2018 Engine Poll – it’s the residual, stupid
Written by Joseph O’Brien for the Airfinance Journal
During the 1992 US presidential election, Bill Clinton’s campaign used a phrasein speeches and political rallies against the campaign of George HW Bush for several months. The phrase “It’s the economy,stupid” focused on the number one issue of the day for most of the US electorate. While completing the annual Airfinance Journal engine survey for 2018, I was reminded of this simple message. How can you rate more than 30 engine types for three different categories of value – investor appeal, remarketing potential and residual value – as the poll calls for? Some of the engine types are no longer produced but have supported an aircraft fleet for more than 30 years, while others are at the initial entry-into-service production phase. Some engine types support large fleets with worldwide user bases and others could reasonably be described as specialist niche engines. The answer is to look at the core principle of all large-ticket asset leasing – residual value.
When an engine lessor acquires engine assets for long-term investment there are several factors to consider. Purchase price is paramount in this evaluation because it has the highest degree of influence on residual value. However, lessor depreciation policy, original equipment manufacturer (OEM) aftermarket support, maintenance reserves (or the lack thereof), airline utilisation, regional environment severity and lessee creditworthiness all play their own significant roles in reaching a lease end or investment end residual value. Technical acumen regarding condition, records review and modification status is also critical, particularly when acquiring used engines.
While considering these seven or eight influencing factors for 33 engine types, you could write the entire bimonthly issue of the magazine on this topic alone. To simplify though, you can deduce there are four or five individual segments in the engine market. Evaluating residual value for the first segment may be the easiest. With the most populous fleets and engine types, the Boeing 737 family and the Airbus A320 family, there is a plethora of information available in the market. There are many users spread across the world, shop visit data is generally voluminous and easily obtained and confirmed, and perhaps, most important, there are lots of known trades of the assets with or without underlying leases regardless of whether the engine is attached to a wing or sold as a standalone asset.
The first poll question for the types, investor appeal, based on a rating of one to seven is complicated but easier in this segment than all of the other engine types. New investment at market prices today should be cautioned. However, if the price is reasonable, the engine types, the CFM56-5B and -7B and the V2500, remain attractive investments because the fleets will disperse further and continue to fly for a long time. Investor appeal is scored four to five. On the question of remarketing potential, these engines are the premier assets of the day to own. As the entry-into-service issues for the replacement engines are worked out, demand for the types is at its highest in years. Remarketing potential is scored at six to seven. The last category to value, residual value, is toughest to rate. Considering all the factors listed above along with a demanding and tough lessee base and competitor market, a prudent lessor should be able to rate residual value at four to five. Below that rating some risks were taken or decisions made that suggest lower returns might be acceptable to a lessor.
The second segment, the most interesting in the poll, is the new narrowbody engines, the CFM LEAP and Pratt & Whitney PurePower models. The orderbook for both types is incredible. The PurePower engine has sold more of the type at inception than the total engine sales of IAE in its 30-year history. The LEAP backlog stands at more than 12,000 engines.These engines will be great assets to own long term but how to respond to the poll today in 2018? Investor appeal is not great at the current time. Entry-into-service problems are significant as is normally the case for a new engine type. An investor must be cautious about any value diminution that might be associated with the early-production MSNs. Perhaps there are two scorings: short-term investor appeal is zero but long-term is six to seven? Scoring remarketing potential is a similar problem. In the short term, remarketing potential does not exist. The manufacturers are supporting the product fully. In the long term, we expect scores would be much higher but difficult to predict. Once reliability is improved, remarketing opportunities may be limited until a first run of shop visits occurs.Residual value will be strong but possibly not as robust as we see in the current narrowbody models. Why? The technology incorporated in both the LEAP and PurePower models may not have the same repair opportunities found in the components of the older models. For instance, the high ceramic content in the LEAP may require a full replacement protocol where all material removed is scrapped. That does not necessarily mean residual value will be lower but it certainly challenges the current model for engine residual value that incorporates a certain amount of used serviceable material that can be harvested from an older end-of-life engine.
The third market segment may be best described as older kit that still enjoys a sizable and sustainable underlying fleet. For purposes of discussion, the CF6-80B family is a good example of the type. The aircraft operated, the 747 and 767, are clearly in their twilight as passenger aircraft but there is a significant cargo market for the types and the engine is enjoying a revival and bump in value in 2018. Some of that value is simply from the need to harvest used serviceable material from run out engines and some maybe from what is termed as the Amazon effect, a new operator requiring a sizeable fleet for future cargo operations.How do we rate that? There are mid-life lessors which know this market well and would respond as follows: investor appeal is all about price and creditworthiness now. There is no second or third run to recover from paying too high a purchase price or making a bad credit decision where the operator does not pay for time used. As the market is generally too efficient to allow bargain purchase prices, a rating of three to four is sensible at the right price with a good operator. Remarketing potential, however, is low, perhaps two to three, as the operator base continues to shrink.Residual value as noted is highly related to purchase price. At the right price a five to six score is warranted. If wrong, it could be a very poor investment indeed.
The fourth segment proves much more difficult to score. We would include all the widebody engines in the group except the variants for the A380. Although it is easily argued this is incorrect, the challenges across the types are similar and significant. Purchase prices are high. The GE90 in full thrust, fully kitted configuration is more than $36 million. The GEnx, a newer type in the group, is generally at or about $30 million at full list price. Because of the high hour-to-cycle ratio, life-limited parts stacks are generally projected to have little or no replacement over the life of the engine. The user base is smaller and many of the programmes are dominated by comprehensive OEM support packages that include spares support.Our ratings for a GE90 versus a Trent 772B or GEnx differ greatly but can be generally categorised as follows: investor appeal is highest with those more impressed by dollar ticket size than management challenges. In this category, a score of four to five is appropriate. For experienced engine lessors with diverse portfolios, three to four may be more appropriate. Remarketing potential is tough. A score of two to three is warranted. Perhaps this is where the biggest challenge lies in the category. If you hold a long-term view, are patient and can afford to hold such an expensive asset off lease, opportunities will come. Depending on the type, that patience may be required for more than one year. Residual value scores for the category must be low, perhaps two to three given all the challenges.
The last segment, for want of time and space, includes the engine types with smaller fleets or specialist perations. This includes the regional jet engines, turboprop engines and the 717 and A380 variants. No doubt there are specialist lessors which would argue against such a grouping or the scoring. In this category, it is essential to know the operator base intimately to have investor success. Few mistakes can be made in order to avoid a poor investment. Investor appeal is highly limited to such specialists and is therefore best rated at a low score of one to two. Remarketing potential is highly challenging and limited and therefore rated low as well – one to two. Scoring residual value in the group is all about price and depreciation policy. Prices should be low and depreciation more aggressive, although there is still a great deal of risk in investing in the types. A score of one to two is warranted because investors in the type will generally focus on an acceptable running return to minimal book value.It is easily argued the categories and scorings are an oversimplification of an annual poll that presents a daunting task to complete. Many simply score the engine types they invest in but that is not the challenge presented. To score the whole of the poll, we must look at residual value and all of the factors and the respective weighting of each factor for each engine type.
As noted above, scoring 33 engine types with seven major categories of value to consider means each recipient needs to weigh more than 200 factors to respond in full. Few have the knowledge or time to do this. However, if you focus on the top 10 aircraft fleets and their subject engine variants, more than 70% of dollar value of the engine market can be scored and this is where the interests of most readers lie.How best to invest? Know your risk appetite, understand the users of the engines invested in and employ competent staff in the legal, technical and marketing disciplines. In the engine world, residual value is the critical issue for any long-term investor.