This week both major aircraft OEMs announced price increases. Airbus raised its list prices by 2%, and Boeing raised its list prices 4%. With average discounts already above 50% for most airline and leasing company customers, list prices have become meaningless in the industry, except for the announcements of deals at “list prices.” The reality, however, is quite different than press releases, and margins are not what the PR folks at OEMs would like us to believe they are.
We’ve examined and answered some questions that industry observers might have regarding list prices.
Q:Does Airbus smaller price increase provide it any competitive advantage?
A: No, as airline campaigns are based on projected total economics over the lifetime of the aircraft including operating costs, maintenance costs, and a number of factors. The OEMs clearly know how competing aircraft perform, and have mastered the process of pricing to the point of economic indifference.
Q: Do we need to assume higher discounts from Boeing vis-à-vis Airbus?
A: Pricing of aircraft is on a campaign by campaign basis, often taking queues from competitive behavior. Since nobody pays list price, the competitive market will determine pricing. But if Boeing is inflating its list prices faster than Airbus, one would, ceteris paribus, expect slightly higher discounts from that artificial number from Boeing.
Q: Do list prices impact residual values of aircraft?
A: Typically, an increase in the list price of an aircraft would be adjusted for discounts by appraisers in their assessment of a market, so the list price provides a replacement cost baseline for new models. But replacement cost is only one factor in estimating the future value of an aircraft, which also needs to consider market demand and relative economics vis-à-vis competing aircraft. The impact of an increase in list prices on estimates of future aircraft value are minimal if appraisers correctly apply an appropriate discount in their estimation process.
Q: Do increases in list prices result in higher aircraft prices?
A: The relative pricing for aircraft depends on the supply-demand balance in the marketplace for each type. For example, while Airbus has raised the list price of the A380 in recent years, the lack of demand has probably not led to higher sale prices, which are deeply discounted. By contrast, the A321neo is in high demand, and is typically not discounted to quite the level of its competition, as its suitability for middle of the market roles and economic advantages provide it a leg-up in “pricing to the point of economic equivalence” against less efficient competition.
Q: Why are list prices so high and unrealistic?
A: The trend in discounting of aircraft has changed over the years, with typical discount levels increasing from the 25% range to the 50% range over the last three decades. Whether as a result of over-estimating inflation, or increasing competitiveness between the major OEMs trying to gain or defend market shares, the gap between actual and list prices has been growing.
Q: Is there a chance that one of the OEMs might break the tradition and utilize a more realistic price for aircraft?
A: We view this as unlikely, as consumer behavior has been shaped around obtaining higher and higher discounts. A large discount makes the customer feel that he’s obtained a great deal, even though everyone gets a similar discount. While illogical, we see no immediate change in this industry practice.
Q: How much should we now assume for discounts from list price?
A: For most models, about 50%, which discounts of 60% for models that are poor sellers, and in the 40%-50% range for hot sellers in high demand. For most order announcements of $X billion dollars at list prices, we would cut the number in half to provide a more realistic estimate.
Q: What other factors should one consider when thinking about list prices?
A: Aircraft OEMs are likely to follow the model established by the engine makers and bundle services with aircraft to the degree possible. Engine makers prefer to sell their engines with “power by the hour” to ensure they earn aftermarket revenues. Their pricing is based on a longer-term revenue stream and typically results in deeper discounts to win the multi-year stream of spares and services. As aircraft OEMs follow the lead of the engine makers, we will likely see discounts rise even further than today’s levels. While this will never quite reach razor and blade levels, we’ve seen engine deals, in certain competitions, with discounts into the 90% plus levels to secure the services contracts. Factors such as services complicate pricing transparency.
The Bottom Line
Aircraft list prices are meaningless numbers and should be ignored. With services growing in importance, pricing transparency will likely be further obscured as discount levels rise in the future, rendering them even more meaningless in the future.
Today’s new aircraft and engines have integrated data acquisition and transmission systems that can actively monitor and store data on the performance of an engine or airframe component. This generates tremendous amounts of data for a fleet of aircraft, typically measured in petabytes. A petabyte is one quadrillion bytes, which is a lot of data.
Collecting and transmitting this data requires a number of sensors on board the aircraft, data storage devices to collect and store the data, and transmission capabilities for either real-time or post-landing download, depending on the criticality of information and the design of the integrated hardware and software on board the aircraft.
The newest aircraft models, including the Bombardier C Series, Embraer E2, Boeing 787, and Airbus A350 have the most advanced health management systems for airframes, while the new technology Pratt & Whitney GTF, CFM LEAP, and GEnx and GE9X, and Rolls-Royce Trent 1000 and Trent XWB are leading the way in engines.
But what happens next? A massive amount of data are collected that need to be analyzed and turned into useful information for customers. It is in the analytics behind big data that will enable the data collection systems to prove their worth.
Big data will tell us when a component is going to fail, and the condition of a number of variables that could impact that component at and leading up to the time of failure. Analyzing conditions that lead to failure can then lead to a set of “early warning” criteria that a component may soon fail, providing the operator an opportunity to fix the fault before a failure occurs to avoid lost revenue. Much like monitoring exhaust gas temperatures in an engine can determine when an overhaul is due, the additional data from an engine or airframe can provide new inferences and guidelines for maintenance activities.
How big is big data for an aircraft or engine? The first health management systems monitored only a few key elements of an engine or airframe. Today, the technologies that are driving the Internet of Things (IoT) have improved in capabilities at lower cost. As a result, we may now have 5,000 or more parameters to analyze on an aircraft at any given point in time.
It may take quite some time before the impacts of changes in each parameter are known well enough to develop predictive models that will produce tangible benefits for new aircraft models.
Simulation is one software tool that has been shown promise in this regard and has resulted in “Digital Twin” technology from GE Aviation. Digital Twin technology is, in its simplest form, a virtual model of a physical product. By pairing the virtual and physical worlds, analysis of data and monitoring information enable advanced analytics that can predict failures and reduce maintenance costs.
The concept of a digital twin has been around since 2002 but has only recently become feasible with the availability of monitoring data gathered through sensors and connectivity that form Aircraft Health Management Systems and collects tremendous volumes of data for analysis.
Essentially, a digital twin is an advanced simulation of a physical entity, collecting data that mirrors the physical experience of an aircraft in a simulation model, capturing the operational characteristics and conditions to enable prediction of future behavior. A digital twin for an aircraft engine utilized on an Emirates aircraft based in Dubai may show quite different results than one for the same type of engine used by Delta based in Atlanta.
Operational considerations, including temperatures, pressures, operating in an environment with a lot of sand in the air, or near ocean water, will have a difference on wear and tear on an engine and its components. Those environmental factors, along with performance data from engine sensors provide a richer database for analysis and refinement of simulations to mirror the performance of a given engine based on its utilization, environment, and operational history.
The ability to accurately predict engine or airframe component behavior is essential to carry out the mission of health management systems, which is to provide maintenance and money-saving ideas. GE Aviation is leveraging its Predix software suite, which provides an integrated platform for storing, analyzing and creating digital twin simulations across a variety of industrial applications, including Aerospace. That cloud-based environment includes a number of robust applications and analytics routines for building customized applications, as well as a library of tools to create and deploy machine learning models that detect anomalies, direct controls, and predict maintenance. The digital twin models created within the Predix environment enable analysts to determine correlations and cross-correlations between variables and to more rapidly understand, predict, and optimize the performance of an engine or aircraft.
The Bottom Line:
Health management systems and the Big Data they gather need to be analyzed and structured into useful information that is actionable to improve performance, reduce downtime, and predict failures before they interrupt operations. Digital twin technology is a logical approach to the problem, simulating physical operations to predict future maintenance events and helping to optimize engine and aircraft performance.
While collecting the data is important, the ability to quickly and accurately analyze the data and turn data into actionable information that provides a payback is key. The MRO business is changing, from borescopes and wrench turners to simulation modelers and logistics systems that will determine when a part needs changing and having it at the right place at the right time to minimize costs and downtime. IT is changing the way we think about MRO.
Canada has filed a WTO complaint against the United States with respect to anti-dumping and countervailing duty proceedings today. This is likely in response to recent actions with respect to the Bombardier C Series aircraft as well as actions taken against the Canadian lumber industry by US regulators in the last year.
While we do not expect this WTO complaint to change the outcome of the Department of Commerce and International Trade Commission hearings regarding aircraft, this does provide Canada and Bombardier one further avenue to pursue as they argue their case against US sanctions.
The retaliation by Canada is evident that Ottawa is prepared for a trade war, and that Canada will not accept the recent actions by US authorities without a fight. The US and Canada, who are the number one trade partners for each country, stand to lose more than they gain should a full blown trade war erupt.
Let’s hope some sanity enters the process before it escalates beyond control.
As we look over the technology landscape, several innovative technologies are moving from concept into production as new aircraft and engine programs reach the market. Let’s take a look at those that will soon explode in volume and provide intriguing opportunities as they move from R&D to mainstream.
Big Data and Analytics
Virtually every new aircraft and engine program features “health management systems” that enable monitoring of a number of parameters and to predict when maintenance action might be required before an in-service failure. The benefits of these programs are promising, but require the OEMs to store and analyze petabytes of data to implement these predictive benefits.
This will require massive data storage facilities, new analytical software, and communications capabilities to alert operators around the world to potential problems. Almost every OEM has a control center with multiple computer monitors tracking their customers and equipment in service in real-time around the world. These are complex systems, with the massive investment required, to generate the benefits of data for their customers by reducing catastrophic maintenance events and minimizing schedule disruptions.
In the narrow-body world, the C Series and E2 Jets are farther advanced than the A320neo and 737 MAX families in this regard, while the 787 and A350 lead the charge in wide-body aircraft. In the engine side, GE’s Digital Twin concepts go beyond traditional health management and may be the most advanced application in its class.
Additive Manufacturing goes Mainstream
The new Advanced Turboprop Engine from GE has about 35% of its parts produced using additive manufacturing. The benefits of additive include the ability to create designs and shapes that would be difficult using conventional techniques, and lighter weight components. In the ATP, 855 individual parts are replaced with 12, reducing complexity and maintenance cost while providing improved performance.
At the same time, research and development into additive manufacturing technologies will result in faster processing to enable more rapid completion of complex parts, which are relatively slow to build today. Our projection is for a doubling of speed in 2018 and a redoubling of speeds in 2019 as refinements are made in these technologies.
Innovative technologies using titanium have resulted in Norsk Titanium building a specialized facility in upstate New York to produce additively manufactured components from titanium in a unique, hybrid process. Their 787 parts can be ordered one day and shipped overnight the next to a customer, perhaps a precursor to the next generation MRO facility that will have high-speed 3D printing capabilities instead of racks of parts inventories.
We’re seeing additive manufactured parts on engines from the GTF and LEAP, with large-scale applications on the ATP. Additive has arrived.
Out of Autoclave Composite Materials Streamline Manufacturing
The composite materials utilized for most aircraft today are thermoset pre-pregs that require “baking” in a pressurized autoclave to “set” the polymers to form strong but lightweight structures. Today, the second generation of composites is emerging, with materials that can be produced “out of autoclave” and do not need a pressurized high-temperature manufacturing process. Speeding the manufacturing process, at lower energy costs, is viewed favorably by aircraft OEMs, who are looking closely at alternative materials We see the industry gradually moving away from traditional thermoset materials to thermoplastic materials that include PEEK and PEKK materials, and to lower cost thermoset pre-preg materials. While this transition will not be complete until the next generation of aircraft is introduced, those new materials are being tested and evaluated today for future programs.
CMCs are a unique set of composite materials that are formulated with silicon chemistries and have unique high-temperature applications in aircraft engines. GE is utilizing CMCs in the LEAP engine, which requires a massive ramp-up of CMC production for the first high volume civil application. With the same weight and strength benefits of composites over metal, plus an additional 400 degrees in temperature resistance, these components will prove valuable as future aircraft engines increase pressure ratios and operating temperatures.
Advanced Avionics for Autonomous Aircraft Operations
While we aren’t quite ready to eliminate pilots from aircraft, the aviation industry has the capability today to take off, navigate, and land aircraft without a pilot. The drone industry is growing substantially, and the ability to remotely control an aircraft provides the potential for safety improvements.
The aviation industry pioneered autonomous operations and remains well ahead of the auto industry in this leading-edge technology. Autopilots and flight management systems are complex avionics systems that are becoming more and more sophisticated, and could soon provide the fail-safes that will enable single-pilot plus computer/ground backup operations. The technology is ready, although passenger and union (not to mention regulatory) acceptance remain in the future.
The Bottom Line
Technology integration into commercial aerospace is accelerating, with a focus on materials, manufacturing process, control systems and IT. The next generation, currently in R&D, will provide even more advances as nanotechnology and quantum computing bring new possibilities. We are entering an exciting time of change for our industry.
New accounting standards have impacts on those to which the rules apply. In the case of IFRS 16, which takes effect in January 2019, the impacts could be significant for airlines, lessors, and financiers. Airlines in the US will deal with ASC 842, in which operating leases are on balance sheet, but doesn’t change P&L reporting in the same was as IFRS 16 internationally.
Essentially, IFRS 16 forces airlines to recognize lease payments as liabilities, and operating leases that were once “off balance sheet” are now “on” the balance sheet, impacting leverage ratios and loan covenants. That will have a significant impact on airlines. In addition, internationally, the capitalization of leases will essentially raise EBITDA and EBIT for airlines that more heavily utilize operating leases outside the US.
Airlines that rely heavily on leased, rather than owned, aircraft, may be forced to renegotiate some of the terms and conditions of aircraft leases and create new standard terms for aircraft leases. Airlines will seek to reduce liabilities and minimize any impacts on leverage ratios. The question is whether lessors, who have little incentive to do so, will agree to change conditions. Many in the industry believe most will, as the industry will seek standardized terms and stability.
Operating Leases – Impacted by Rule Changes?
The off-balance sheet nature of operating leases will likely be the most impacted by IFRS 16, as that key advantage disappears. In a recent Deloitte survey of industry participants, 47% believed that the number of operating leases would decrease as a result of IFRS 16, with 20% predicting no change and 33% predicting an increase. Operating leases tend to be more expensive in the long run, but provide several advantages, including flexibility, faster access to popular aircraft, and lower initial capital requirements. As a result, they remain popular, particularly with LCCs and start-up carriers.
Sale and Leasebacks will Also be Impacted by Accounting Treatments
Aircraft that are sold and rented back by airlines will also move onto balance sheets under IFRS 16. The unknown issue is how this will impact demand for sale and leaseback transactions as if the asset remains on the balance sheet, either way, a major incentive disappears. This could result in this segment of the aircraft leasing market potentially seeing decreased demand. We believe that the financial community will be creative, and that such creativity will result in different forms of aircraft leasing that will have variable payments and thus under IFRS 16 will not be forced to appear on the balance sheet.
This type of “flexible” lease arrangement will likely result in changes in lease terms to base payments on utilization rather than a fixed rate to remain off-balance sheet under the new rules.
Will Leases be Restructured?
One of the mechanisms to reduce the impact is for airlines to seek shorter lease terms, with renewal provisions, to minimize overall debt burdens and leverage ratios. The question is how auditors will treat lease extension provisions with respect to the new rules. Lessors do not like shorter terms as they increase re-marketing risk, which leads to higher rates.
IFRS 16 requires currency translation of liabilities on the balance sheet, which adds an element of currency risk. Airlines current purchase and lease aircraft in US dollars, but will be required to add the liability of leases to their balance sheets in local currency. This increases the currency risks that airline CFOs will need to manage.
The Bottom Line
The financier’s today already take into account operating leases when evaluating the creditworthiness of an airline. IFRS 16 will formalize that practice and incorporate it into accounting rules. This will result in changing balance sheet metrics that will impact loan covenants, likely making it more likely for airlines to violate them. A key task for airline CFOs in 2018 will be to review existing loan documentation to ensure that any covenants that will be impacted by the new accounting rules are modified to reflect the new rules.
International comparisons, due to differences in treatment of income statements and cash flows between the US ASC 842 and international IFRS 16 will result in apples to oranges when looking at airline financial statement. Comparing AF-KLM with Delta, or Lufthansa with United will require a restatement of one of the parties for comparison due to conflicting P&L treatment of operating leases.
Leasing is an essential element of aircraft financing, and we don’t foresee major movements or changes in the industry financing process. But in the interim, we do expect an increase in fee revenues for auditors and potential headaches for CFOs who will need to change accounting treatment of their existing leases, and ensure that those treatments don’t negatively impact loan covenants.