Predicting Aircraft Valuation Trends
Few industries amplify the impact of the economic cycles as forcefully as the airline industry. For every yin of the economic boom when the industry is able to string several profitable years together, there is the much dreaded – but never surprising – yang of the economic downturn nipping at the heels and claiming yet a few more airlines (and related companies) each recession. Aircraft valuations, in particular, are very sensitive to the economic cycle. For the aircraft financing and leasing community that is dependent on aircraft collateral, the importance of future aircraft valuations is self evident. However, because aircraft are the principal asset bolstering the industry, variations in aircraft valuations have wide ranging implications that resonate throughout aviation.
Supply and Demand in a Cyclical Industry
Aircraft valuations tend to exist in a state of perpetual disequilibrium. This is due to the fact that on the one hand, passenger traffic (which represents the underlying driver of demand for aircraft) exhibits rapid and unexpected movements during turning points in the global economy. On the other hand, the production of new aircraft exhibits significant inertia due to the inherent complexity and large workforces associated with the aerospace supply chain.
The result of the foregoing is that aircraft OEMs will target production rates based upon long-term growth trajectories, allowing for minimal adjustments to output from year to year. The effect of this is that the OEMs will oversupply aircraft into the market as a downturn progresses, and undersupply aircraft into the market as an upturn matures. This stands in stark contrast to industries such as real estate where the supply of new stock can be more readily and drastically adjusted, and it is precisely the reason for the significant volatility experienced in aircraft values during turning points for the industry. Developing an index that attempts to measure supply-demand disequilibrium to statistically ‘explain’ cycles in the valuation of aircraft would therefore be helpful to the aircraft financing and trading community.
Aircraft Valuation Index
The basic framework of supply and demand can be used to develop a valuation index. While airlines use available seat miles/kilometers (ASM/ASKs) and revenue passenger miles/kilometers (RPM/RPKs) as supply and demand metrics within the industry, in developing the Aircraft Valuation Index the use of aircraft seats and not ASM/ASKs presents a more stable and predictable variable. ASM/ASKs are dependent on aircraft utilization and aircraft stage lengths, and therefore are vulnerable to slight changes in either metric. However, the supply of seats in the industry can be predicted with far more certainty, hence making aircraft seats a more reliable variable for developing such an index.
RPM/RPK growth is sensitive to the global economy and patterns of consumer spending thus making it less predictable than aircraft seats. However, we believe that this metric is the best indicator of demand.
The Aircraft Valuation Index is, therefore, comprised of:
- Supply: the existing inventory of worldwide passenger aircraft + aircraft produced by manufacturers in the relevant time period – aged aircraft listed as stored – retired, scrapped and converted aircraft; and,
- Demand: historical and forecast world RPM/RPK growth calculated by applying air traffic multiples to world GDP growth.
Figure 1 shows the Aircraft Valuation Index as derived by detrending the cumulative difference between the annual percentage changes in demand (RPM/RPKs) and supply (seats), indicating where valuations currently sit within the cycle and where aircraft prices are headed.
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Figure 1: Aircraft Valuation Index from 1970 to 2006 |
It is important to note that the Index does not directly measure the amount of fluctuation in the values of specific aircraft. Rather, it indicates the cumulative differential between the long term supply and demand for aircraft, with positive values indicating that cumulative demand is outstripping cumulative supply.
One of the central observations of this metric is that, contrary to the assumption behind appraisal base values, long term supply and demand are never in equilibrium but for quick crossover points. The intransigence of large and complex workforces, tooling, supply chains and lengthy production lead times makes it impractical, if not impossible, for the supply of new aircraft to mirror fluctuations in worldwide demand.
Historical Aircraft Values vs. Aircraft Valuation Index
When superimposing historical market values of aircraft on the Aircraft Valuation Index, both narrowbody aircraft and widebody aircraft display a significant level of correlation (with a few exceptions, which are generally explainable by exogenous forces). Figure 2 shows the Aircraft Valuation Index in relation to historical market values of narrowbody aircraft. In the case of the Boeing 737-300, the correlation between the Aircraft Valuation Index and aircraft historical market values is striking. The result is particularly meaningful given the large and diversified operator base for this aircraft type. (Correlation is measured by the indicator R2, or coefficient of determination, which measures the amount of change statistically “explained” by the Index over the measured time period. Note further that the levels of correlation are calculated using the following year’s appraisal value, further supporting the predictive value of the Index.)
The A320-200, on the other hand, outperformed the Index over the illustrated time period which we believe is due in part to the disproportionate growth of business models predicated upon point-to-point services and high utilization of aircraft, which generally favor new generation aircraft like A320s and B737 NGs (not illustrated).
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Figure 2: Historical Market Values Indicative of 5-Year Old Aircraft |
Historical market values of widebody aircraft (not illustrated) also result in a high level of correlation to the Aircraft Valuation Index with B747-400s and A330-200s having R2 of 75% and 66% respectively. The A330-200 slightly outperformed the Aircraft Valuation Index over the analysis period, which we believe reflects the relative growth of long-haul point-to-point services and an increased likelihood of a freighter afterlife.
Projecting the Aircraft Valuation IndexWhile the supply side of the equation – aircraft seats in the market at any given time – can be forecast with relative accuracy due to inertia in the supply of aircraft, the demand for air travel (and hence aircraft) remains the more illusive. As Figure 3 depicts, worldwide growth of GDP has a significant correlation with RPM/RPK growth and thus is a key determinant of demand for aircraft.
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Figure 3: World GDP vs. World RPM Growth |
Furthermore, a high level of correlation between GDP growth and RPM/RPK growth and a significant causal link between RPM/RPK growth and fluctuations in the Index ensure that the correlation between the Aircraft Valuation Index and World GDP is also relatively high.
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Based on the foregoing discussion, it is evident that forecast RPM/RPK growth is the key variable on which the behavior of the Aircraft Valuation Index depends. Using the Airline Monitor’s projected RPM/RPK growth as the base case, Figure 5 applies high and low RPM/RPK growth scenarios by adding and subtracting 0.5% RPM/RPK growth from the base over the projected period to illustrate the Aircraft Valuation Index through 2015.
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"Wildcard" Likely to Impact Magnitude of Next Downturn
A key consideration in assessing the next downturn is the fact that pilot contracts at four US major airlines become amendable between May 2008 and January 2010. Prolonged negotiations, in which the pilot groups expect to reap the rewards of an industry that may be at peak profitability, and to compensate for the sacrifices made during the previous downturn, could potentially exacerbate the next downturn given the fact that the US industry still represents a large proportion of the global industry.
Appraisers assume a reasonable degree of equilibrium in supply and demand to derive their long-term base valuations for aircraft. However, the impracticality of adjusting supply (new aircraft production) to demand (RPM/RPKs) means that steady state equilibrium in supply and demand will not coexist the vast majority of the time. This analysis derives an Index that gauges the relationship between supply and demand to determine shorter term trends in the valuations of aircraft.
Barring an exogenous event that shifts the consensus view of the current business cycle, the Aircraft Valuation Index suggests that aircraft valuations will peak at the end of this decade just when four U.S. major airlines are likely to be in labor negotiations, the results of which may very well impact the degree of volatility in aircraft prices during the next downturn.
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