Escalate the problem or inflate a solution?

Aviation has been on a roller coaster. We have experienced the biggest drop in demand in its history and many airlines have had to make many adjustments to survive. While there has been a positive impact from the recent upswing in the Americas travel markets, Europe has been a case of starts and stops. Similarly, the Asian market has recently reopened many previously closed borders to attract more traffic, but there are still areas with stricter measures in place to prevent Covid that are weighing on the recovery.

Inflation plays a role in almost every segment of the aviation industry. It affects the price of planes, the debt; global operations of airlines and other aviation participants. One of the most important components of an airline’s cost base; other than fuel, is the aircraft itself. Inflation manifests itself in the steady increase in official list prices of aircraft from major manufacturers (Boeing and Airbus) and their suppliers, which we see publicly.

Manufacturers regularly raise their prices in the normal course of business. One aspect of this is due to the rising costs of the underlying inputs to production such as labor, raw materials, financing, etc. But the increases can exceed inflation in the event of increased demand dynamics. The last decade has not been unduly inflationary in terms of materials/labour and buyers have been relatively indifferent to inflation risks. Interest rates were for years at historic lows and commodities tumbled, but eventually stabilized at relatively low prices during this period (eg oil). No one seemed to remember the days of double-digit base rates or high commodity prices. This situation is exacerbated by the facilitation of growing demand and the use of escalation.

I have reviewed numerous aircraft purchase agreements between manufacturers and airlines/lessors, as an aircraft investor and former lawyer. They all contain price escalation conditions. Simply put, the price of the plane goes up if the manufacturer’s costs go up. I’m sure there may be a contract in the market that doesn’t have escalation, but that would be a rare case and even the most revered airlines have escalation clauses in their agreements. People in the industry will tell you that they negotiate escalation caps in their agreements, and I agree that those who place large orders or are established clients, generally cap their exposure. The cap sets a limit on the rate of price increase, i.e. the percentage by which the agreed purchase price of the aircraft can increase is limited to the amount of the cap – 3%, 5%, 6% or more, depending on who you are. The formula may have a sharing element above the cap and in times of “super inflation” the burden above a certain hurdle may fall on the client. It often depends on the strength of the market; the inflationary environment and the relative strength and influence of the buyer. There are, however, clients with unlimited escalations, and escalations are usually a compound formula.

As a general rule, a contract may indicate that the “Base Prices” of the “Airframe” and “SCNs” and the “Propulsion Systems Reference Price” are subject to revision in accordance with the different price revision formulas up to to and including the Delivery Date. » The formula in the United States requires that prices be determined at the time of aircraft delivery according to a formula, using adjustments linked to the employment cost index for workers in aircraft manufacturing – salaries and wages”, as well as the “Index of prices and producer prices – Index of industrial raw materials”, sprinkled with averages and theoretical rates. Fluctuating raw material costs, labor shortages, embargoes, punitive duties and supply chain disruptions mean manufacturers are facing unprecedented times.

Simply put, if you place an order for 20 aircraft over 5 years, the first will be closest to the initial contract price and the last could be significantly higher with inflation throughout the period. Even in times of modest inflation, this could mean a 15%+ increase with a relatively normal increase of 3% per year compounded. Most aircraft component manufacturers’ price lists increase by this amount every year. So where is the problem you might ask? The problem is that in times of hyperinflation an airline may not have anticipated such increases or may have been able to cap the fare at a lower level. Deliveries may have been postponed (which has also happened with many airlines and lessors following the Covid-19 disruption) and escalation will continue to accumulate from the year date of reference at which the purchase contract was signed, unless there is further restructuring or an expanded order. In the event of a postponement, the cost of the plane could increase considerably and the buyer may not have the means to finance the purchase. Long-term financing may have been arranged on strict terms or an SLB lessor-financier will have tied the final purchase price of the aircraft to the lease amount using a formula. The rent could be much higher than the airline had hoped or expected. A more expensive plane translates into a more expensive lease rate.

In terms of financing, interest rates are a primary factor and as transactions are normally in US dollars this should give investors and airlines sleepless nights. US interest rates have been extremely subdued, but are now expected to rise several times before the end of the year. Currencies can also be problematic. During the last recession, it was the disparity between the US dollar and other currencies that was a primary factor in the woes of many airlines in the developing world. Their income was in local currency and all expenses, such as rental payments, loan repayments, fuel, airport fees and insurance were in dollars. A variation of 30% of the relative values ​​cannot be absorbed by a reduction in costs.

Inflation could be helpful if you bought attractive next-generation planes before the inflation spike. If you have taken delivery of it recently, then compared to future rival aircraft, these rivals will be delivered at significantly higher prices. The observation seems simple, but if you are a lessor, you will have taken delivery and immediately rented the property on the basis of a pre-existing contract. Your benefit may be an accounting exercise (book value may be reassessed) as you are committed to a lease and only time will tell if the market accepts the perceived increase in value in the interval of the lease, in the event of a sale , or at the time of the lease end. A recession can also mean manufacturers are keen to offer incentives to attract new customers or a slowdown in travel in general.

If you are an airline, you may be able to resell and lease your aircraft at a higher price, although the lease is calculated based on this higher price. An ABS/EETC structure may allow you to borrow based on the revised valuation, but typically a redelivery will be financed by a bank or other lender, based on the contract price. Conservatism will creep in as financiers perceive more risk.

Those with older modern aircraft coming out of leasing could see leasing rates increase as values ​​may be adjusted upwards to compete with more expensive new deliveries. A word of warning, as older aircraft may not be as efficient and with current oil prices may mean they are not as economically viable. If you’re sitting in a room with aviation bankers these days, ESG can be abysmal for all but the newest types of assets. Older-technology widebody planes can cost up to $1 million a month more to operate than newer, more efficient offerings. A bigger problem for the many parked widebodies now that fuel prices are up and passenger cargo rules are being reintroduced.

Let’s also not forget that the airline industry has been on life support, bailed out by governments, banks and lenders to a level akin to an organ transplant. How can these airlines cope with higher rental rates, fuel, labor costs and overhead in a market where their consumers are struggling to pay their heating bills; refueling their cars and paying for food remains to be seen.

— With Tasos Michael, CEO of Inception Aviation Holdings Limited