Inflation Hits New Aircraft Deliveries: Escalating The Problem Or Inflating A Solution? - Financespiders

Inflation Hits New Aircraft Deliveries: Escalating The Problem Or Inflating A Solution? - Financespiders

Aviation has been on a roller coaster. We have experienced the biggest drop in demand in its history and many airlines have had to make many adjustments to survive.

While there has been a positive impact from the recent uplift in the Americas travel markets, Europe has been a case of starts and stops. Similarly, the Asia market had recently reopened a lot of previously closed borders to attract more traffic, but there are still areas with tougher measures in place to prevent Covid which are weighing on the recovery.
 

Inflation plays a role in almost every segment of the aviation industry. It affects the price of aircraft, debt; overall operations of the airlines and other aviation participants.

One of the largest components of the cost base of an airline; other than fuel, is the aircraft itself. Inflation is exhibited through the steady increase of the official aircraft list prices of the predominant manufacturers (Boeing and Airbus) and their suppliers, which we see publicly.
 

Manufacturers routinely raise their prices in the normal course of their business. One aspect of this is due to the increased costs of the underlying inputs for production such as labor, commodities, financing, etc.

But the increases can run above inflation when there are increased demand dynamics. The past decade has not been unduly inflationary in terms of materials/labor and buyers have been relatively apathetic to the risks of inflation.
 

Interest rates have for years been at historic lows and commodities have seesawed, but ultimately have settled at relatively low prices during this period (for example, oil). Nobody seemed to remember the days of double-digit base rates or high commodity prices. This is exacerbated by the facilitation of growing demand and utilizing escalation.
 

I have reviewed many aircraft purchase agreements between manufacturers and airlines/lessors, as an aircraft investor and a former lawyer. They all contain price escalation terms. In simple terms, the price of the aircraft goes up if the manufacturer's costs go up.

I am sure there may be a contract in the market that has no escalations, but that would be a rare case and even the most revered airlines have escalation provisions in their agreements.
 

People in the industry will tell you that they negotiate escalation caps in their agreements, and I will concur that those placing large orders or who are established clients, usually cap their exposure.

The cap sets a limit on the escalation rate of the price,i.e. the percentage by which the agreed purchase price of the aircraft can rise is limited to the amount of the cap—3%, 5%, 6%, or more, depending on who you are.
 

The formula may have a sharing element above the cap and in times of “super-inflation,” the burden over a certain hurdle may fall back onto the customer. It often depends on the strength of the market; the inflationary environment and the relative strength and influence of the buyer. There are, however, customers with unlimited escalations, and escalations are usually a compound formula.

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Typically, a contract may read that the “Base Prices” of the “Airframe” and of “SCNs” and “Propulsion Systems Reference Price” are subject to revision in accordance with the various price revision formula up to and including the Delivery Date.”
 

The Formula in the United States requires that the prices are determined at the time of aircraft delivery according to a formula, using adjustments linked to the U.S. Department of Labor, Bureau of Labor Statistics “Employment Cost Index for workers in aircraft manufacturing - Wages and Salaries,” as well as the “Producer Prices and Price Index - Industrial Commodities Index,” sprinkled with averages and national rates.

Fluctuations in the costs of raw materials, labor shortages, embargoes, punitive duties, and supply chain disruptions, mean that manufacturers face unprecedented times.
 

In layman’s terms, if you place an order for 20 aircraft over 5 years, then the first will be closest to the original contract price and the last might be substantially higher with inflation throughout the period.

Even in times of modest inflation, this could mean an increase of 15%+ with a relatively normal 3% increase per annum compounded. Most aircraft component manufacturer price lists rise by that sort of amount per year.
 

So where is the problem you might ask? The problem is that in times of hyperinflation, an airline may not have anticipated such rises or have been able to cap the rate at a lower level.

The deliveries may have been postponed (which has also happened with many airlines and lessors as a result of the Covid-19 disruption) and the escalation will continue to accrue from the base year date when the purchase agreement was signed unless there were further restructurings or an enlarged order.
 

In cases of postponement, the cost of the aircraft could rise substantially and the buyer may not have the means to finance the purchase. Long-term funding may have been arranged on strict terms or a lessor-financier SLB will have linked the final purchase price of the aircraft to the lease amount using a formula. The rent could be much higher than the airline had hoped or planned. A more expensive aircraft results in a more expensive lease rate.
 

In terms of finance, interest rates are a prime factor and as transactions are normally in United States Dollars, that should be giving investors and airlines some sleepless nights. U.S. interest rates have been at extremely subdued rates but are now set to rise several times before year-end. Currencies can also be problematic.

During the last downturn, it was the disparity between the United States Dollar and other currencies that was a prime factor in the woes of many airlines in the developing world.
 

Their earnings were in local currencies and all expenses, like lease payments, loan payments, fuel, airport charges, and insurance were in Dollars. A 30% move in relative values cannot be absorbed by cost-cutting.

Inflation could be helpful if you bought attractive new generation aircraft before the spike in inflation. If you took delivery of them recently, then when compared to rival future aircraft, those rivals will be delivered at substantially higher prices.
 

The statement appears simple but if you are a lessor, you will have taken delivery and immediately leased the asset based on a pre-existing contract.

Your advantage may be an accounting exercise (book value may be reassessed), as you are committed to a lease and only time will tell if the market accepts the perceived increase in value in the interim of the lease if sold, or at the lease-end. A recession may also mean manufacturers are keen to offer incentives to entice new clients or a slow-down in travel generally.
 

If you are an airline, you may be able to sell and lease back your aircraft at a higher price, although the lease will be calculated based on that higher price. An ABS/EETC structure may allow you to borrow based on the revised valuation but usually, a new delivery will be financed by a bank or other lender, based on the contractual price. Conservatism will creep in as financiers perceive more risk.

Those with modern older aircraft coming off lease may see lease rates rise as values might be adjusted upward to compete with the more expensive new deliveries. A word of caution, as older aircraft may not be as efficient, and current oil prices may mean that they are not as economically viable.
 

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If you sit in a room with aviation bankers these days then ESG may spell disaster for anything but the newest asset types. Older technology widebody aircraft can be as much as $1 million a month more expensive to operate than newer and more efficient offerings. A bigger problem for the many parked wide bodies now that fuel rates are on the rise and passenger freighter rules are being reintroduced. Source: Fobes
 

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