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Dark clouds loom ahead of blue skies

New EU banking rules, oil price or interest-rate rises, and Brexit could cause turbulence for the aviation sector

Ryanair chief executive Michael O’Leary has been flagging the issue of flight agreements between the EU and UK after Brexit. Photograph: Nick Bradshaw

Ryanair chief executive Michael O’Leary has been flagging the issue of flight agreements between the EU and UK after Brexit. Photograph: Nick Bradshaw

 

The aviation sector has had a significant tailwind in the past three years but that doesn’t mean it is all blue skies ahead.

For a start, new EU banking rules, known as Basel IV, which are designed to ensure banks are sufficiently capitalised, may have unintended consequences for aircraft leasing.

Under them, banks will have to allocate significantly more capital against a loan, which will reduce profitability. The upshot is likely to be that banks will more frequently originate loans but then syndicate them on to other lenders. This could push up the cost of finance.

“Defaults in aviation loans have tended historically to be very low and that allowed EU banks to allocate very little against them, because they were so well performing. Regardless of that fact, banks will now have to allocate more capital against them. That will compress banks’ margins, or they will have to pass that cost on. Ironically, it also has the potential to drive banks into riskier deals because the capital required to be allocated to a riskier deal is the same as for a more conventional deal,” says Tom Woods, head of aviation finance and leasing ar KPMG Ireland.

On the capital markets side, appetite for aircraft debt has grown substantially. “International investors are seeing a maturing of the industry and getting more comfortable lending to it. We are seeing huge liquidity in the capital markets,” he says.

This is reflected in the fact that last year saw nine ABS (asset-backed securitisation) deals close, a 10-year industry high. “Capital market investors are searching for yield, looking at this sector and seeing that, for a relatively low risk, they could get a relatively decent return,” Woods says.

Aircraft offer a significantly more attractive investment option than ships, for example, not least because there are just two main manufacturers, Airbus and Boeing, enabling a tight correlation between supply and demand.

For airlines, with three years of strong profitability behind them, the mood is upbeat. Passenger numbers rose 7.5 per cent last year, 2.5 per cent above the historic 10-year trend of 5 per cent.

“We have a very benign market supporting good growth. In such cases, the question is always is a down cycle coming? Are we peaking?” says Woods, who interviewed all the major industry CEOs for KPMG’s Aviation Industry Leaders Report 2018, published this week.

Currently, the main identifiable clouds are the risk of costs increasing due to oil price, labour cost or interest-rate rises, he says. With aviation, there is always a risk of unforeseen shocks too, both natural and geopolitical, from pandemics to volcanoes to terrorism, all of which can dampen demand but are hard to predict.

Technology

On the technology front, however, the biggest changes in the industry will be evolutionary rather than revolutionary. Recent years have seen manufacturers introduce reengineered aircraft that are quieter, cleaner and more environmentally friendly. While there have been some clean-sheet designs, resulting in lighter bodies and more fuel-efficient engines, Woods doesn’t expect any more in the near to medium term.

Just as hotels have bed nights as a key performance indicator, the airline industry has its load factor. And, like Dublin hotels, these have been jammers, hitting 97 per cent last summer.

“On aggregate, the airline sector has not been profitable for years but the last three or four years have been a sweet spot, largely attributable to oil prices being low, which has allowed airlines to keep using older aircraft,” says Tom Conlon, academic director for UCD’s MSc in Aviation Finance.

If oil prices were to rise, however, things could change significantly, given that airlines spend 25 per cent of their revenues on fuel and operate on net margins that, at less than 5 per cent, are already tight. “Oil prices are a significant worry for airlines – if they go up, a lot will go under profitability,” says Conlon.

This will be compounded for those airlines that have lowered, and in some cases even eliminated, the amount of oil they have hedged, which some have done in a bid to cut costs.

And while traditionally funding was done on a secured basis, the trend for unsecured lending, as markets move towards riskier investment opportunities, is likely to continue. “Everybody is hunting yield,” he says.

For now, however, the mood is buoyant. “In terms of growth it’s all still positive and IATA’s latest figures in terms of passenger numbers are ahead of what it predicted,” says Angela Fleming, tax director at BDO Ireland.

Some US airlines have announced staff bonuses and, “if US tax reform does what it is supposed to, it will put more money in people’s pockets”, driving growth further, she adds.

On the hardware side, currently 40 per cent of global aircraft are leased and the expectation is that will rise to 50 per cent , “so things are very positive there too”.

The practical implications of Brexit, in relation to flight agreements between the EU and UK, have yet to be dealt with, says her colleague Carol Lynch, partner at BDO Customs & International Trade Services. “It’s an issue Michael O’Leary of Ryanair has been flagging and it’s a discussion that needs to be had, and quickly – legally it is a risk factor,” she cautions.

Equally, the implications of Brexit on airline share ownership rules must still be ironed out. “At present, under EU rules, airlines must be 50 per cent owned by an EU member country. Once the UK departs, airlines that currently adhere to those rules might find themselves in breach of them,” says Lynch. With the clock ticking on Brexit, that too is a runway that’s looking increasingly shorter.