While airlines are set to be the most impacted part of the aviation sector by Covid 19, book values of aircraft could decline as much as 40%, making valuing lessors both more complicated and complex, said an analyst note from JPMorgan.
According to JPMorgan the Covid 19 pandemic will have a material impact on the entire industry including manufacturers, supply chains, labour, and global traffic flows.
“Aircraft Lessors will not be exempt, in our opinion,” said the note. “While we have identified leasing as inherently lower risk than airlining – and current liquidity remains strong – investors are increasingly justified to be concerned with growing worldwide deferral requests and a pace of future capital deployment meaningfully below pre-virus expectations, in our view.
Book values are vulnerable to impairments given values that are set to decline 10%-40% across the aircraft spectrum if we use prior downturns as a guide,” said JPMorgan.
JPMorgan said it believes that the vast majority of global airline customers are seeking payment relief and lessors who repossess aircraft from bankrupt airlines may be looking at 25% , or more, reductions on new lease values, which may not start for several months given the current economic environment.
The net result say JPMorgan’s analysts is that lessor modelling has now become both more complicated and complex. Rent deferrals make valuing lessors more difficult due to current US GAAP rules, which allow deferrals to drive an increase in accrued rent balances but which don’t penalise firms for the decline in cashflow – until the accrued rent is written off an uncollectable.
According to JPMorgan, even rent abatement may have less impact on lessors’ GAAP figures than would be expected, given that accounting rules allow firms to amortize the loss over the full timeframe of the contract. The note cites the example of a three month rent free period within a five year contract – in that instance the total accounting impact would be a 5% decline in revenues across the 60 month contract, whereas it implies a 25% fall in cashflow over the current financial year.
JPMorgan said that it is in the process of updating it models to account for what it said would become an increasingly important distinction.
“On impairments specifically, rent relief of any form does not immediately trigger impairments. Lessors retain GAAP flexibility to measure expected lease cash flow over the life of the aircraft, which most often does not trigger write-downs for young aircraft with a longer cash flow. In contrast, asset sales, especially in weak market, are much more likely to trigger impairments.
Liquidity of course is a function of cash in and out the door, and that’s why how the Lessors manage capex will become a critical factor in a world where the demand for aircraft (old and new) is materially depressed in the short to perhaps intermediate term.”
According to JPMorgan, however, while lessors will be hit financially by Covid 19, the firm is confident the sector would retain its function as financial intermediaries, funding more than 40% of global fleets due to a number of merits associated with the business model.
The positive cited by JPMorgan included strong asset portability versus asset classes such as commercial real estate, scalable purchase economics with the OEMs, and sophisticated underwriting and risk management controls.
“It’s the global airline industry we’re really worried about first and foremost – Publicly and privately, CEOs are speculating that materially fewer aircraft will be required post-virus - see comments from [firms such as] EasyJet, Lufthansa, [and] Delta.
We can cite several airlines targeting fleet reductions of 20% [or more] as preparation for a post crisis traffic environment which is not expected to snap back to 2019 levels anytime soon,” said JPMorgan.
The US bank’s analyst cited the potential impact of ongoing social distancing regulations as being a major future burden for airlines whose business model is predicated on high seat density.
“The JPMorgan view specifically is that global traffic may not recover to 2019 levels until 2022 or 2023.”