right to use an asset over a contracted period, instead of incurring the full cost of asset-ownership upfront. Leases are typically classified as finance or operating leases, depending on the degree to which all the risks and rewards of ownership are transferred to the lessee.

In an aircraft-operating lease, the risks and rewards of aircraft ownership sit with the operating lessor but risks and rewards of operations remain with the lessee (the airline). The lessee is obliged to make regular rental payments in exchange for the right to operate the aircraft over an agreed fixed term. Meanwhile, the lessor retains the right and discretion to sell the given aircraft with the attached lease.

Similarly, under a finance lease, the lessee also makes periodic payments to the lessor over a defined period, but typically (1) has the added option to purchase, or (2) is automatically granted ownership of the given aircraft at the end of the lease term. As such, residual value risks are borne by the lessee under finance leases.

The rights and obligations that accrue to lessors and lessees in aircraft-operating leases are largely similar to that of property rental contracts.

The key differences between the two, however, lie in currency denomination and tenure. While real estate contracts are often denominated in their respective local currencies, aircraft-operating leases are largely denominated in the US dollar. Aircraft-operating leases also carry longer contractual terms, of 6-12 years on average, compared to about two years for real estate leases. In addition, terms for asset mobility and maintenance payment also often differ.

A variety of funding sources are available to airlines for growing their fleet, depending on their business models, operating environment, and financial status. Operating leases have been increasingly popular over the last five decades as they offer airlines fleet flexibility and financial flexibility as well as shorten the lead time for direct purchases or equity-raising. They also reduce residual value risks for airlines.

According to Flightglobal’s Fleets Analyzer, smaller airlines (with a fleet of less than 20 aircraft) were estimated to have leased 48% of their fleet while larger airlines (with a fleet of at least 20 aircraft) had approximately 39% of their fleet on operating leases in

Appendix

Aircraft-leasing popular among airlines

December 2015. Meanwhile, operating lessors are estimated to have placed approximately 81% of their total fleet with these larger airlines.

There are three main channels for aircraft acquisitions, namely (1) direct orders from OEMs such as Airbus and Boeing, (2) purchase and leasebacks from airline customers, and (3) purchase of aircraft from the secondary market, which is further discussed in a later segment.

In general, lessors will first place an order for aircraft directly with OEMs before sourcing for potential lessees (airline customers). Once identified, both the lessor and lessee would proceed to negotiate terms for the lease, including periodic lease obligations, tenure, maintenance obligations, and remarketing.

The lessor usually finances the asset purchase with a mix of debt and equity (cash). Prior to delivery, lessors typically collect a security deposit (between 1-6 months of rent) and ensures that the new aircraft and lease agreement are adequately insured.

After taking delivery of the new aircraft (noting delivery lead time of about four years, on average), the lessor proceeds to lease the asset to its airline customer, in exchange for periodic lease payments over the contracted lease term. In the event that the lessee defaults, the operating lessor will repossess and remarket the aircraft.

The lessor also has the option to dispose of the asset - with and without the attached lease – in the secondary market.


51

Diagram 41: Percentage of aircraft fleets on operating lease by airline fleet size (as at December 2015)

Source: Ascend Flightglobal Fleets Analyzer

Airlines with >= 20 aircraft

in fleet

Airlines with < 20 aircraft in

fleet


What’s Driving the Popularity of Aircraft Leasing?

While there are a myriad of factors contributing to the attractiveness of aircraft leasing as a means of asset financing from an airline’s perspective, we focus on seven key drivers as highlighted by commercial aviation finance solutions provider, Investec:

1. Financial flexibility: Leasing allows carriers to optimise the use of its capital and focus on operations rather than fleet management.

2. Avoid large upfront investments: Upon making an order, the buyer has to make large upfront payments for the aircraft. Through leasing, lessees avoid significant capital outlay.

3. Fleet flexibility: Leasing, as opposed to ownership, allows carriers to better adapt to changes in aviation market conditions.

4. Reduced delivery lead time for new planes: For narrow-bodies and aircraft with newer technology, delivery slots are often limited, with long delivery lead times. Leasing provides airlines with reduced order lead time compared to direct orders with OEMs.

5. Preservation of capital: Smaller airlines with higher costs of funding can leverage on lessors’ often superior access to capital through leasing.

Diagram 42: Illustration of a typical aircraft operating leasing model

Source: Aircraft Financing, 4th Edition

Aircraft Manufacturers/

Owners

6. Mitigate residual value risk: With leasing, residual value risks are borne by lessors rather than airlines.

7. Asset-light model – particularly for LCCs: With the proliferation of LCCs, leasing lowers the barrier to entry and mitigate as much as possible the significant capital commitments and hence better allow the LLCs to capture market share.


53

Diagram 43: Why airlines choose to lease

Source: Investec, DBS


Critical Success Factors for Aircraft Lessors

Focused on investing, managing, and trading their fleet, aircraft lessors are fundamentally viewed as financial-service providers.

Often bearing the cost of borrowing, related expenses, and risks pertaining to the ownership of aircraft, the individual lessor’s success lies in the extent to which it is able to deliver on the following:

(1) Lower cost-to-value ratio for aircraft purchasesThe three key channels from which lessors typically acquire aircraft are:

1. Direct from OEMs: Direct orders from OEMs typically require pre-delivery payment financing (PDP) two years prior to delivery. Meanwhile, operating lessors seek to place out aircraft 12-18 months prior to delivery, on average.

2. Purchase-leaseback (PLB): Under PLB, operating lessors purchase new or existing aircraft from airlines, which are subsequently leased back to the respective airlines.

3. Secondary market: Lessors also have the option to acquire a single – or a portfolio of – aircraft from other lessors or financier-owners.

Aircraft orders with OEMs are typically placed up to four years in advance for aircraft with the latest technologies.

Lessors typically place orders periodically with OEMs to ensure steady access to newer aircraft technologies, which are more efficient than previous generations of aircraft. Examples include the next-generation Boeing-737 MAX and Boeing-787 Dreamliner, which are highly sought after as they are approximately 20% more fuel efficient than older models.

Another interesting aspect of direct bulk purchases lie in the substantial 10-30% discount concession (on average) off catalogue/list prices, effectively lowering lessors’ all-in aircraft purchase costs.

Access to latest technologies, aircraft

models

Extracting better value through bulk discounts

(2) Access to cheaper fundingCapital markets provide aircraft leasing companies with depth and lower cost of funds via:

1. Loan products. Faced with higher costs of financing following the introduction of the OECD’s 2011 Aircraft Sector Understanding (ASU), the role of export credit agencies (ECAs) in aircraft financing has gradually diminished over the years. As such, only 11% of aircraft deliveries in 2016 are expected to have been financed via EX-IM banks or ECAs. Meanwhile, nearly 20% of aircraft purchases are financed by commercial bank debt, particularly in Japan and China.

2. Debt capital markets. Boeing estimates that about 45% of aircraft lessor’s funding requirements are sourced from debt capital market products, including asset-backed securities, as well as secured and unsecured notes/bonds.

The leading role played by debt capital markets as a primary source of funding for aircraft lessors can be mainly attributed to:

1. Better access to capital. Lessors are able to reach a wider investment audience who are often more sophisticated and thus receptive to varying debt structures.

2. Liquidity and pricing. Active trading in the secondary markets could provide debt instruments (issued by aircraft lessors, in this case) with improved liquidity and pricing support.


55

Draw of debt capital markets

Diagram 44: Catalogue prices of selected commercial aircraft

Aircraft Model Type List Price US$

Airbus 2016 average list prices

A320-neo Narrow-body $107.3m

A321-neo Narrow-body $125.7m

A330-200 Wide-body $231.5m

A350-800 Wide-body $272.4m

A380-800 Wide-body $432.6m

Boeing 2015 average list prices

B737-Max 8 Narrow-body $112.9m

B737-Max 9 Narrow-body $116.6m

B747-800 Wide-body $378.5m

B777-300ER Wide-body $339.6m

B787-8 Wide-body $224.6m

Source: Airbus, Boeing, DBS


3. Longer tenor. Unlike traditional bank financing, capital markets generally allow users to take on longer-tenor loans. This provides capital-intensive businesses, such as aircraft-leasing companies, with greater financial flexibility and ability to manage cashflow.

Lessors’ funding costs are largely dependent on their respective financial strengths. Aircraft lessors with higher credit ratings are thus able to raise debt more cheaply.

Meanwhile, issuers with weaker credit ratings may be subject to higher risk premiums and typically commit to higher yields – thus incurring higher funding costs relative to higher-rated issuers. Therefore, a higher credit rating could serve as a significant advantage in the capital-intensive aviation industry.

An aircraft-leasing company typically borrows up to 75% of an aircraft’s base value while funding the remaining with equity (cash) – which is sizeable considering that an aircraft can cost north of US$100 million.

By financing its aircraft purchases with debt and subsequently servicing its loan obligations through aircraft lease payments collected from its lessees, aircraft lessors with access to cheap funding are therefore well-positioned to deliver enhanced returns.

(3) Securing higher aircraft lease ratesLease rates are often largely driven by market forces. Apart from economic conditions, other factors that come into play when forecasting lease rates include:

1. Residual value: Difference between the expected and actual residual value of the aircraft at the end of the lease term.

2. Credit worthiness of the lessee: Lessee (airlines) with lower credit quality are usually subject to higher lease rates.

Credit rating plays a pivotal role in funding

costs

Enhancing returns through financial

leverage

Diagram 45: Long-term credit ratings for selected tier-1 lessors (as at 26 July 2016)

Aircraft Lessor Fitch Ratings

AerCap BBB-

Aviation PLC B+

Aviation Capital Group BBB

BOC Aviation A-

SMBC Aviation Capital BBB+

Source: Fitch, DBS

3. Acquisition price: The higher the cost of the aircraft, the higher the expected lease payment.

4. Aircraft age: All else being equal, a younger aircraft with lower maintenance needs (which are borne by lessees) should command a premium in lease rates.

5. Level of technology and aircraft type: Helped by technological improvements, newer aircraft types tend to be more cost-efficient (better fuel efficiency, better resistance to corrosion, etc.) and should thus command a premium.

6. Other variables that may affect lease rates include:

• Interest rates: Often incorporated into the lease rate formula

• Relevant taxes: Which differs across jurisdictions

• Tenor and lease terms: Such as return conditions, maintenance and maintenance reserve requirements

Due to higher aircraft purchase costs, wide-bodies tend to have higher lease rates. Depending on model and demand, lease rates for newer aircraft have on occasion risen above US$1 million a month.

According to data provided by International Bureau of Aviation (IBA) and Capital Aviation Research, lease rates for narrow-bodies have historically ranged between US$150,000 to US$400,000 per month.

Underlying conditions for and responsibilities of both the lessor and lessee in aircraft-leasing transactions can be found in the lease agreement, and typically include:

1. Lease tenor: Lease terms typically vary with aircraft type and region, and are usually shorter for narrow-body aircraft (3-7 years on average) than wide-bodies. At the end of the lease, the lessee is obliged to return the aircraft to the lessor in good order, and may have the option to either renew the lease or purchase the underlying aircraft at fair market value.


57

Aircraft Lessor Fitch Ratings

AerCap BBB-

Aviation PLC B+

Aviation Capital Group BBB

BOC Aviation A-

SMBC Aviation Capital BBB+


2. Useful life: The useful life can further be broken down into three key phases – each with a different ROE, which affects lease rates:

3. Lease extension: On average, 15% to 30% of expiring leases are extended between 20 and 40 months.

4. Other important terms include:

A. Commitment fees: Before the commencement of the lease, a commitment fee (similar to that of deposits) is paid by the lessee to the lessor.

Diagram 46: Aircraft lease ROE for first, second, and third lease

Source: Ascent Advisory

Young Phase Due to customised cabins, the first phase for new aircraft typically lasts 10-15 years. Given higher demand and lower maintenance costs, lessors tend to enjoy higher lease rates and returns during this phase.

Mid-life Phase The second phase is usually shorter, and lasts 3-8 years. Mid-life aircraft are often marketed to 2nd- or 3rd-tier carriers at lower lease rates.

End-of-life Phase This phase is typically the shortest, with the lowest lease rates compared to the first and second phases.

B. Security deposit: To mitigate potential losses (in the form of foregone lease payments and additional remarketing expenses) for lessors in the event of default by the lessee, the latter is expected to maintain a cash deposit or letter of credit with the lessor prior to delivery.

C. Insurance: As the lessee usually assumes the operating risk, they are required to be adequately insured:

• Hull insuranceHull insurance and insurance designed to protect the lessor’s aircraft assets and coves all potential loss in the event of an accident or physical damage, including the cost of the aircraft restoration or placement.

• Liability insurance According to Article 50 of the Montreal Convention 1999, the lessee is required to have adequate liability insurance coverage for potential third party liabilities. Premiums paid are typically a function of the maximum take-off weight and passenger carriage capacity.

D. Maintenance reserve: Lessees are generally responsible for the maintenance of leased aircraft, and may be liable for periodic supplemental maintenance rent payments.

Maintenance rents are calculated based on the utilisation of the airframe, engine, and other essential components required to keep the aircraft in service. Once the qualifying maintenance has been undertaken, the lessee is usually reimbursed for maintenance rent paid.

For leases that do not entail maintenance rent payments, apart from normal wear and tear, lessees are still obliged to return the aircraft in good order.


59

Diagram 47: Maintenance reserve events and cost structures

Young Phase Due to customised cabins, the first phase for new aircraft typically lasts 10-15 years. Given higher demand and lower maintenance costs, lessors tend to enjoy higher lease rates and returns during this phase.

Mid-life Phase The second phase is usually shorter, and lasts 3-8 years. Mid-life aircraft are often marketed to 2nd- or 3rd-tier carriers at lower lease rates.

End-of-life Phase This phase is typically the shortest, with the lowest lease rates compared to the first and second phases.

Cost Fixed interval Variable interval

Fixed cost Engine life limited parts

Variable cost Airframe maintenance check Auxiliary power units overhaul

Landing gear overhaul Engine performance restoration and overhaul

Source: IATA, DBS


In the case when aircraft are sold, accumulated maintenance reserves previously held for future maintenance needs can often help lift trading profits from the sale of aircraft.

Approximately 12-24 months prior to lease expiry, aircraft leasing companies will begin to remarket the given aircraft to other potential carriers.

To reduce time spent on remarketing, aircraft in the young phase are usually marketed to tier 2 or 3 carriers at lower lease rates.

(4) Maximising returns through disposalsThe residual value of aircraft is only realised when the lessor or owner disposes of an aircraft from its current portfolio in the secondary market, and pays off all outstanding debt related to the given asset.

Influenced by a host of factors, fluctuation in aircraft values may affect the resale value of aircraft. All else being equal, however, lessors are often able to register gains on disposal if the amortisation of debt outpaces the asset’s rate of depreciation.

The current low-oil-price environment, coupled with airlines’ capacity constraints (as evidenced by the firm order backlog for newer aircraft) has made it more viable for airlines to boost capacity by operating older aircraft, lifting demand and secondary valuations for used aircraft in the process.

Conversely, events detrimental to the demand for certain aircraft types (due to operational and safety concerns) or the broader air travel industry (in the case of an economic downturn, for instance) can weigh on the market value of these assets, and may result in potential impairment.

As most aircraft transactions are not publicly disclosed, the determination of aircraft value is largely left to professional aircraft appraisers.

A blend of both art and science, the valuation of aircraft is hinged upon the appraisers’ technical expertise, forecasts, and assessment of the aircraft market.

Passenger aircraft are often depreciated against an economic life of 25 years but in reality, may be able to extend their useful life through freighter conversions. Further value may also be extracted through the sale of parts.

According to Investec, the impact of depreciation on an aircraft’s base value can be anywhere between 3% and 9% p.a., and accelerates as the aircraft ages. While most aircraft values are determined via appraisal, a useful rule-of-thumb estimation we can use to gauge aircraft value over time is as follows:

Unutilised reserves could help bolster gains

Remarketing aircraft

Realisation of residual value

Appraisers play an outsized role

Drivers of Aircraft Value

A number of factors play a pivotal role in determining the value of an aircraft. They can simply be categorised into: (1) Market drivers, (2) aircraft factors, and (3) economic drivers.

Market drivers1. Product life-cycle: Aircraft with a longer production run tend to retain value better

and hence have higher residual values, as aircraft with longer production runs typically are more numerous, and hence have better liquidity, wider operator base, and a higher market share within fleets. Stages within the production cycle too have an impact on aircraft values.

• Early-stage production aircraft typically do not have good value as they tend to have higher operating weight and thus higher operating cost as well as other issues associated with early production. OEMs may thus price them more competitively.


61

Aircraft age Approximate aircraft value

More than 5 years 70% of initial value




Source: Investec, DBS

Diagram 48: Determinants of aircraft value

Source: Airline Monitor, Jackson Square Aviation, Airfinance, DBS


• Mid-stage production aircraft will have most, if not all, production issues ironed out and units tend to have much more stable aircraft values and depreciate at a more balanced and predictable rate over time.

• Late-production units are often subject to larger decline in value given they are competing against new offerings which tend to offer better efficiencies. These however are compensated by large discounts typically offered by the manufacturers. For instance, United Airlines in early 2016 turned down aircraft with new technology such as the Bombardier C-series in favour of 25 additional late-stage B737-700s that will be soon be discontinued. This was likely driven by a huge discount Boeing gave for the order – said to be more than 50% off catalogue prices of US$80.6 million, according to Airway News senior business analyst Vinay Bhaskara.

1. Supply and demand: The number of stored aircraft is often used to gauge the health of the airline industry. A high number of stored aircraft implies weak market demand, pushing down valuations, and vice versa.

For any particular type of aircraft, it’s important to know if the aircraft is being stored because of technical or economic obsolescence, in which case these aircraft are likely to remain parked forever; if it is being stored due to the cyclical nature of the airline business, that would imply an oversupply of the aircraft. An example for the first scenario would be out-of-production aircraft types such as the MD-80, and an example for the second scenario would be a 747 freighter.

Diagram 49: Stages within the aircraft production cycle

Source: Airline Monitor, Jackson Square Aviation, Airfinance, DBS

2. Market liquidity: Further de-composed by two key factors:

• Order book: An aircraft’s order book reflects the number of firm orders for an aircraft type, broken down into the number of deliveries and the number on firm backlog. It provides clarity on the market share (and popularity) an aircraft type has achieved, and is one of the most important drivers of aircraft value and its retention.

• Market penetration: The market penetration an aircraft type has achieved is another important driver of its value. The higher the customer (operator) base and the wider the geographical base, the better the aircraft value.

3. Secondary markets: If there is sufficient market liquidity as addressed by all the other factors above, the aircraft asset can be easily disposed of in the secondary market, which helps it achieve the highest possible value in a secondary sale. Secondary markets tend to be strong in up-tick economic cycles with many sources of financing available. Passenger-to-freighter conversion and the suitability of an aircraft type to do so also helps with the secondary value of an aircraft.

4. Aircraft value cycle largely driven by market cycle: The aircraft value cycle may be understood by considering the relationship between Current Market Value (CMV - the spot trading value) and Base Value (BV - underlying long term economic value). The chart below illustrates the previous and current aircraft value cycle, demonstrating the cumulative proportion of installed fleet compared to CMV / BV. It shows that the trough of the prior (2001-2008) cycle in July 2002 and the trough of the current cycle are quite similar. We also note that the peak of the prior cycle in July 2008 lies considerably to the right of the current position in the cycle. By February 2016, aircraft market values have only improved by about half as much as they did in the prior cycle, indicating potentially further upside since.

(2) Aircraft factors1. Aircraft type. An aircraft type (or family) in particular has a strong influence on its

value. This is largely due to the difference in the rate of market value depreciation versus book value deprecation. Lessors tend to favour aircraft with low depreciation as there is higher residual value and hence, it provides more certainty in terms of the aircraft value as and when the planes are traded in the secondary markets. Furthermore, there exists differences even within aircraft of the same family.


63


2. Aircraft specifications. Production aircraft are usually offered with various specifications in 1) engines and configuration, 2) operating weights, and 3) cabin builds and Buyer Furnished Equipment (BFE) options. Differences in these specifications will impact the value of an aircraft and in the case of cabin builds and BFE options, highly standardized aircraft tend to have a higher resale value.

3. Technology. The latest variant of aircraft such as the Boeing’s B787 Dreamliner features newer technology and composite material construction which is lighter and less susceptible to corrosion; a switch to major electric architecture instead of the bleed valve system creates strong reliability and reduces more weight, given the smaller need for all the pneumatic-piping wrapping around the aircraft. New aircraft also have more accommodative features, for instance, lower cabin altitude which increases overall passenger cabin comfort– something that carriers like to have as part of their service offering. All these new technologies help reduce operating costs and maintenance effort while potentially increasing loads – which make the Dreamliner an attractive asset to operate for any carrier.

(3) Economic drivers1. Fuel prices. The cost of fuel often makes up between 30% (for full service carriers) to

50% (for LCCs) of an airline’s operating cost. The fuel efficiency of an aircraft therefore has a huge influence on the profitability of its operator. A low fuel price environment

Diagram 50: Aircraft value matrix (Most desirable aircraft)

Source: Investec, Ascend Advisory, DBS

tends to help support the value of the older aircraft types while the reverse holds true when fuel prices are high. It has also been argued that high fuel prices would help the value of new, fuel-efficient aircraft and that low fuel prices would diminish the attractiveness and thus value of the newer aircraft types.

2. Economic cycle. The economic cycle also plays a role in determining aircraft value namely on 1) demand – aircraft values tend to be firmer when demand for air travel and thus aircraft is high, and 2) liquidity – aircraft asset values tend to be stronger when there is ample financing to fund aircraft acquisitions in the primary and secondary markets.


65

Diagram 51: Industry life cycle

Source: Avolon, DBS

Disclaimers and Important Notices

The information herein is published by DBS Bank Ltd (the “Company”). It is based on information obtained from sources believed to be reliable, but the Company does not make any representation or warranty, express or implied, as to its accuracy, completeness, timeliness or correctness for any particular purpose. Opinions expressed are subject to change without notice. Any recommendation contained herein does not have regard to the specific investment objectives, financial situation and the particular needs of any specific addressee.

The information herein is published for the information of addressees only and is not to be taken in substitution for the exercise of judgement by addressees, who should obtain separate legal or financial advice. The Company, or any of its related companies or any individuals connected with the group accepts no liability for any direct, special, indirect, consequential, incidental damages or any other loss or damages of any kind arising from any use of the information herein (including any error, omission or misstatement herein, negligent or otherwise) or further communication thereof, even if the Company or any other person has been advised of the possibility thereof.

The information herein is not to be construed as an offer or a solicitation of an offer to buy or sell any securities, futures, options or other financial instruments or to provide any investment advice or services. The Company and its associates, their directors, officers and/or employees may have positions or other interests in, and may effect transactions in securities mentioned herein and may also perform or seek to perform broking, investment banking and other banking or financial services for these companies.

The information herein is not intended for distribution to, or use by, any person or entity in any jurisdiction or country where such distribution or use would be contrary to law or regulation.


67

www.dbs.com

Living, Breathing Asia

s asian nsits - dbs bank airbus estimates that by 2035, the number of aviation mega-cities (which it...

Documents