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Posts Tagged : aviation

Balancing the Books

Getting readers’ attention with a post about an accounting standard is not easy.

But when in a survey 90% of executives in an $800 billion industry suggest that one of the key pillars of their business will be subject to contract renegotiations because of accounting changes, some might want to listen up.

I’m talking about the impact IFRS 16 Leases will have on the airline industry when it comes into effect as of 1 January 2019.

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What’s going on?

To understand the impact of IFRS 16 on airlines it is essential to first explain some of the basics of aircraft management, i.e. how airlines operate their fleets.

Of the roughly 26,000 commercial aircraft globally today, 38% are no longer owned by conventional airlines, data from the Airfinance Journal Fleet Tracker shows. Increasingly, planes are instead leased from specialist lessor companies. The two largest lessors, General Electric’s GECAS and Netherlands-based AerCap own and manage about 2,000 and 1,500 aircraft respectively. In the words of The Economist, they are “airlines with no passengers”.

Leasing makes sense for most airlines. Because leasing allows them to scale fleets up or down quickly when demand changes, it reduces their exposure to volatile aviation travel markets.

Leasing is also less capital intensive than buying aircraft outright.

There’s something else, though:

If an airline buys a plane and finances it with debt, the plane will show up on the balance sheet as an asset, and the associated debt as a liability. If, however, the same plane is added to the airline’s fleet under an operating lease agreement, there’s no asset or liability to be recognised under the current standard for lease accounting, IAS 17. Operating leases are – until now – means of off-balance sheet financing.

Social_1200x628_GreenThat’s advantageous for airlines, because it means that operating leases have no impact on a number of key performance metrics, such as gearing, EBITDA, or return on capital employed (ROCE).

This off-balance-sheet treatment of operating leases will change when IFRS 16 kicks in in less than 12 months. According to Fleet Tracker, a whopping $325 billion of aircraft assets will then transfer to airline balance sheets.

The impact of the associated “new” liabilities on performance metrics could cause certain domino effects. For instance, in some cases credit ratings might change. Or airlines might break certain performance-related covenants in contracts.

And that’s why airlines think that operating lease contracts will be renegotiated.

When Euromoney Thought Leadership, working in conjunction with Deloitte, recently surveyed industry experts, 90% of airline executives told us that this is what they are expecting to happen. Even a huge majority of lessors agreed.

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If the airlines are right, the sector should get ready for flurry of activity to renegotiate lease contracts, in particular, according to the survey, with regard to the lengths of leases, lease rates, and security deposits. The lessors though, despite similar expectations, might be somewhat reluctant.

David Breen, for instance, is sceptical about renegotiating. The Head of Finance at Avolon, a lessor with a portfolio in excess of 900 aircraft, told Euromoney Thought Leadership that lessors – who face extra remarketing costs from shorter leases – would resist shorter leases.

There’s also little indication that the market for aircraft leases will dry up, even if some of the advantages of leases might be less pronounced under IFRS 16.

“The core commercial reality of lease rates and lease terms will remain consistent with the supply and demand we currently have in the market,” Breen says.

The survey data, at least, does not show that the market is about to collapse. 47% of respondents said the number of operating leases would decrease, leaving a small majority to predict either no change, or even an increase.

The complete report, Balancing the Books: IFRS 16 and Aviation Finance  by Euromoney Institutional Investor Thought Leadership in conjunction with Deloitte, is available for free here.

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UK Aviation after Brexit

Serving almost 76 million passengers in 2016, London Heathrow is Europe’s busiest airport. The decision by the UK government in October last year to support a third runway to be built by 2025 — after eight years of political squabbling — should pave the way for further growth.

But does it?

While a third runway might address the crucial capacity issue that is currently holding back the airport from serving more customers, the future of aviation in the country will also depend on, like almost all other aspects of the British economy and life, the terms of Brexit. And those are yet unknown.

International aviation is based on terms agreed between different countries in so-called air service agreements (ASAs).

In the early 2000s the European Court of Justice had ruled that any ASA between an EU member state and a third country needs to be open to airlines from all EU states. On that basis member states renegotiated around 340 bilateral ASAs in the past fifteen years to make sure they comply with the court ruling.

More and more often, the European Commission (EC) also took over as direct negotiator with countries outside the Union. Instead of leaving it to each member state to amend their respective bilateral ASAs, the EC negotiated new agreements with third countries that would cover all EU members. To date, the EC has negotiated new horizontal agreements with 41 countries, representing 670 bilateral agreements.

The implications for aviation in the UK in a Brexit-context are twofold: firstly, the country will need to come up with a plan to deal with those arrangements the EU has in place in the name of its member states. Most likely the UK will have to negotiate its own bilateral agreements with third countries currently covered under EU-wide horizontal agreements. And secondly, the UK will need to negotiate an ASA with the EU to address their future relationship in the skies.

Replacing the US-EU Open Skies agreement

One — crucial — example for an ASA negotiated by the EC in the name of EU member states is the Open Skies agreement with the United States. From the UK perspective this ASA, which came into effect in 2008, replaced the bilateral US-UK Bermuda II agreement, which had limited transatlantic competition from London Heathrow to just two US and two UK airlines.

It was the EU-US Open Skies agreement that opened up the market for competition as it exists today. Without Open Skies, disrupters like Virgin Atlantic would not challenge incumbents for routes to New York and other US destinations.

That’s why not replacing Open Skies, or doing so with an agreement inferior to the current arrangement, could have serious consequences for Heathrow as the dominating international airport in Europe.

Open skies

To find out how aviation experts expect this to play out Euromoney Institutional Investor Thought Leadership teamed up with Deloitte to survey more than 400 aviation experts globally.

Specifically, we wanted to know whether experts expect the UK to negotiate agreements that are, in essence, similar to the existing US-EU Open Skies agreement. We asked this question with regard to a future UK-US agreement, and to a UK-EU agreement.

The good news is: most of the respondents to our global survey think such agreements will come in the foreseeable future. Only 23% believe reaching agreement with the US will take longer than four years or not happen at all.

Less optimism about a deal with the EU

Interestingly, our survey panel — more than two thirds of which are C-level, VPs and senior directors — takes a somewhat more pessimistic view when it comes to a deal with the EU. 5% think the UK won’t be able to negotiate a deal with the Union at all (only 2% think so for the US), and 18% believe it will take longer than four years.

This expectation, that it will be harder to negotiate a deal with the EU than with the US, is confirmed even by those who generally think deals can be struck within the foreseeable future: Only 37% expect a deal with the EU to come within two years, versus 40% for a deal with the US. And, in line with this finding, 42% believe a deal with the EU will take between two and four years, but only 37% think so for the US. In short: Our panel thinks it will be easier and faster to get a deal with the US than with the EU.

If panellists are correct in their predictions, this could be bad news for Heathrow and the wider UK aviation industry. Europe is by far the most important destination for flights from the UK. According to the latest available data from the UK Civil Aviation Authority (for the rolling year ending Q1 2016), 61% of UK flights originate from or go to Europe. Only 9% of routes connect the island with North America.

In addition to the impact of Brexit, our report “Game Changer not Game Over” also looks at the challenges facing aviation and aviation finance in particular in light of upcoming international tax reform. The report can be downloaded for free from the Euromoney Thought Leadership website.

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