As airlines prepare to expand their fleets for the upcoming travel season, global financial market volatility casts a shadow over their financing plans. With rising borrowing costs and uncertain prospects for leasing companies, how can carriers navigate these challenges to make prudent leasing decisions that ensure profitability? This analysis examines the financing dilemmas facing airlines, explores the future of aircraft leasing markets, and provides practical valuation methods to help airlines seize opportunities in this complex environment.
I. The Airline Industry in Financial Crisis: Challenges and Opportunities
While airlines aren't directly exposed to complex financial derivatives, the credit crunch stemming from financial crises is beginning to impact the sector. Carriers across all business models face mounting borrowing costs. For instance, the CEO of Air France-KLM reported the company's borrowing costs have increased by 2-3% over the past year. Low-cost carrier Monarch Airlines noted its LIBOR spread has doubled from 0.80-1% in normal markets to 1.80%.
A key medium-term challenge is whether operating lessors can secure sufficient funding for aircraft deliveries in coming years. Boeing previously projected operating lessors would finance 22% of its 2008 deliveries, down from 34% in 2007. While export credit agencies may fill some gaps, this remains a crucial funding source for the 1,200+ aircraft scheduled for global delivery. The situation grows more precarious as airlines continue taking delivery of thousands of aircraft ordered during the recent boom, driven by low-cost carrier expansion, growth in China/India/Middle East, and demand for fuel-efficient aircraft amid high oil prices.
II. Operating Lessor Outlook: Resilience Meets Uncertainty
Can operating lessors meet this financing challenge? Market attention focuses particularly on International Lease Finance Corporation (ILFC) after its parent company AIG's near-collapse. Under government rescue terms, AIG must pay up to LIBOR plus 8.50% on its $85 billion loan, and has indicated ILFC and other "non-core" businesses are for sale.
Despite current turbulence, operating lessors have demonstrated remarkable resilience during past downturns, maintaining operations even when airlines failed. After 9/11 and its aftermath led to bankruptcies like Swissair and Sabena, major lessors absorbed the shock by keeping aircraft operational, even as lease rates plummeted during 2002-2004. This track record proves the sector's fundamental viability, making ILFC potentially attractive to well-capitalized investors—especially as more leasing adopts sale-leaseback structures that provide stable payments for 8-10 years.
III. Core Competencies of Operating Lessors
Leasing companies typically operate lean with key capabilities most financial institutions lack:
- Aviation technical expertise: Enables careful ordering, strict maintenance requirements, and quick turnaround of expiring aircraft.
- Global reach: Allows redeploying aircraft to growth markets when others face crises.
However, access to low-cost aircraft financing—their third critical capability—is now threatened. Major lessors can't avoid reduced debt financing availability, especially those traditionally relying on short-term commercial paper markets. AIG's collapse has dramatically lowered ILFC's credit rating, increasing borrowing costs unless a deep-pocketed buyer emerges quickly.
IV. Airline Options: Valuing Leasing Flexibility
The operating lease model transfers residual value risk to lessors, with airlines paying for this through higher implicit financing costs in lease payments. Leasing provides strategic flexibility for major global carriers, with a common rule of thumb being to lease about one-third of capacity. By staggering return dates, airlines ensure capacity expires annually if demand drops—as currently anticipated in Europe/North America. Lessors' global reach should enable redeploying this capacity to still-growing markets like the Middle East.
V. Lease Valuation Techniques: Quantifying Flexibility Costs
The operational flexibility and risk transfer provided by lessors comes at a cost airlines must quantify. Finance managers can use two primary evaluation methods, both based on discounted cash flow (DCF) techniques:
1. Real Options Analysis (ROA): Uses Monte Carlo analysis of project NPV to quantify risk, then inserts resulting volatility into binomial lattices to calculate option values for returning/re-leasing aircraft. However, volatility calculations rely on potentially unreliable historical/subjective estimates, and the complex "black box" methodology faces skepticism from practitioners.
2. Adjusted Present Value (APV): Our research with Cranfield University's Dr. Peter Morrell shows most airlines use NPV/IRR rules for aircraft investment evaluation. Building on this, we propose an APV variant that clearly assesses risk transfer costs by discounting different risk-class cash flows at appropriate rates.
VI. The APV Approach: Clearer Lease Cost Assessment
| Discount Rate | Purchase Scenario | Operating Lease Scenario |
|---|---|---|
| Debt Cost | Financing cash flows: interest and principal payments | Lease cash flows |
| Equity Cost | Operating cash flows; aircraft purchase and residual value | Operating cash flows |
This method offers two key advantages:
- Clarifies that aircraft ownership/operation risks are borne by equity investors
- Directly compares financing options and estimates flexibility costs inherent in leasing
Valuation differences prove significant. First, APV yields lower overall valuation by discounting operating cash flows at higher equity rates, correctly reflecting shareholder risk. Second, purchase scenario APV exceeds operating lease, showing residual value risk transfer costs. In our example, leasing's additional cost versus borrowing is clearly identified at $4.4 million per aircraft.
VII. Conclusion: Prudent Decision-Making for the Future
Many global airlines will focus more on financing availability than cost in coming years. However, carriers that carefully evaluate aircraft financing alternatives using robust valuation techniques will see benefits on their bottom line. By deeply understanding leasing market mechanics and applying appropriate valuation methods, airlines can make wiser decisions to maintain competitiveness and achieve sustainable growth in challenging market conditions.