Current activity and future thoughts on UK aircraft finance
By Colin Sach, Sach Avro Limited
Colin Sach of Sach Avro Limited discusses the upheavals faced by the UK aviation market over the last 18 months or so – the impact of terrorism, the Brexit vote and the loss of further airlines to name but three.
A major part of the UK market, as with most northern European countries, but more so in the UK is the vacation market to the warmer climates. In recent years the pattern of travel has changed with many taking several holidays and the destinations have become more varied covering southern Europe, the north African coast and Egypt.
However, with recent terrorist events in Egypt, Tunisia and other locations, coupled with the refugee crisis hitting Turkey and Greece, these markets have either closed or become unattractive during the last 12–18 months.
This has concentrated activity on Spain, Portugal and the traditional locations. Airlines have adapted their route network with many more flights from several airlines targeting the same destinations. This has had the effect of creating a mini price war placing severe financial pressure on some airlines.
Overall the UK airlines had a difficult year but so far have weathered it well, although sadly the number of indigenous airlines continues to shrink and the proportion of trade in the UK taken by airlines based outside the UK continues to increase. In light of the UK vote to leave the EU, this may become important.
I have written on previous occasions that there are too many carriers and capacity in Europe that style themselves “low cost” and there simply, in the long term, will not be a viable business model for some members of this group.
Sadly, in the last few days this has been visible by Monarch, one of the oldest surviving UK airlines entering administration, with little prospect of it re-emerging and formal liquidation the end result.
Undoubtedly the major item affecting the UK airline industry is the referendum decision in 2016 for the UK to leave the EU. In the long term, the UK transport patterns are likely to alter and adapt to the new position, but it is too early to comment on those. Both passenger and freight traffic patterns will change.
For example, if tariffs were to apply to agricultural goods from the EU to UK, it is likely that much of the crop growing would then take place in North Africa and other nearby locations. Holiday destinations may well change, as it is worth remembering that while the growth of the foreign holiday developed in the 1960s, most of the growth has happened after the UK joined the EU in the early 1970s.
Undoubtedly, the UK leaving the EU creates major opportunities for other countries outside the EU to develop their tourist industry, but the immediate issues facing airlines from the decision are:
- the ability and basis for airlines to fly to and from the UK;
- the participation in the various regulatory agencies that control safety – such as EASA;
- the ability of freight to move about and constrictions at major airports; and
- ownership of airlines
By value, still the greater part of air travel from the UK is outside the EU area, although about half by passenger numbers and flights are to EU destinations.
It would appear perverse if arrangements for the continuing flights were not arranged, considering that most airlines traffic in and out of the UK is not flown by UK based airlines, thus any curtailment would damage EU-based businesses.
It must be remembered that for each take-off there has to be a landing. The loss of trade to many European airports would be considerable if there was a serious interruption to flights. Dublin, Malta and several Spanish airports have a considerable number of UK flights every day. For example, in respect of Dublin, eight of the 10 busiest routes, by flights, are to/ from the UK. It is clearly not a one-way argument.
I am confident that even at the 11th hour a “sticking plaster” fix will exist to allow flights to continue between the UK and the rest of the EU. The issue may be that the 11th hour is not sufficient to avoid disruption to 2019 bookings in 2018.
Most of the rest of the world will probably revert to the original agreements without too many problems, and in cases are still the agreements that govern the flying as not all agreements are on an EU basis.
In my opinion the major problem will arise with the UK/US agreements. Considering that the EU/US agreement only took effect about 10 years or so ago, it is unfortunate as it would have been a lot easier if matters were still governed by the old Bermuda 2 agreement. If both parties were willing, and with relatively minor changes, the agreement could be resurrected.
However, considering the political winds and the general US move to protectionist policies, this could well be a difficult treaty to agree. It will potentially be a long and drawn out negotiation. This will be a major issue for IAG’s BA subsidiary where the US market, and the premium US market, is particularly important.
Problems are likely in respect of freight and re-establishing the customs protocols and clearances. Partly due to the EU rules and partly that freight is largely out of sight at airports, it will be easy for delays to arise with the inbound valuable freight.
This may be a great opportunity for the UK customs to harness the digital age with appropriate “on-line” services that pre-clear shipments, and/or agree approval at the point of delivery. It would be possible to devise a system for all goods, and a process for approving agents, or carriers, and for them to operate the system.
Indeed, most UK companies are already extensive tax collectors via VAT, and PAYE (employment taxes) and so highly connected to the UK authorities.
There is an opportunity to “think out of the box” and create some innovative solutions, or potentially matters could get stuck in a morass of paper and forms. Watch this space.
Other issues concerned with Brexit are the ownership of airlines and similar businesses. In the aviation world there are usually regulations about ownership and control. Typically, there is a requirement for the share ownership to be less than 50% by foreign shareholders and the majority of directors or control to be local staff.
In the past in the UK, ownership has not caused many issues and for many years the majority of UK airlines, except BA, were owned by overseas shareholders – over the years to name but a few, Monarch, BMI, Virgin, CHC and Britannia. Therefore, I doubt pure ownership will create too many issues for the UK, although some foreign jurisdictions may have issues with the airlines flying into their airports.
It is likely that the Europeans may well seek to enforce the rules and one airline that may have an issue is Ryanair where over 50% of its shareholders may be UK based, but arrangements can be put in place to reduce the voting control so that those within the EU still exceed 50%.
However, IAG may have issues as it will have to walk a tightrope of managing three jurisdictions when looking at the US flights from the UK. Usually bilateral agreements define what constitutes a carriers’ base country, so that IAG will have to show that BA is a UK resident airline, and Iberia is a EU airline, when wishing to fly to the US.
This can be achieved but it requires careful structuring and the goodwill of aviation authorities. I would not expect the UK to be the most difficult in such negotiations.
In general, I would consider that the issues will arise with third-party countries rather than between the UK and the EU.
There is a strong pool of experienced aviation managers in the UK, so control should not be a major issue.
One would hope that EASA would still be open to UK membership as it is primarily a safety organisation and unrelated to politics. The UK at the outset contributed a major portion of the starting data and it would be sensible for the UK to remain a member. In any event the way all countries are moving it is likely that, in the not so distant future, in order to fly into a major airport compliance with local legislation will be required. This will raise a number of interesting problems.
I believe that there is usually a better bespoke route to financing aircraft, or gaining their use, than the operating lease. True, sometimes for availability or ease, an operating lease is the simple solution. The inflexibility of an operating lease is an issue and unless carefully negotiated some of the terms that lessees agree to are sometimes baffling and make the lease an expensive option.
However, I suspect that now many airlines will look more carefully before committing in future to a standard operating lease.
Why do I say this? From next year airlines that adopt International Accounting Standards (IFRS 16) will have to show on the face of their balance sheet the aircraft they have on operating lease and include their calculated capital value and their asset value on both sides of the balance sheet.
As with many accounting standards the idea is appealing as it will provide a better indication of the assets used to generate the profits and will also reflect the liabilities. The asset and liability are determined by present valuing the lease rentals and other committed costs.
However, for an airline that may have a majority of its fleet on an operating lease it may not be so meaningful, especially for a carrier that does not report in US dollars.
Once capital sums have been calculated, both the asset and liability will annually depreciate, however not at the same rate. This has the perverse impact that effectively the lease cost will be higher in earlier years than the later years. The asset will reduce at a constant rate so opening a gap in the earlier years as the profitability on the lease will automatically increase in the later years. All the time the annual cash cost will remain constant.
For airlines that have a constant fleet of aircraft acquired via an operating lease over time matters will balance out, but for growing airlines and ones that use a variety of financings matters could be very different, and instead of charging the constant cost of the aircraft leases, profitability will be artificially depressed.
Issues may well arise with maintenance reserves, especially if the surplus is not repaid to the airline at the end of the lease.
A further major issue will be the currency conversion, for airlines that do not report in US dollars, as the asset and liability are treated differently, thus creating a mismatch at each balance-sheet date, the asset side is valued at the historic rate while the liability is revalued at the current rate each year.
Therefore, after IFRS16 is fully introduced in a year or so airline accounts will look very different and in ways it will be significantly more difficult to fully understand the true assets and liabilities of the business.
Currently, most UK airlines are busy trying to amass the data for the change, but in due course there will need to be a reassessment of the operating lease product and if it still fits the requirements of the airline.
I would expect that some fundamental changes to the operating lease product will be required, and more sophisticated airlines may well review if other approaches meet their financing needs.
As I mentioned in a previous article, I believe we are on the cusp of seeing some major changes in the methods of aircraft finance but as always it is an exciting and dynamic business and likely to remain so.
Colin Sach Director
Sach Avro Limited