by PETER MAESTRALES - July 14, 2013
Simply put, the decline in values of pre-owned business jets since 2008 is astounding. It’s been a prolonged trend and now with increasing concerns of a failed global economic recovery, many professionals within the General Aviation industry are feeling anything but optimistic about a reversal occurring anytime in the near future. However, I have a counter viewpoint and will refer to indications that this market is finally bottoming out. There are various market conditions currently being overlooked by many within the industry. These conditions have played a key role in depressing this market and I will explain why there is a sharp reversal at hand that I believe has already begun.
To make my case, I won’t bother analyzing graphs, charts, recent sales data, or any other statistics because this information is already heavily cited in other market forecasts. Furthermore, relying on “hard data” as a key market indicator is illogical because it’s simply a report of sales activity from the past. It is irrelevant because the past is already “priced in” to the current market. Therefore, to gain insight into the future, just knowing data from the past will not suffice. To see the future we must understand the past on a much deeper level.
UNDERSTANDING HOW WE GOT HERE
As was the case with most major asset classes, prices for all business jets were increasing at an unsustainable pace prior to the financial crisis of 2008. In addition, participation in fractional ownership programs increased exponentially and resulted in massive orders for new aircraft by companies such as Net Jets, Flex Jet, etc. These jets eventually ended up in the used aircraft sales market, and are responsible for much of the supply pressure we see in today’s market.
Looking back, it was without a doubt a bubble just as US real estate was a massive bubble, both of which were fueled by cheap money and debt. But bubbles burst, and when they do its always ugly for the people who did not see it coming. On the other hand, we also know that markets are cyclical, and their cyclical nature is simply a result of ever unwinding imbalances in the economy. The unwinding of these imbalances always carries the potential for side effects, or what is sometimes referred to as “economic phenomena”, where the price discovery process is unable to function normally, often due to an irrational fear amongst potential buyers. When a market lacks or has lost a functioning price discovery mechanism, the result is usually extreme price volatility. This is exactly what we have witnessed over the past decade with aircraft values. As the debt bubble inflated the market to extreme highs, it was followed by the ongoing crash back down to the current levels that have proven to be just as extreme to the downside. Ultimately, a reversal will take place as the market seeks equilibrium and stability.
WHERE IS THE SMART MONEY?
Identifying when a reversal will take place in a market where prices are rapidly falling is no easy task, because fear is usually present and typically results in irrational behavior. Therefore the buyer who is most likely to overcome the fear of entering a Bear Market is usually the buyer with the most knowledge and understanding of that particular market, simply because they are most capable of recognizing when the market is undervalued. This also known as the “smart money” and is always the key ingredient needed to spark a market reversal.
Unlike other asset classes such as real estate with which all are familiar, business jets are complex machines that are operated, maintained and managed by aviation professionals only. Therefore, aviation professionals and companies are actually the “smart money” in this particular market because they possess the expert knowledge and understanding of these amazing machines. However, General Aviation companies do not purchase jets as they once did decades ago.
For example, my family has worked in General Aviation for nearly 40 years now and I have witnessed first-hand how the ownership dynamic in the market has evolved.
As a child I grew up watching my father, a small-business owner and professional pilot, successfully grow his Part 135 Air Charter Company that he built from scratch. From the very beginning, he sold charter flights only on aircraft that he owned, which is in contrast to the standard model of most of today’s Part 135 Charter companies who typically sell charters on managed aircraft since they do not own any of their own airplanes.
Like most entrepreneurs of that time my father started small, giving flying lessons in single engine piston aircraft. When he had saved enough, he moved up to a Cessna 310 twin-piston and began selling charters on it. After that came Cessna 340’s, 402’s, Bell helicopters, and ultimately business jets. In total my father has owned and operated nearly 50 different aircraft. Executive air charter, air freight, and air-ambulance were among the ways these aircraft were utilized in order to generate income for our business and the many families of employees it supported. These airplanes were not purchased for personal enjoyment or convenience. They were the tools with which we earned a living. This made buying and selling aircraft fast and easy, there was no fear involved. We knew value when we saw it because we work with these machines every day.
Over time the prices of business jets increased to levels that made it impossible for charter companies to own aircraft, much less turn a profit with them. Naturally, air charter companies adapted to the trend and as a result became Aircraft Management companies, who operate and sell charter on aircraft that are owned by HNWI’s and corporations. This change appeared to be a good thing as the industry grew at an incredible pace resulting in many new jobs.
Unfortunately the growth came to an abrupt end, and now that the dust has settled it is painfully obvious that the years of prosperity removed something very important to the business jet market specifically, the “smart money”. General Aviation companies are no longer legitimate market participants as they once were long ago. As a matter of fact, the ownership dynamic has slowly evolved to the point where now it’s bizarre to think that a General Aviation company was ever a legit market participant.
The fact that today’s Air Charter Companies sell charters on managed aircraft is supposed to offset the overall cost of ownership for those individuals or entities. The concept is much like utilizing an agent to sell time shares on a vacation property that would otherwise not be utilized during certain time periods. However, if the aircraft management company/air charter company was also an owner of aircraft within their fleet of managed aircraft, there would be a conflict of interest present with regard to the designation of aircraft for revenue flights, especially during slow travel periods.
THE FEAR FACTOR
With the “smart money” no longer being a legitimate market participant, fear continues to dominate the pre-owned business jet market. I believe it is this dynamic, in particular, that is responsible for the continued weakness in the pre-owned sector, while at the same time helping to support demand for factory new aircraft. This trend has proven to be a saving grace for Original Equipment Manufacturers (OEMs).
Fear is not a driving force in acquisitions for new aircraft because prospective buyers are more confident and comfortable making choices based on apples to apples comparisons in which the choices are all “0” time aircraft, and come with a factory service warranty. The pre-owned market is just the opposite as there are numerous variables to be considered, all of which effect a valuation. Terms such as Avionics, Hot Sections, Mid-Life, Pre-Buy, Engine Programs, Maintenance Records, Log Books, Inspections Schedules, Airworthiness Directives are unfamiliar to buyers looking to enter the market for the first time. And as a result, many potential buyers are understandably frightened out of the pre-owned market.
While an analysis of these variables does require a qualified professional or at the very least a knowledgeable and seasoned buyer, an aircraft acquisition is actually not as complicated and risky as many of these same professionals would like consumers to think. Ironically, aircraft brokers and acquisitions consultants have essentially become a victim of the same fears they promoted. Now, I am in no way saying that they do not bring value to their customers, as I believe they are invaluable to the acquisition process. I’m simply pointing out the fact that during the boom years, over-hyping the complexities and risks associated with pre-owned aircraft acquisitions was utilized as an effective marketing tool and ultimately became the basis for the aircraft sales broker business model. But this strategy only worked in the past because buyers couldn’t be scared out of a Bull Market. However, promoting fear in a Bear Market simply will not work.
MARKET REVERSAL
Now that we have a better understanding of the factors responsible for depressing the pre-owned business jet market, we can begin to explore the future. The reason this knowledge is of critical importance is because in order for the downward trend to reverse, each of these negative forces must be resolved. Therefore, with a comprehensive understanding of the problems, we will naturally be more capable of recognizing how these extreme imbalances will begin to unravel as the market seeks equilibrium. In addition to the resolution of negative forces, we will also examine some current and future trends that are already pointing to a sharp reversal in the used aircraft market.
THE MANUFACTURERS
Basic economic theory tells us that markets are ruled by supply & demand forces. We also know that the new aircraft of today will become the used aircraft of tomorrow. With this in mind, the best place to start when determining future supply is with the Manufacturers (OEM’s).
As I have already pointed out, consumer demand for factory new aircraft has remained somewhat stable when compared with pre-owned aircraft where demand has essentially vanished completely. However, this sharp divergence in demand is relatively minimal compared to the extreme divergence in price. Without significant innovation to serve as justification, this extreme divergence is totally unsustainable.
In the next decade OEM’s will face monumental challenges that will undoubtedly result in the failure of some brands, as already witnessed in the 2012 bankruptcy of Hawker Beechcraft Corporation which was founded in 1932 by Walter H. and Olive Ann Beech. These failures will not be related to product quality, but rather will be attributed to weak business leaders, lack of innovation, and an explosion in production costs.
Increasing costs of energy, commodities, debt service, labor, R & D, and airworthiness certification will continue to push new aircraft prices to ever higher levels, thus slowing demand for new jets. Decreased demand will result in a reduction in output. A decrease in current output of new planes now will ultimately tighten future supply in the pre-owned market, as the new airplanes of today become the used planes of tomorrow.
Unfortunately, this is not good news for an industry that has suffered both economically and from a Public Relations perspective ever since the CEO’s from the “Big Three” automakers flew their “corporate jets” to Washington D.C. in 2008 to plead for public funds to save their companies. Ironically, some OEM’s will soon find themselves in very similar circumstances, but with zero hope of a Government brokered bailout courtesy of the US taxpayer. But there are no victims in a free market, just winners and losers. Over the long term, markets will ensure that the winners are deserving of their title, as are the losers. This spirit of competition requires leadership, discipline, vision, and ingenuity in order to prevail. In other words, the health and success of an organization always begins with its leadership.
LEADERSHIP ISSUES
The biggest challenge facing today’s business-jet makers is that they are being cornered by market conditions for which they simply aren’t prepared but should be, if not for weakness in leadership. For example, I was disappointed when I read a recent article in which Scott Donnelly, CEO of Textron Inc. (NYSE:TXT), Parent company of Cessna, offered his outlook on the future of the business jet sales market and how he plans to lead the Cessna brand into the future. Donnelly, who has been predicting a turnaround in the business jet market for the last few years, said that he’s “not guessing anymore. Nobody knows”.
Mr. Donnelly’s admission is indicative of the overall lack of leadership currently coming out of the General Aviation community. Furthermore, as Chief Executive Officer of a Fortune 500 company, Donnelly probably shouldn’t be “guessing” about anything because as leader of a company with over 30,000 employees, planning for the future is not a guessing game, it is serious business. Mr. Donnelly may also think that “nobody knows” where the market is headed in the future but obviously doesn’t realize the fact that HE is actually the person that is being paid to “know” where the market is headed in order to best position the company for the future. Now I’m not saying he needs to be the next Lawrence Bell or that his job is easy, but I do feel Textron’s investors, customers, shareholders and employees should certainly expect more from the company’s leader.
While many corporate execs such as Donnelly may honestly be under the illusion that future market trends cannot be predicted, the reality is that they are wrong. In fact, markets are only unpredictable in the short term, while longer term trends are very predictable. In finance this concept is similar to the difference between “traders” who look to capitalize on short-term market moves and “investors” who tend to be long-term thinkers. So rather than confronting these challenges with innovation and imagination in order to salvage the future of their brand, those who lead these companies will instead do what they do best, which is play with the numbers.
In my opinion, general aviation leaders of today have been relegated to roles more fitting of general managers that specialize in mergers, acquisitions, investor relations, profit margins, and of course share price. Gone are the days in which airplane manufacturing companies were led by pioneer aviators and innovators such as Lawrence Bell, Clyde Cessna and Walter H. Beech who were driven by their passion and imagination as opposed to the price of a share of their creation.
SMART-MONEY COMEBACK
As we know from earlier, if this market is really going to turn around, the fear factor must be resolved and will ultimately happen by way of a “smart-money” comeback. But we also know that the days in which US based General Aviation companies acquired jets for operational revenue are likely gone forever. Therefore, the key question for the future is when, where, and in what form will the “smart money” show up?
The answer is to this question is of course very simple, as logic tells us that “smart money” will only appear when, where, and in any form in which it makes sense to do so economically. In other words, profitability is all that matters to industry professionals who are seeking opportunity. If we look closely, we can already see signs that the General Aviation Industry itself has identified pre-owned aircraft as being significantly undervalued at current levels, and is looking to capitalize.
In the coming years the “smart money” will re-enter the pre-owned aircraft sales market in two specific forms. First, an increasing number of General Aviation companies will identify the profit potential in acquiring aircraft for part-out. This is a normal stage in the industry cycle and is overdue. It is easily identified and occurs when the value of the aircraft, even a relatively young one, is exceeded by the value of its major components, especially engines. Second, significant demand will come by way of cross-border transactions in which Air Charter Companies based outside of the US & Europe look to acquire additional aircraft in order to satisfy the growing demand for ad-hoc charters in emerging markets. Many regions such as Latin America, Africa, Asia, and Australia are just beginning to be introduced to private jet travel. Adding to this potential is the fact that certain areas within these regions are extremely difficult, or in some cases nearly impossible, to access via Commercial Air Carrier.
Over the long term, both of these trends will have a positive impact on the value of all types of aircraft. The increased presence and utilization internationally will result in increasing awareness and interest into the benefits of flying private. The part-outs will assist the market in reducing supply of pre-owned aircraft available for sale, thus supporting values of the remaining fleet. In addition, the increased supply of replacement parts will ultimately lead to reduced maintenance costs for servicing the active fleet. The lower maintenance costs will in turn make ownership more appealing to potential buyers, which will also increase demand for pre-owned aircraft.
GROWING INTERNATIONAL DEMAND
In addition to the Air Charter Companies based internationally, many corporations and HNWI’s will also begin considering pre-owned aircraft options for acquisition. This will be a new trend because over the last decade, the tremendous increase in foreign and emerging market demand for private jets has essentially been focused almost exclusively on factory new aircraft only. The reason for this is OEM’s have marketing capabilities and access to markets abroad, while individual owners of pre-owned aircraft typically do not. However, the end result of the marketing efforts of OEM’s combined with the presence of their product in these markets has naturally resulted in more educated buyers who are seeking value or may be limited by budget.
MARKET DEPRECIATION FACTOR
The most obvious factor pointing to a reversal in the pre-owned aircraft market is the fact that much of the age-based depreciation has already been satisfied by way of market depreciation. When using the standard 30-year lifecycle for age based depreciation, all pre-owned jets are significantly ahead of their lifecycle depreciation, especially if inflation is factored in. For example, if a corporate jet that was manufactured in 1998 sold for $12M new, sells for $1.2M now, it would mean that the asset has already lost 90% of its value, but is only halfway through its lifecycle. With this in mind, potential buyers are in a very good position in terms of investment risk. Unfortunately this indicator, as extreme as it is, is rarely acknowledged.
ADDITIONAL FACTORS
Pre-owned aircraft will also experience increased demand in the future as a result of the ever increasing difficulties associated with Commercial Air Transportation. Mergers of major Airline companies will naturally result in higher fares and a reduction, or in some cases elimination, of service into smaller airports and less populated region. In addition, TSA screening procedures will likely become more problematic, time-consuming and humiliating for travelers in the future. These issues as well as countless other problems will continue to deteriorate consumer demand for commercial flights and will in turn support any alternatives.
Another factor that I will investigate in detail in a future article which will further reduce supply of pre-owned inventory will be courtesy of the US Congress and the FAA, who are banning all Stage II aircraft from operating from the contiguous U.S. after December 31, 2015. The new law, which is included in the “FAA Modernization and Reform Act of 2012”, will eliminate nearly 600 U.S. registered and privately owned early-model aircraft from the General Aviation fleet. The ban will significantly reduce used aircraft inventory which in turn will support prices within the remaining fleet.
THE FUTURE
The future of General Aviation is bright. All airplanes are truly amazing machines with many productive applications. The unique characteristics of these assets is rarely acknowledged and vastly underappreciated. Airplanes do not age quickly like cars do. In fact, it’s very seldom that you’ll ever wear an airplane out. This is evident in the fact that there are commercial airframes currently in service which have over 80,000 hours on them and have the potential to continue on for many more hours. Airplanes are also portable assets and they sell on a global market, thus making them immune to regional and geopolitical risks that affect other asset classes such as businesses and real estate.
Across the globe the scramble for tangible assets is on, as we are witnessing a major shift in how the world measures wealth. And even in an environment of rising interest rates, political instability, and economic uncertainty, the fact is that pre-owned business jets are grossly undervalued at current levels. I am advising all of my clients who have been considering buying a jet that now is the time.
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This article (Huge Turnaround Brewing in Pre-Owned Business Jet Market) was originally developed by and is property of American Banking News.
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