Challenges for the Aviation Industry | KPMG | IE
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Main Challenges

Main Challenges

Aircraft lessors are bullish about the global demand for aircraft and the relative health of airlines around the world.

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Industry cycles and areas of stress

Despite some airline bankruptcies, mainly in Europe, and other areas of stress around the world created by terrorism and war, sanctions and regulatory pressures, the airline industry remains profitable and passenger demand continues to rise, boosting demand for lift.

The relatively muted impact of the recent airline bankruptcies in Europe – Alitalia, Air Berlin and Monarch – is demonstrative of the current robustness of the aviation sector. Despite all three airlines failing within a short space of time, the aircraft were quickly taken up by other carriers, mostly in Europe, which is seen as a healthy development by lessors and airlines that view this as “back-door” consolidation, which most respondents say is still needed in the European market.

Lessors have differing views on whether the aviation business cycle should be revised in light of a change in the relationship between GDP growth and revenue passenger kilometres (RPKs). Despite the benign environment, lessors are always looking for signs of stress in the marketplace – rising interest rates, oil prices and operating costs, changes in liquidity and aircraft production rates. Rising competition is a major issue for lessors with new entrants coming into the space with lower cost of funds, which is being blamed for pushing down lease rate factors considerably.

Airlines are showing signs that rising costs are beginning to impact the bottom line, which are predicted to continue rising in 2018 at the same time as fierce competition is pushing down yields.

Banks are focused on interest rate changes and the continued robustness of the capital markets, while changes to the regulatory capital requirements rules dominate European bankers’ lists of challenges.

Regional Outlook

Challenges and areas of stress do vary by region. We asked executives from each of the three segments how optimistic or pessimistic they were for continued growth and opportunities in several areas of the world. The results were unsurprising – with optimism levels highest for China and Asia in general, although pockets of stress in South East Asia are a concern for some.

Financial Trends

Leasing companies are using the burgeoning capital markets more and more for raising debt and equity. In 2017, 12 ABS transactions were closed, which is the most since before the financial crisis. Furthermore, leasing companies are tapping into the secured and unsecured bond market to regularly raise operating capital. Capital markets investors are gaining a greater confidence in the robustness of the aircraft finance industry through cycles which lessors hope will ensure the markets remain open in future downcycles. However, there are concerns that the new investors coming into the space will exit when defaults do rise and some complex deals need to be unwound.

The American carriers continue to benefit from record-breaking price stamps on enhanced equipment trust certificates as well as unsecured bond issuances in the capital markets. The commercial bank market is also very open to airline credits, with the major aviation banking entities being challenged by financial institutions reopening or creating aviation finance teams, with balance sheet capacity for aviation deals.

New Technology Aircraft and Useful Economic Life

The entrance of new technology aircraft has changed the market and the number of variants being introduced by the manufacturers has complicated the environment. The 737Max family of aircraft, for example, has five variants, which is more than any product grouping in history. The Airbus A320/1 family is less stratified but this may change if Airbus launches a re-engined A321, dubbed the A322. For lessors, the key to purchasing assets is assessing the user base and in this regard the A320 Neo and B737 Max 8 should remain the industry workhorses. The financing of new, more liquid assets is also favoured by the banks but they mostly take credit risk rather than residual value risk on aircraft investments. However, for airlines the main driver of aircraft choice is operational efficiency.

The speed of technological advancements to engine and airframe design has led some to question again whether the economic useful life of an aircraft should remain at the standard 25 years. While most lessors agree that a 25-year depreciation curve makes the most accounting sense, there is some division on whether the economic life of a new aircraft is shortening or lengthening. Some consider the useful life of an aircraft to be closer to 20 years, where the economics of overhauling an 18-year old aircraft and revitalising the interiors doesn’t make sense.

Others view the technological advancements as increasing the useful life of an aircraft. Airlines, depending on their business models, either operate aircraft for their full life – 25-30 years – or tend to depreciate owned aircraft over 20 years to 10%.

There is a delicate balancing act for airlines between using new technology aircraft to hedge their fuel consumption, or owning lower cost, older aircraft that require more maintenance. However, most airlines agree that the customer’s preference is always for new airplanes.

Technology

Advances in technology is not confined to the equipment in the aviation industry. Like other industries, aviation is being impacted by the move to digitalisation, the advent of advanced technologies such as distributed ledgers, or blockchains, to big data and artificial intelligence.

For lessors, the onus to date has been on digitalising aircraft maintenance records – a major underlying factor in the appraised value of an aircraft asset – as well as how to manage and commoditise big data. More firms are leveraging software tools to streamline processes and have better visibility on the detail in the information they have already.

For airlines, the addition of predictive maintenance capabilities is a major benefit to their business, helping to reduce costs and time on ground, keeping their aircraft in the air generating revenue. Big data is also a major area that airlines are working on to commoditise their product offerings and to distinguish them from their competition.

The challenge for airlines and lessors for the near-term is to determine who owns the data generated by their aircraft – the OEM, the airline operator or the owner.

The financial services industry is undergoing a period of accelerated change as financial technology (fintech) disruptors encroach on market share in the commercial lending market particularly and internally, more and more financial processes are being digitalised and automated as banks find ways to become more efficient, regulatory compliant and meet rising customer demands. However, advanced technologies such as distributed ledgers (blockchain), artificial intelligence and machine learning, are yet to impact aviation finance in a meaningful way, according to most survey respondents, who maintain that the aviation business is relationship based and would not benefit from such developments, although there are those that would like to see most vanilla commercial banking transactions done online.

Final Thoughts

The mantra of many aviation industry economists over the past few years has been that the current operating environment is “as good as it gets” and there are few signs yet of that changing in the near-term. Despite the arguments over the shape of the cycle, the industry remains a cyclical business that will continue to be driven and impacted by changes in GDP even though its relationship with RPKs has altered slightly, which is making it very difficult for economists to predict the next downturn.

Pressures are building, however all three areas of the industry. Interest rates, oil prices and operational costs, such as salaries, are all rising. Increasing competition is impacting airline yields although passenger demand is offsetting that to keep profits up, for now. Liquidity remains but the recent past has shown that market shocks can cut off sources of liquidity abruptly.

Airlines are generally better at managing capacity, but competition pressures have fuelled expansion in pockets of the world that could see a correction.

New entrants to the leasing space and the desire for scale to heighten efficiencies and cut costs is driving consolidation in the leasing market but the general sense is that there will likely be more smaller scale deals than larger scale mergers although there remains the potential for some larger scale transactions, particularly if the market changes.

Awash with liquidity, banks are helping renew fleets. New technology aircraft are aiding the sector with airlines hedging their fuel risk with more efficient equipment, although there are some concerns over values being impacted by too many variants and a potential impact on the useful life of aircraft.

Advances in technology and big data to help drive predictive maintenance and better consumer services is helping airlines and lessors alike to cut costs and attract more customers. Despite being impacted by new technology disruptors in the financial services space, the aviation finance business seems insulated from the worst of this change and lags behind advances that could help to commoditise products, although there are differing opinions on the benefits of such progression.

The robustness of the aviation sector is attracting new investment into the space with aircraft leasing more recognised globally for generating strong and stable returns. This is attracting more talented individuals into the industry. Airline profitability is healthy thanks to better capacity and cost management and strong demand. The state of the industry is strong and durable and certainly as good at its gets going into 2018.

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