Aircraft Finance: Strategies for Managing Capital Costs in a Turbulent Industry

by Bijan Vasigh, Reza Taleghani, Darryl Jenkins

Overview

One of the largest assets that an airline has are aircraft, therefore it is critically important to develop a methodology that estimates an aircraft's value, and which also determines efficient utilization to ensure an acceptable rate of return on the asset. Aircraft Finance provides a comprehensive review of aircraft finance and valuation and presents a detailed methodology for accurately valuations. The methodology measures return on investment, improves the efficiency of managing operating costs and more effectively determines revenue analysis.

Product Details

ISBN-13:	9781604270716
Publisher:	Ross, J. Publishing, Incorporated
Publication date:	06/01/2012
Pages:	408
Product dimensions:	6.00(w) x 9.00(h) x 1.10(d)

About the Author

Bijan Vasigh is professor of Economics and Finance in the College of Business at Embry-Riddle Aeronautical University, Daytona Beach Florida. Dr. Vasigh received a Ph.D. degree in Economics from the State University of New York and he has written and published many articles concerning the aviation industry. The articles have been published in numerous academic journals such as the Journal of Economics and Finance, Journal of Transportation Management, National Aeronautics and Space Administration (NASA) Scientific and Technical Aerospace Reports, Transportation Quarterly, Airport Business, Journal of Business and Economics, and Journal of Travel Research. Bijan is also author of North America's leading aviation textbooks entitled An Introduction to Air Transport Economics: From Theory to Application and The Foundations of Airline Finance: Methodology and Practice. Reza Taleghani is currently a Managing Director with J.P. Morgan Securities in New York where he has spent the majority of his career as an investment banker to the air transport sector. He also has a deep understanding of the operational aspects of the industry, having recently served as President and CEO of Sterling Airlines, a leading Scandinavian low cost carrier. His expertise in aircraft finance arises from his experience originating and structuring financings of transportation assets in J.P. Morgan's Securitized Products Group, as well as operating a fleet of jet aircraft at Sterling. During his time at J.P. Morgan, he has also worked on mergers and acquisitions; initial public offerings; secured, unsecured and ECA-backed financing in the syndicated finance and capital markets; leveraged finance; restructuring; and risk management for airline and lessor clients in Europe, the United States and Latin America. Mr. Taleghani holds dual AB degrees in History and Organizational Behavior and Management from Brown University. He received his JD and MBA from Villanova University. Darryl Jenkins's aviation experience covers over thirty years. Recent work includes extensive merger and acquisition experience at United Airlines and Delta Air Lines. Previously, he was at GWU for fifteen years and served as director of the Aviation Institute and was the Director of the Graduate Certificate Program in Aviation Management from 2001 to 2003. He was visiting faculty at Embry Riddle Aeronautical University in 2004. As a consultant he has worked for the majority of the world's top fifty airlines. He is a regular commentator for the major media (ABC, NBC, CBS, Fox, CNN, MSNBC, and CNBC) on aviation issues and is regularly quoted in the print media as well. He is a regular speaker at trade and other conferences and is the author of several books.

Read an Excerpt

CHAPTER 1

The Globalization and Evolution of the Commercial Aircraft Industry

With a short dash down the runway, the machine lifted into the air and was flying. It was only a flight of twelve seconds, and it was an uncertain, wavy, creeping sort of flight at best; but it was a real flight at last and not a glide.

— Orville Wright, on the first flight of a heavier-than-air aircraft

In the aircraft business, as in a Trollope novel, things are often not what they seem. In the 1980s, Boeing still reigned supreme. Its airplanes covered the market. Its product support was exemplary. Boeing was universally judged one of America's best and most admired companies, partly because its sales of large commercial airplanes were the country's biggest export, and partly because it had learned to build those airplanes better, faster, and cheaper than anyone else had done ... Today, things have turned around. Boeing and Airbus are the sole suppliers of big airliners, but over many of the past twenty years, the two companies were moving in opposite directions. Boeing's multiple troubles, most of them self-inflicted, signaled an end to its dominance and pointed up Airbus' methodical rise.

— John Newhouse, Writer and Correspondent

Aircraft manufacturing is a vital industry that greatly influences the entire economy of a nation. The industry receives significant attention from policymakers and industry analysts. Nowadays, the commercial aircraft industry is dominated by two companies, primarily due to high barriers to entry and high degrees of operating and financial leverage.

Those two companies are Airbus and Boeing. In 2010, Airbus delivered 510 aircraft and received net orders for 574 new planes. During the same period, Boeing delivered 460 aircraft and received net orders for 530 jets. In 2011, Boeing deliveries rose 3% to 477 from 462 the year before. Total orders for Boeing commercial aircraft surged 52% to 805 in 2011, after 116 cancellations.

Development of new commercial aircraft requires massive initial investment in labor, capital, equipment, and technologies. Historically, this has led to the formation of large, consolidated firms with financing from public and government sources. For example, the A380 development cost was more than $14 billion, with one-third of the cost financed by European members of the Airbus consortium. France, Britain, Germany, and Spain have each invested heavily in the A380 program. The Boeing 777 cost approximately $5.5 billion to develop, of which $3 billion was used toward overcoming production delays. While there were several aircraft manufacturers, including Ford in North America and Junkers in Europe, from the early 1900s through the late 1980s that made significant contributions, the industry has undergone considerable consolidation in the past two decades, resulting in the emergence of a relatively stable duopoly for narrow-and widebody commercial airliners: Boeing Company in North America and Airbus S.A.S. in Europe.

This chapter presents a brief history and overview of the product offerings of major commercial aircraft manufacturers, as follows:

Early Contributions to Commercial Aircraft Manufacturing

• Ford Tri-Motor

• Junkers German Transport

Commercial Aircraft Manufacturing

• North America

• Western Europe

• Russia and Eastern Europe

• Asia

• Regional Jet Markets

At the end of the chapter is a Summary for chapter review and a Bibliography for further study.

Early Contributions to Commercial Aircraft Manufacturing

The commercial aircraft industry requires a large investment to develop and manufacture aircraft, avionics, and engines. Economic problems may significantly impact profitability. Many aircraft manufacturing companies have gone out of business or merged with peers. The industry is littered with the reminiscences of unsuccessful commercial aircraft endeavors. The three-engine Ford Tri-Motor aircraft series produced during the 1920s and 1930s were classic planes of that era. In Europe, Junkers was a major German aircraft manufacturer, manufacturing some of the best-known aircraft over the course of its 50-plus years in business. The Lockheed L-1011 was a wide-body aircraft that entered into commercial operations following the launch of the Boeing 747 and the McDonnell Douglas DC-10. However, Lockheed withdrew from the commercial aircraft business due to poor sales. Subsequently, in 1997, McDonnell Douglas faced a financial crisis and merged with its rival, Boeing.

Ford Tri-Motor

In the early 1920s, Henry Ford and his son Edsel, along with a group of 19 others, invested in the Stout Metal Airplane Company. The first Ford/Van Auken airplane, powered by a Model-T engine, arrived in 1909, only six years after the Wright Brothers' first flight. It would not be until 1927, however, that Ford would enter the commercial aviation arena with the first of the 4-AT series Ford TriMotor, referred to as the Tin Goose. Previous Ford-manufactured aircraft, like the model 2-AT Air Transport, had been used by Ford to ship auto parts, mail, and personnel between Denver, Detroit, and Cleveland.

The Ford Tri-Motor was the first plane primarily designed to carry passengers instead of mail. The aircraft could carry 14 or 15 people, possessed a cabin high enough for passengers to walk without stooping, and had room for a flight attendant. The Tin Goose's three engines made it possible to fly as high as three miles at a speed of about 130 miles per hour. Its sturdy appearance and Ford name had a reassuring effect on the public's perception of flying (Ingells, 1968). The Tri-Motor had a range of approximately 500 miles and was not capable of crossing continents without refueling. Ford, unlike his cars, did not manufacture the engines for these airplanes.

From 1926 through 1933, there were 199 Ford Tri-Motors built. The TriMotor sales dropped from a peak of 86 per year in 1929 to only two sales in 1932. The Ford Motor Company ceased manufacturing this aircraft in 1932 (Larkins, 2007). The end of Ford's contribution to commercial aircraft manufacturing was likely due to a combination of various issues at the time: the tightened market and economy of the Depression era, the overall loss incurred in the production of the airplanes, the diminished need for a three-engine aircraft, an increased need for a faster and more economical design for airline use, and Henry Ford's diminishing interest caused by the deaths of three test pilots in crashes.

Junkers German Transport

"Junkers" is a name that quickly became associated with important aerodynamic and structural advances in aircraft in post-World War I Germany. The company was founded by Hugo Junkers. In 1919, Junkers began designing aircraft that would become the world's first all-metal airliner and also the forerunner of all commercial transport aircraft. The single-engine, low-wing, cabin monoplane was of particularly small dimensions since it was necessary to work within the onerous restrictions forced upon Germany. It was in production for 13 years and in commercial use for about 20 years (Kay & Couper, 2004).

Junkers produced the F13 commercially, and the aircraft was made entirely of Duralumin. It was designed to be dismantled into sections for easy shipment to export markets. The F13 first flew on June 25, 1919, and the first order for an F13 came from an American businessman named John Larsen, who planned to sell it as a JL6 in North America. A total of 322 F13s were produced, mainly between 1923 and 1925; most went into service in Germany and Russia (Kay & Couper, 2004).

Commercial Aircraft Manufacturing

As historical data on the commercial aircraft industry shows, the entire industry was influenced by a few major companies. Today, the industry enjoys a tight duopolistic, or oligopolistic, market structure due to significant barriers to entry. Since the merger of Boeing and McDonnell Douglas in 1997, the industry is dominated by two major players: Boeing in North American and Airbus in Europe.

North America

Worldwide aircraft manufacturing was, and to a large measure continues to be, dominated by North American manufacturers. After World War II, four prominent players emerged in the business of building commercial jets: Boeing, McDonnell, Douglas, and Lockheed. McDonnell and Douglas merged in 1967, and the combined entity remained a long-standing competitor to Boeing until its ultimate merger with Boeing in 1997.

Lockheed merged with Martin Marietta in 1995, and the combined entity later refined its focus to primarily military aircraft manufacturing (Sandler & Hartley, 2007). Both Boeing and Lockheed Martin competed for American defense contracts, and it has been claimed that Boeing used its defense division to crosssubsidize its commercial airline development.

Boeing and Lockheed dominated the North American aircraft manufacturing landscape both in terms of civilian and military aircraft. Together with McDonnell Douglas, Boeing was a world leader in commercial aircraft manufacturing into the 1980s, when Airbus Industrie evolved into a major competitor that would eventually surpass Boeing in market share. Figure 1.1 chronicles the mergers of commercial aircraft manufacturers in the U.S. over the last century, with omission of military aircraft manufacturer mergers for the sake of clarity.

Boeing Aircraft Company

Boeing has been a dominant player in the commercial aircraft market for the greater part of the last century. Recent loss of market share to Airbus does not diminish the fact that Boeing is a strong company and a leader in commercial aviation. While this section will focus on commercial aircraft history, it is important to note that Boeing's start and its success came from the sale of military aircraft. In 1916, William Boeing (founder and namesake) built his first seaplane, which he sold to the New Zealand government. The following year, Boeing sold 50 seaplanes to the U.S. Navy and continued to receive military and defense contracts from the U.S. government, including a $35 billion contract to build a new generation of refueling tankers for the Air Force. The financial success of military aircraft projects allowed the company to enter into high-risk commercial aircraft projects that may not have been profitable. Having the financial ability to undertake high-risk commercial aircraft projects is one of the reasons that Boeing is at the forefront of aircraft development.

Boeing began to learn the aircraft manufacturing trade by first building and modifying existing designs from other manufacturers. In 1918, founder Boeingwas contracted to build the Curtiss-designed HS-2L, a military patrol plane. Later, in 1919, he modified the de Havilland DH-4 (Heritage of innovation, 2009). These modifications allowed Boeing to take apart and rebuild aircraft in order to relocate the fuel tank. As most engineers know, being able to take apart and re-assemble a manufactured product such as an airplane allows one to see how the item is constructed and how it works, providing insights into how to make the item. The process of designing something through the deconstruction and reconstruction of a similar item is called reverse engineering. The use of reverse engineering helped Boeing to develop its own planes, including its first commercial aircraft, the B-1 mail plane, which was launched in 1919, beginning a 90-year history of building commercial airplanes.

Boeing's real start into the commercial aviation business came through the U.S. mail network. The U.S. Postal Service awarded Boeing a contract to transport mail by air between San Francisco and Chicago in 1927. Boeing founded the airline Boeing Air Transport to fly this route, and used its own mail plane that Boeing had developed, the Model 40A. The Model 40A was unique in that it had a nose made from steel, combined with a wood and fabric fuselage (Heritage of innovation, 2009). Boeing built 25 mail planes for the Boeing Air Transport fleet. The Model 40A could hold two passengers, making it the first real passenger aircraft. Boeing continued to design passenger aircraft through the late 1920s and early 1930s, progressively building aircraft that could hold more passengers as well as mail. The 1932 Model 247 presented the best combination of speed and capacity, carrying 10 passengers and 400 pounds of mail at speeds of up to 200 miles per hour. Together with the Douglas DC-2, the Model 247 heralded the modern era of air transportation (Comprehensive index of historical products, 2009).

The 1930s were a slow time for Boeing, especially on the commercial aviation front, due to the Great Depression. During this time, Boeing mainly focused on military aircraft such as the B-17. Boeing could never have known how big the B17 Bomber project would be. Nicknamed "The Flying Fortress," the B-17 would prove crucial in World War II for Allied forces in defeating the German and Japanese military (Heritage of innovation, 2009). Despite the tough economy and the B-17 being the only major success for Boeing at the time, Boeing was laying the groundwork for future successes. In 1936, Boeing bought the 28 acres that constitute the modern-day Boeing Field in Seattle (Heritage of innovation, 2009). In addition to buying the site, Boeing invested $250,000 to build a facility to manufacture airplanes on site. Boeing decided to develop two new commercial aircraft despite the ailing economy of the late 1930s. It developed the Model 307 Stratoliner and Model 314 Clipper, and the gamble of developing new aircraft during tough economic times paid off. Both models were bought by Pan American Airways and were wildly popular. The Pan Am Clipper became an icon of modern air transportation, opening up the Americas, Europe, and Africa to the world. However, all was not successful on the Model 307 project; the prototype crashed during a test flight, killing all 10 people on board (Heritage of innovation, 2009). The crash of the Model 307, along with the crash of a B-29 during test flights, led to the creation of improved pre-flight testing protocols for new aircraft, including the design of wind tunnels for performance testing.

World War II brought a renewed focus on military aircraft for Boeing as the defense business was lucrative at the time. It was not until 1952 that a major development in the commercial aviation industry would come from Boeing as it began to build a prototype of the 707, named the Model 367-80, or "Dash 80" for short. The Dash 80 would become Boeing's first commercial jetliner and one of the first jetliners in the world with military and government applications as well. The Dash 80, currently on display at the Smithsonian Museum in Washington, D.C., was the basis for the KC-135 military fuel tanker and the first Air Force One (Heritage of innovation, 2009). Used for mid-air refueling of other aircraft, Boeing would produce 820 of the KC-135 tankers by the time its production ended in 1965.

On the commercial side, the Dash 80 prototype would undergo a few years of testing before the first 707-120 was produced and delivered to Pan Am in 1958. Before introducing the 707, Douglas and Lockheed aircraft were preferred by U.S. airlines. That changed after the 707 became the first U.S.-manufactured jetliner and Boeing became the premier aircraft manufacturer for U.S. airlines and airlines around the world. In all, 916 Boeing 707s were delivered to customers from 1958 to 1982 (Eden, 2008). The 707's success spurred the development of a line of narrow-body aircraft from the 1950s all the way through the 1980s. In addition to variants of the 707 itself, the fuselage cross-section of the 707 would be used as the basis for designs of the 727, 737, and 757. The first of these aircraft to be produced was the 727 in 1962.

The 727 was the only commercial tri-engine jet that Boeing would design and produce, as well as the only T-tail jet. The three-engine design allowed for a compromise between airlines that wanted the efficiency of a twin-engine aircraft and airlines that wanted the performance of a four-engine aircraft. This mix of efficiency and performance led the 727 to be a popular aircraft for medium-haul routes. The 727 became a mainstay of U.S. airlines like American, Delta, and United until the year 2000. The success of the 727 led Boeing during the 1970s to develop a stretch version of the airplane that would seat about 180 passengers. In part due to the oil crisis of the 1970s, Boeing eventually decided to scrap the idea of a stretched version of the 727 and developed a conventional two-engine replacement. This aircraft, the 757, provided a narrow-body aircraft that could be used on short-, medium-, and long-haul routes while still offering the superior performance that airlines had come to expect from the 727. The 757 could be found on diverse missions at short-field, noise-restricted airports (such as Orange County, CA) and transatlantic flights. Due to its versatility and performance, many 757s are still in service despite the fact that their service dates back to 1983 (757 Program, 2009).

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Table of Contents

About the Authors xiii

Acknowledgments xv

Foreword Kelly Ison xvii

Preface xix

Prologue Kenneth Dufour xxiii

Web Added Value™ xiv

Chapter 1 The Globalization and Evolution of the Commercial Aircraft Industry 1

Early Contributions to Commercial Aircraft Manufacturing 3

Ford Tri-Motor 3

Junkers German Transport 4

Commercial Aircraft Manufacturing 4

North America 5

Western Europe Aircraft Companies: Evolution and Constellation 22

Russia and Eastern Europe 30

Asia 42

Regional Jet Markets 44

Embraer 45

Bombardier Aerospace 48

Mitsubishi Aircraft Corporation 51

Summary 52

References 53

Chapter 2 Aircraft Variants and Manufacturing Specifications 57

Boeing Commercial Aircraft 58

Boeing Existing Fleet 59

Boeing Retired Fleet 65

Airbus Commercial Aircraft 71

General Characteristics of the Fleet 73

Physical Characteristics of the Fleet 73

Operational Characteristics of the Fleet 76

Comparative Analysis of the Airbus Aircraft Family 76

McDonnell Douglas Commercial Aircraft 78

General Characteristics of the Fleet 78

Physical Characteristics of the Fleet 80

Operational Characteristics of the Fleet 80

Comparative Analysis of the McDonnell Douglas Aircraft Family 80

Lockheed 83

Regional Jets 83

Embraer 83

Bombardier 87

Summary 90

References 91

Chapter 3 Aircraft Efficiency: Operating and Financial Metrics 95

Airline Fleet Composition 96

Single Factor Ratios 97

Aircraft Technical Performance Ratios 99

Operating Ratios 102

Fuel Efficiency 103

Aircraft Utilization 103

Average Stage Length 107

Financial and Operational Performance 112

Aircraft Financial Performance through Financial Ratios Analysis 113

Comparative Analysis of Efficiency 118

Narrow-body: Boeing 737NG vs. Airbus A320 119

Wide-body: Boeing 777-200 vs. Airbus A330-300 127

Regional Jets: CRJ100/200 vs. ERJ 145 130

Summary 133

References 133

Chapter 4 A Methodology for Aircraft Valuation 135

Intricacy and Resourcefulness 136

Current Market Practices 140

Aircraft and Data Selection 140

Boeing Aircraft 141

Airbus Aircraft 142

Potential Sources of Revenue 142

Passenger Revenue 143

Cargo Revenue 144

Ancillary Revenue 145

Aircraft Total Cost Structure 147

Total Operating Costs 149

Direct Operating Costs 149

Indirect Operating Costs 151

Non-operating Costs 151

Aircraft Valuation Methodology 152

Weighted Average Cost of Capital 152

Discounted Cash Flow Model 153

Summary 155

References 155

Chapter 5 Aircraft Valuation and Sensitivity Analysis 157

Value of Physical Assets 158

Theoretical Value of Airbus Aircraft 160

Theoretical Aircraft Value vs. List Price 160

Theoretical Aircraft Valuation Trends 162

Aircraft Value Volatilities 164

Impact on Theoretical Aircraft Valuation of Input Changes over Lifespan of Aircraft 171

Theoretical Value of Boeing Aircraft 173

Theoretical Aircraft Value vs. List Price 173

Aircraft Value Volatilities 178

Theoretical Aircraft Valuation Trend Comparison 180

A320-200 vs. 737-700 180

A330-200 vs. 767-400ER 181

Elasticity 182

Summary 183

References 183

Appendix to the Chapter 184

Chapter 6 The Principles of Effective Cost Management and Capital Structure 185

Fixed Assets Financing 186

Equity Financing 188

Common Stock 188

Preferred Stock 189

Debt Financing 193

Bonds 194

Yield to Maturity 198

Cost of Debt (Bonds) 198

Strategic Labor Cost Management¹³ 199

Financial Crew Cost Analysis 200

Operational Crew Cost Analysis 201

Rules of Thumb 207

Summary 210

References 211

Chapter 7 Aircraft Secured Bond Transactions and Securitization 213

Aircraft Secured Bond Products 214

Asset-backed Securities 217

Conventional Equipment Trust Certificates and Pass-through Certificates 220

Bankruptcy Protection Issues 221

Chapter 11 Reorganization 221

Chapter 7 Liquidation 224

Aircraft Lease Securitization 225

Aircraft Lease Portfolio Securitizations 225

Enhanced Equipment Trust Certificates 231

Tranching 234

Liquidity Facility 235

Cross-default 236

Ratings Agencies 236

Standard & Poor's 236

Moody's Investors Service 237

Fitch Ratings 238

Altman Bankruptcy Index 239

Summary 240

References 240

Chapter 8 General Aviation Aircraft and Appraisal 243

General Aviation Aircraft 244

General Aviation Aircraft Manufacturers 246

Appraisal Standards and Requirements 253

American Society of Appraisers 254

International Society of Transport Aircraft Trading 254

Appraisal Company Requirements 255

General Aviation vs. Commercial Aviation Appraisal Methods 255

Aircraft Bluebook Values 256

Scope of Appraisal 258

Diminution of Value Assessment 262

Diminution of Value Scope of Work 262

Fixed-base Operators 264

Scope of FBO Appraisals 264

Summary 265

References 266

Chapter 9 Aircraft Leasing and Finance 269

Commercial Aircraft Leasing 270

Characteristics of Aircraft Leasing 274

Advantages of Aircraft Leasing 274

Disadvantages of Aircraft Leasing 276

Classification of Leases 277

Operating Lease 277

Financial (Capital) Lease 279

Cross-border Aircraft Leasing 281

Sale and Leaseback 281

Dry and Wet Leases 283

Financial Considerations for Aircraft Leasing 284

Buy vs. Lease Analysis 284

Business Jets Market and Fractional Ownership 291

Summary 292

Appendix: Major Commercial Aircraft Leasing Companies 292

General Electric Capital Aviation Services 293

International Lease Finance Corporation 293

CIT Aerospace 293

RBS Aviation Capital 294

Babcock & Brown Aircraft Management 294

Ansett Worldwide Aviation Services 294

Aviation Capital Group Corporation 294

Boeing Capital Corporation 295

References 296

Chapter 10 Airline Fleet Selection Process 299

Network Planning and Aircraft Selection 300

Operating Environment 301

Market Forecast and Route Analysis 305

Analyzing the Competitive Dynamic 306

Choosing an Aircraft Type 310

Aircraft Selection Methodology 311

Detailed Aircraft Performance 312

Cost Efficiency 312

Payload vs. Range 320

Modeling Techniques and Issues 322

Assessing Aircraft Profitability-Cost Components 322

Assessing Aircraft Profitability-Revenue Components 326

Sensitivity Analysis 327

Summary 328

References 329

Chapter 11 Export Credit Agencies and Aircraft Finance 331

Background of Aircraft Export Credit Finance 332

Export Credit Agencies throughout the World 333

Overview of Large Aircraft Sector Understanding Rules 334

ECA Finance Supported by the U.S., EU, Brazil, and Canada 335

Cape Town Convention 339

Overview of UNIDROIT Convention 339

ECA Financing and the Cape Town Treaty 340

The 2011 Aircraft Sector Understanding 340

Export Credit Rules and the New Aircraft Sector Understanding 340

Grandfathered Transactions 344

Financing Alternatives Utilizing ECA Support 344

How Aircraft Financiers Utilize the ECA Guarantee to Lower Borrowing Costs 344

Loan and Bond Instruments and Structures 346

Summary 349

References 350

Appendices 353

Appendix A Top 20 Commercial Airline Leasing Companies 353

Appendix B Top 4 Commercial Aircraft Manufactuers, 2011 354

Appendix C Top 20 Airlines, 2011 354

Appendix D World Airline Vital Statistics, 2011 355

Appendix E Aircraft Seat Capacity by Manufacturer, 2011 358

Glossary 363

Index 371