Battle-tested: Aviation’s terrible year, Dublin’s status, and the striking resilience of the aircraft lessors

This week is usually a hectic one of breakfast meetings, lunches, and dinners for the world’s aviation leaders. Last year, over 2,000 executives flew into Dublin to attend back-to-back Airline Economics and Global Airfinance Conferences, in a week that brings the entire industry together.   

This time, with the conferences taking place virtually, there isn’t the same frenetic pace. But it is still an intense week, albeit built around computer screens. With all of the world’s top 25 aviation firms owning assets or platforms in Ireland supporting some 5,000 jobs, the sector remains incredibly important, despite the onslaught of Covid-19. 

Thirty-eight-year old Joe O’Mara, who is head of aviation financing and leasing at KPMG, has taken time out between meetings to talk to The Currency as KPMG publishes its annual report into the industry called The Aviation Industry-Leaders Report 2021 – Route to Recovery. The report draws upon the experience of some of the biggest players in the sector including Aengus Kelly (AerCap) and Michael O’Leary (Ryanair).  

O’Mara is open about the challenges facing the sector, as well as the new emerging themes as it adjusts to life after the crisis of Covid-19. I’d interviewed him this time last year when the virus was not on the airline industry’s horizon outside parts of Asia, so it is back then where we begin.  

Tom Lyons: When we last spoke in January 2020 we discussed the expectation of a super cycle in aviation finance but instead, we had Covid-19. How would you describe 2020 for the sector?

Joe O’Mara: For aviation, the pandemic has clearly delivered the largest exogenous shock the sector has ever faced, and 2020 was the most challenging year the aviation world has ever faced. COVID-19 resulted in a collapse of air traffic, particularly internationally. Annual air travel growth has averaged four to five per cent in the last 20 years, generally following a two time multiple of global GDP. The 2020 figures highlight the outsized impact the crisis has had on aviation. Global GDP is expected to contract by less than five per cent in 2020. By comparison, Revenue Passenger Kilometres (RPKs) fell 65 per cent in 2020, with a reduction of 88 per cent in international RPKs and 41 per cent in domestic RPKs. 

TL: The industry swung from a profit of $26 billion in 2019 to a loss of over $118 billion, an incredible turnaround, how do you expect 2021 to go financially, and how soon might the sector as a whole return to profit?

JOM: The early International Air Transport Association (IATA) forecast for 2021 is for this loss figure to reduce to a still monumental figure of $38 billion. The name of the game is survival for now and there is no concrete expectations on what year profitability will come back. 

The longer term forecast for the recovery in air travel might give some guidance. IATA’s expectation on that front is that it will be 2024 before we see a return to 2019 levels of air travel. That said, aviation has always been a cyclical sector, and the bounce backs after previous downturns have been dramatic, so hope remains that the vaccine releases that pent-up demand to allow traffic to recover quicker than expected.  

TL: We’ve seen some casualties in the sector in 2020, but not as many as were at one stage feared. Why is that? 

JOM: The primary driver of this has been the remarkable levels of government support, which has now topped $170 billion and come in the form of loans, guarantees, wage subsidies, tax deferrals and equity injections. 

We have also seen airlines, predominately in the US, raise significant debt on the capital markets, where the demand was reflective of the wider yield chasing environment. A further sign of airline resilience has been the innovative fundraising that has been backed by the use of loyalty programmes, gates, slots and routes. 

These levels of additional debt and support will have wider long-term repercussions for the airline sector, but the here and now is about survival and every dollar is welcome. 

Airline survival has also been aided by an environment where enforcing on one’s security (either as a lessor or a banker) is a zero-sum game. With no current market for repossessed planes, lenders and lessors have been flexible creditors, if at all possible. Better to have your asset with a distressed customer than none at all. 

On the aviation finance side, aircraft lessors have felt the impact of the crisis from the outset as they dealt with widespread deferral requests from their airline customers. As the challenging environment prevailed, these deferrals in some cases have morphed into more complicated lease restructurings. However, by the end of 2020 the level of deferrals had reduced significantly. Aided by the strong liquidity position of lessors at the outset of the crisis, we have seen limited public distress in the leasing community, with few formal debt restructurings. 

TL: Do you think there might be a lag where companies who survived 2020, fail in 2021?

JOM: On the airline side, the next six months heading into the summer season will be telling. This is when airlines make the majority of their revenues and it remains to be seen if vaccine rollout will allow for a reasonable summer season. 

The other point to note is that the driving factor behind the vast government support is the strategic importance, both from a trade and tourism perspective, of having airlines flying in and out of your country. This fundamental fact won’t change in 2021 and so you are unlikely to have a dramatic shutting off of government support in the near term. 

On the leasing side, those at risk are perceived to be newer entrants, who lack a committed deep-pocketed shareholder and do not have an investment grade status to support them accessing the bond market. That said, there is not an expectation that we will see widespread distress coming through in the leasing sector. 

TL: There has been resilience too in the sector, what determines which firms win and lose? Who do you think specifically has done well?

JOM: The key metric now is cash. For airlines, those that manage cash burn and maintain liquidity will be best placed to prosper. You will recover more quickly in situations where you have a greater reliance on domestic travel and do not have a significant focus on business travel to drive revenues. You can see that some of the low-cost carriers (Ryanair, Wizz) are looking at this crisis as an opportunity to increase market share over the medium term. 

On the aircraft leasing side, we have seen the large investment grade lessors display a remarkable ability to raised unsecured debt at reasonable rates. AerCap deserve kudos for being the first to test that market in June of last year. Since then, many others (the likes of Air Lease Corp, Avolon, DAE) have gone to the capital markets and raised unsecured debt at rates which compare reasonably to the pre-COVID period. 

While this is reflective of the macro capital markets environment, it also highlights how aircraft leasing continues to become more mainstream and that there is significant market confidence in the business model. 

TL: Usually, when a sector goes through a big shock, there is consolidation and M&A. When do you think we will see that in aircraft leasing?

JOM: Leasing companies have a long track record of delivering impressive returns and generating a lot of cash. As such, large scale M&A in aircraft leasing has generally been driven as a result of a distressed seller, rather than a desire to offload the business. 

In previous downturns, that distress has taken a couple of years to push the seller into action. For example, the AerCap acquisition of ILFC arose out of difficulties that AIG faced as a result of the financial crash, but this deal didn’t happen until 2014.

There is a general view that we could see some acceleration to that timeline, and we are aware of a couple of transactions that may take place on the leasing side over Q1 or Q2 this year. It will be an interesting time over the next 12 to 24 months. 

TL: What will the crisis mean for the demand for more fleet in the sector? Will there be a glut of airplanes that mean that airlines don’t have to upgrade their fleet?

JOM: The crisis will accelerate the retirement of certain older types of aircraft and will have a greater impact on widebody aircraft. Airlines that have the bandwidth to act strategically will take the opportunity to avail of the replacement cycle and move to newer technology, more fuel-efficient equipment. The A320 neo family and the 737 MAX will remain in high demand. 

On the manufacturer side, the duopoly of Airbus and Boeing is expected to continue to act rationally and manage the supply side in a reasonable fashion. 

For Boeing, coming off their lowest production numbers in 40 years, the recertification of the 737 MAX is a major milestone. As can be seen from recent sale and leaseback activity, the aircraft has widespread support across the airline and lessor community. It is hoped that customer trust can be quickly earned. How the dislocated market responds to the 400 manufactured aircraft that were awaiting delivery will be interesting to observe. 

TL: In terms of financing, a lot of the traditional financiers in the sector are nursing big losses and understandably have slowed or stopped lending. Where can fresh financing be found?

JOM: Given the market uncertainty, the traditional aviation banks have retrenched and the ability to obtain warehouse facilities or non-recourse debt is extremely limited. As I mentioned earlier, the capital markets have stepped up in a big way and will likely to continue to be a key source of funding. 

Given the quantum of additional liabilities airlines have assumed, it is generally expected that there will be an increase in the importance of the leasing channel for airlines as a funding tool. The broad consensus is that the percentage of leased aircraft will break the 50 per cent barrier in the coming years. 

Those lessors that either have a very supportive shareholder – the likes of SMBC, BOC Aviation, CDB – and those that can access the capital markets – the likes of AerCap, Avolon, DAE – will be well-placed in this respect. 

We may also see an increase in non-traditional lenders into the space. Castlelake are a good example of someone who is exploring this area. 

The ABS (asset backed securities) market has become a key pillar of aviation finance and it funded $10bn of aircraft purchases in 2019, attracting new investors to the space. The ABS market has been effectively shut to aviation since March and there are mixed views as to when it will reopen.  I expect we will see it return in a reduced form over the coming months and that would be a positive step for the sector. ABS debt will be important in driving the trading market, particularly given that the bank market will likely be constrained for some time.   

TL: The last time we spoke President Trump was in office and there were fears of trade wars etc. Do you think the new US administration will be good news for the sector? Could it lead to extra taxes?

JOM: There was some concern that the US cut to federal taxes, which went from 35 per cent to 21 per cent under the Trump regime, could have impacted the Irish leasing sector. However, this didn’t prove to be the case and that federal rate is only going one way with the Democrats controlling the three branches of the US government.  

Under Trump, we have seen challenges on the tariff side between the US and Europe which have impacted Boeing and Airbus. There is a hope that this issue will dissipate with better EU/US relations likely under the Biden administration. 

We will also likely see a greater focus on climate change issues, and this could accelerate the shift to newer technology aircraft. This will have repercussions for the sector and be positive for some and more challenging for others. 

TL: Dublin is a global capital for aviation leasing. Do you have a sense of how many job losses there have been in the sector?

JOM: I’m not aware of any significant reductions in work forces. In looking at a leasing companies, staff are generally well remunerated – the most recent CSO report put the average salary of the 2,000 or so direct leasing employees at over €200,000. However, salary costs remain a relatively small part of SG&A (selling, general and administrative expense) for such a capital-intensive business. 

If you have the belief that the market will recover and that demand for leasing will remain strong, then it logically follows that companies will want to maintain talent. 

TL: What has been the impact on pay and bonuses for employees in aviation leasing traditionally one of the best-remunerated sectors in Ireland?

JOM: This is not something I would have close sight of. Though I would note that ultimately the individuals who work in the sector are well paid as they are highly skilled. A lot of those skills will be transferable to other sectors and the war for talent has not gone away as a result of COVID. There are plenty of areas within our economy that are performing very well and highly skilled people will remain in demand. Those that want to take advantage of a recovery will be doing their best to retain and motivate their teams.

TL: Is there anything the government could do, if anything, to help the sector?

JOM: There are a couple of factors to consider here. One is our international reputation. Aviation is of pivotal importance to our small open economy. We are clearly in a very difficult time from a health perspective. However, as we manage our way out of this crisis, there will come a time when people will look at how Ireland acted in the context of international travel, versus our peers. It is important the we act with appropriate foresight and an appreciation of our international reputation. I was pleased to see us sign up to the EU travel traffic-lights system. We also need to make sure we have a best in class testing system for international travel. While we need to be careful in how we manage the reopening of the skies, we also need to be cognisant of the fact that Ireland’s outsized place at the centre of the aviation world is fragile.

The second is around policy. The key tax factors that support the sector are the 12.5% corporation tax rate and the strength of our international tax treaty network, which helps manage withholding tax costs associated with lease payments from airlines to lessors. The government have been strong supporters of these tent poles and that should continue to be the case. 

It was great to see that Taoiseach Micheal Martin joined one of the virtual aviation conferences this week where he was interviewed by the Avolon CEO Domhnal Slattery and he reiterated Ireland’s commitment to supporting the sector and acknowledged the important role it plays in our economy. 

TL: Hong Kong and Singapore are two of our competitors. Is there anything they have done we could learn from, or need to respond to here?

JOM: Aircraft are a mobile asset class, and the likes of Singapore and Hong Kong are constantly looking to challenge Ireland for market share. We have a great position as the global leader in aircraft leasing, but we can’t take that for granted. 

The advantage those jurisdictions have over Ireland in terms of attracting people is their low personal income tax rates and that they also give you closer proximity to the Asian customer and investor base, which are of critical importance in this sector. We can’t compete on those fronts. 

However, we have a better tax system for lessors (particularly with respect to our tax treaty network) and we have a much wider talent pool that has built up over decades. 

We need to keep attracting key talent into leasing, notwithstanding the current challenges, and to maintain that government support we spoke about earlier. 

TL: Climate change and carbon emissions remain a challenge for the sector. Given the crisis, are you concerned it could slip down the agenda for the aviation sector? 

JOM: While it has been less talked about in 2020 as survival was the main focus, it remains to the forefront of the industry’s mind. Everyone acknowledges that the issue of climate change will continue to rise in importance for the sector as a whole. ‘Flight shame’, the imposition of environmental related taxes and the increased Environment, Social and Governance (ESG) focus of investors are real concerns for the industry. It was interesting to note that some of the government support provided over the course of 2020 also had certain ‘green strings’ attached. 

Improvements are being made through new aircraft technology efficiencies and significant investment is being made into alternative fuel sources and hybrid-electric technology. There is general agreement that the sector as a whole (manufacturers, airlines and lessors) needs to better promote the significant positive efforts that are being made. There is less consensus on who should own and promote this message and that is a challenge the sector needs to address in the near term.   

TL: And finally, I know after last year predictions can be hard to make, but nonetheless, what do you think overall 2021 will look like for the sector?

JOM: I’ll give you my hopes rather than hard predictions. An efficient vaccine rollout that releases the huge amount of pent up demand and drives a material bounce back in air travel, though this is more likely in the second half of the year. Hopefully we see limited airline failures as a result of this. We will see the leasing channel grow in importance over the course of 2021. I expect to see a lot of new capital enter the space. We have seen and will see more private equity groups partnering with established leasing companies, looking to invest at what is hopefully the start of a new cycle. Distress drives opportunity. While it is clear there will be financial losers as a result of the pandemic, those that invest at the right time in this new cycle will make significant returns. 2020 was the most challenging year the aviation sector has ever faced. Its resilience in the face of those challenges has been extremely impressive. More difficulties clearly lie ahead, but I am optimistic that the sector will recover more quickly that some anticipate. 

For further information, see: https://home.kpmg/ie/en/home/insights/2021/01/route-to-recovery-aviation.html