5C.3 - Videos Credit Analysis with Andy Mansell PDF

Preview

Summary

Download 5C.3 - Videos Credit Analysis with Andy Mansell PDF

Description

1

I'll be here with Andy Mansell and we're going to talk about airline credit analysis. I've been ISTAT member for almost 20 years and I work for Aviation Capital Group. I head up the global marketing team as well as the aircraft trading team. 1. Why are aircraft financiers and lessors concerned about airline credit risks? the principal security for either banks or lessors is the aircraft itself. When you're looking at the aircraft itself, you then have to move to the jurisdiction as aircraft are mobile assets. So you have to go to the jurisdiction with within which aircraft operate. It's easier rather than looking at how you get an aircraft back from a non-performing customer. It's easier to look to the credit itself, the paying customer, and that would be the airline. And it is for that reason that banks or lessors are primarily focused on the credit being the airline. 2. How do lessor assess and manage airline credit risks? The easiest way to manage risk is to look at the payment record of the airline. So is an airline paying that's your number one. Outside of that, you look at there's four principal things you have to look at when you're looking at at risk. You have the jurisdiction, you have the credit, you have the asset type, and then you have the risk reward profile. You must get all three of the four. And in order or at a minimum, you must have three of the four in order to have a successful deal. Beyond that, you must look at the the history of the airline and then the pattern of the of the airline's performance in order to determine its payment record. 3. What are the most important quantitative factors to consider? Most people in the industry, be it banks or lessors have a very quantitatively focused our company is lessor. Quantitative factors are very important. But rather than look at the ratios or particular numbers, I think it's better to look at the patterns that that come from quantitative factors. So while they're important, they don't mean anything on their own without context. 4. How important is access to liquidity in times of market distress? Access to liquidity is vitally important, regardless of whether the market is in distress or not. Airlines, more than most other industry segments, rely heavily on, heavily capital intensive industry and cashes everything. You can have loss making airlines for decades that as long as they have strong cash flow, they're the perfect counterparty. The nature of the industry is such that, if you take your average narrow body aircraft, a 737 or A320 both packet that is 50 million dollar plane multiply that out of your Southwest. If you're a Delta, if you're a large airline, do 50 million times 600 aircraft and that's your capital investment required. Now factor in all of the other things that come into play. Forget competition for the moment and just think about operation. What happens if an aircraft is grounded because it has a bird strike on an engine? If you have 600 aircraft, that's going to happen as a weekly event. So now grounding aircraft now have an unscheduled maintenance event. What happens if you have a sudden drain of 100, 200, 300, 400 million dollar because of unscheduled maintenance? Then take a look at competition. Gordon Bethune, who used to be the CEO of Continental, has a famous quote where he said, you're only as good as your dumbest competitor. So a picture someone taken. Alaska Airlines, for example, has a very strong North-South network who is now expanding East West or a Virgin

2

America that's growing from its San Fran hub, competing against the likes of United or a Delta or American Airlines. And picture those airlines not wanting to sit by and watch their prime routes being cherry picked by new entrants or established entrants that are new in their market. Historically, if you take someone like a British Airways and who had a or has London, Seattle, for example, as one of their prime routes when another airline started on the same route, British Airways upped its frequency from one 747 daily to two 747 and a 777 daily. Definitely not profitable, but that is to protect their market. The point being that you get a large airline that might be willing to lose 500, 600, even a billion dollars on a single route to protect it for the long term. All of this comes back to cash. If you don't have liquidity, then you don't have the ability to protect yourself against operational risk or competitive risks. 5. Are balance sheet or profitability metrics more important? I would it almost generates more questions. The reason I say that is how can you say what is more important than the other without considering them together, simplistically or intellectually? The profit and loss statement has to be more important because cash is king and cash comes from P&L. However, if the two of your profit and loss and your balance sheet are not in balance, there's something wrong. Let me give a couple of examples. If an airline is making 200 million dollars a year and it has net equity of 300 million dollars, where is their profit going? Are they pulling it out of the airline as they something out of sink with the balance sheet and the P&L. The two have to be in balance much the same. You can turn this around. What if you have to have an airline that has a billion dollars of equity and is making a million dollars a year of profit? That sounds like an airline in decline without the context behind it. You can't say that one is more important than the other. If you're generating strong cash through the P&L, how can you not have a strong balance sheet? The answer might be that you're a growing airline and you might be an emerging LCC. You could be a recovering legacy carrier, but there has to be a story around it. But it's not really possible to have a strong P&L or weak balance sheet or vice versa without having good story behind it and the airline being successful. 6. Why do qualitative factors matter? What are the main qualitative factors to consider? Qualitative factors to ecg everything, they are the context behind the numbers, and I would present it like this, you can look at any balance sheet or any P&L for any airline and you cannot tell how good that airline is. What you need is the story behind those numbers. The qualitative factors could be described to me as the changes in the quantitative factors. So you could take the ratios, you could take your publicly traded lessors, your publicly traded airlines, and look at the at the trends over time or the ratios that these revenue statements and balance sheets produce. And the real interest to me is why the numbers have changed. So the two principal things to focus on are the why and the how. Why have they changed and how is the airline going to deal with it? Examples are numerous. You could have two revenue statements. You have an airline that's making 200 million a year and an airline that's losing 100 million, which is the better airline? And you cannot give me the answer to that without knowing what the qualitative factors are. For example, the airline that lost the money may have purchased a competitor, may have launched 50 new routes and what will be wonderful markets may have had a tremendous

3

business opportunity that produces short term losses or it might be an airline in decline. You have to know the answers. The airline that was producing the 200 million dollars of profit, if you go back three years, maybe it was making one and a half billion dollars of profit. So you still telling me that is the best, that is the better airline or is that an airline that is slowly dying? 7. Is the credit analysis different for LCC versus a flag carrier? It's different, but it's also different for every airline, depending on where it is in its maturity cycle and its growth cycle. So when you're looking at the flag carrier versus the LCC, is the flag carrier dominant in its market? Is the flag carrier showing signs of decline, is the flag carrier protecting its market well? or is the flag carrier looking like it's being squeezed by the Emirates effect, which almost everyone in the world is from the top end and LCC affect from the bottom end? If you're looking at LCC, how well capitalized are they and how fast are they growing? Are they perhaps adding too many aircraft and are struggling to deploy them profitably? Or are they perhaps capital constrained and they're not growing fast enough? Let me look at a couple of examples, in the U.S. If you are a new airline and you are growing airline, if you can’t deploy a typically 50 or more a/c, you gonna struggle in this market, the dominant carrier, the United, the Delta, American, Alaska, Jet Blue aren’t going sit by and watch you take their market, in the states, which is the most well-traveled population in the world. In the states, you have to provide frequency. No one is going to fly on an airline where they can't fly back on a Tuesday because the airlines not flying. And then look at what the competition do, the United's and Delta of this will probably fly 6 times a day to that market. So you have to have a critical mass. So when you're looking at an LCC, you're looking at how well funded is the airline for its future growth. When you're looking at a flag carrier, you're looking at how well that carrier has adapted and adjusted to what has proved to be a very dynamic and challenging market over the last couple of decades. So a flag carrier, you know, what you want to look at is how is that? What does their CAPEX look like? How modern is their fleet? How well are they responding to the competitive threats out there? So it's a different analysis for the LCC than it is the flags. But frankly, it would be a different analysis if you're comparing one flag carrier to another flag carrier or one major to another major or one LCC to another LCC, you have to dig and have a look and see how dominant each airline is in its own market. 8. How important is fuel to the cost structure of an airline? Other risk factors like labor contract status? The answer is fuel and other factors that I'll cover are vitally important and also not. So important, let me reverse that around the not so important is because fuel, labor law and other industry influencing factors are the same for everybody. Pretty much. If you turn that back around, though, fuel historically, if you go back 20 years, fuel took May represented maybe 20% of an airline's cost. These days it's more like 30% or higher of an airline's cost. The management of the fuel risk, if you like, well, that cost risk is and is managed through hedging. But if you get the hedging the wrong way round, that itself becomes a risk. So take LCC, one of the LCC that I used to cover told me that they didn't hedge a dime in fuel because they already didn't like the cost of fuel. So why would they lock in that cost? If you look at a most recently Delta and its last quarterly results, it had to write down a billion and a quarter dollars in fuel hedges where they're

4

the wrong way round in the market. After the market dropped as much as it did, Delta didn't really care because they're the benefit after that was two and a half billion on the upside. My point being is that you can feel like you are being the most responsible airline and you hedge forward. How far forward you might hedge 12 months, 18 months forward on fuel, looking for this average plan that, you know, you're going to be profitable at. And that worked great for a lot of airlines until fuel drop to 50 bucks and then below 50 bucks a barrel. And then the airlines that run hedged have a cost advantage. That is absolutely mammoth. The plus side for these airlines is that cost advantage is not being passed on to the passenger. It's been a tough industry for a long time, and airlines will just take that to their bottom line, outside of fuel rather than individual costs. It's better to look at how some of these costs or influencing factors come together and affect airlines. For example, we already have low fuel. What happens if we have rising interest rates ? That looks to be on the way in the US and we already have a strong dollar. You have two of these three things being low fuel costs and a strong dollar already have a marked impact on airlines. The fuel we've covered, the strong dollar makes a huge difference for any airline that has aircraft on order from the manufacturers because all aircraft are paid for in dollars. So if you're not generating enough dollar income to cover your capital expenditure, which is primarily buying new planes. Think of the impact there's if you're a Russian, for example, the ruble is now worth less than 50% of what it was just a year ago. Go to Europe. The euro has devalued against the dollar. So has almost every single currency. So forget fuel for the moment. If your currency has devalued against the dollar by 5%, 6%, it doesn't sound so much, but your aircraft just became more expensive by the same percentage. If you're talking about a widebody aircraft, that's 150 million dollars on average. If you're talking about something as big as an A380, that's an almost 300 million dollar aircraft. Add 5 or 6% to the cost of that plane and then plug that back into your model and now see how viable that aircraft is for you. If you now add the interest rate cost to that, you probably had to borrow money to buy such an expensive asset or to buy the quantity of aircraft. So if it costs more to borrow and the aircraft is now more expensive, plug that back into your model and see how viable that aircraft now was in your operation. So those costs is not an individual cost that impacts the airlines as much as combining costs or factors together and then seeing what their impact is 9. What are the challenges of assessing the risk of an international airline? The challenges of an international airline in some ways are more and less of a domestic airline. The domestic airline has the comfort of not being international, but it's also confined by the very same factor. So its strength is its weakness. Its 100% captive to that market, when you go international, you then have to look at the two primary factors, one is the route structure, and then the second is the currency risk. You know, the exchange currency risk that that airline has. The international airlines that scare me are the ones that are new to the market and the sort of airline that says, look, I can do this. I have a lower cost structure than British Airways, Singapore Airlines, Lufthansa, and that usually is the airline that will be out of business in 12 months because those airlines are not going to sit by and watch prime routes being cherry picked by a new airline. The point is, is that the international market is quite crowded. So then you have to look at the types of business in the international market. If someone said to you, I'm going to form a new international airline, I'm going to have a premium product and I'm going to fly to the

5

Arab states, I'm going to fly to the UAE, everyone would say you're nuts because of the concentration of airlines that Emirates, Etihad, Gulf Air, Qatar, and they'd be right. So then what if you said I am going to fly internationally, but I want to focus on the leisure market and that that's where I'm going to fly? I'm looking at the Canadian market, perhaps the snowbirds, the people who I have to get out of the cold. And they're very cost conscious. They don't want the overhang that these other major airlines provide. They have no interest in business lounges. They don't like hot meals. What they want is the cheapest ticket. And that, too, may work. The downside, as you just said, that you're flying for one season. So what do you do in your business plan for the season that is not peak? So how do you deploy your fleet? What do you plan to do at that time? Making money in the peak season? Anyone can do that. It's how you deploy your fleet when it's not the peak season and that is about protecting the profit that you made. So when people fly internationally or airlines fly internationally, they reap the rewards of having a varied or a diverse income base as it relates to currency. But is that good or is that bad? Do they now need to hedge against that? What happens if you're earning all of your money in euros, but all of your expenses are in dollars or 60% of your income is now coming from the Japanese yen or from a even worse, a currency that is not majorly traded? How do you hedge against that? So it's the balance that you want to achieve internationally that becomes more important. For the major airlines if you think of the everyday airlines that you would fly on, though those airlines I would consider to say I'd naturally hedge because they'll have considerable expenses in the markets from which they operate. So, for example, if you fly from the US to the UK when you need fuel for the return flight, you're going to be paying for that and the currency and the country that you're at. In this case, you'd be using pounds in the UK, having UK revenue from the passengers that you're bringing back to your market. That is a natural hedge. So you'd have no exchange rate exposure in that sense. So there's a lot of upside for airlines that can match their expenses with their income and the same currency. It's just a natural hedge. But there's also a lot of downside. If you've read the papers about Venezuela and the number of airlines that have stopped flying there as they could not expatriate the money that they'd earned there back home. And that number is huge for some airlines. I don't want to name the airlines, but some airlines have more than a billion dollars stuck in Venezuela with a threat from that government that if they stop flying, they won't get any money back. That would be the extreme example of what happens. You know, if you cannot, you just cannot hedge your currency risk. Additionally, you also have this issue. How do you price a ticket for customers that do not come from your country? Do you price it in dollars or do you price it in their currency? What happens if between the time you price and the time that passenger flies that say that currency has devalued by 40%? Because I can guarantee you're not making money at that stage or the currency may have appreciated against yours. So these are things that have to be considered by these airlines and the airlines that deal with it the best are the larger airlines, because it goes back to what I was saying earlier, that there's a natural hedging process where you get to align your cost base and those countries with your income from those countries and if you've operated there for a long time, you can see the trends and the patterns yourself and you know how much you have to hedge in order to protect yourself against exchange rate movements. 10. Summarize your thoughts about airline credit analysis of what are the main important things you consider?

6

The two principal things I think are really important is to always ask why and how, airline analysis can be very complicated and it's best to simplify it first. The numbers are critically important, but the numbers on their own don't tell us. Don't tell the whole story. So always look at the numbers. We have to start with the numbers that there is so much data out there in the industry. So take the publicly traded airlines, take the closest publicly traded airline to the airline it is you want to analyze yourself. Look at the analysts’ comments and where he writes the airlines on a strong points and its weak points and then use that as the basis or as a yardstick for looking at the airline that you want to look at. One year's numbers for an airline. I mean, absolutely nothing. You've got to have at least 3 years in order to see what the pattern is, what the trends are. And that's the color behind the numbers. And that's the qualitative factors, if anyone in my team comes to me and says, this is a well-capitalized airline. My immediate question is, well, what is that number? And if the number is 50 million, so what does that mean to me? How many aircraft does this airline have? What is the competitive environment that airline is operating in? If someone has a billion dollars of equity, that sounds l...