Resolving the Asset DilemmaWhen David Tweedie was Chairman of the International Accounting Standards Board, he joked that at some point in his career he wanted to fly in an aircraft that actually existed on an airline’s balance sheet. Tweedie was referring to a well-established practice in the airline industry of financing aircraft through off-balance sheet leasing arrangements.
In January 2019, new rules (IFRS 16) came into effect that places virtually all leasing contracts onto the balance sheet. To gain a better understanding of how the new accounting rules impact airline financials, go to Air Canada Speeches and Presentations, click on February 21, 2019 presentation entitled IFRS 16 Leases Information Session.
One accounting firm conducted a study on the impact of lease capitalization and concluded that as a result of the adoption of new accounting rules, the median increase in on-balance debt is projected to be +47%. About 50% of Airlines are expected to increase debts by more than 25%.
As an airline investor you should have at least a general understanding of how leases impact airline earnings and risk profiles. The new standard makes it easier for investors to determine whether a particular airline is a suitable for investors. The information in this post will provide some context, as to how aircraft rent charges impacted airline financial performance over the last 30+ years, and what CEOs should be doing to address the problem.
Until this year, most but not all airlines capitalized their aircraft rent charges (operational leases) over a 7-year period, by multiplying annualized aircraft rent expense by 7. Under IFRS 16, part of the annual rent charges is put onto the balance sheet, while other parts are moved to other financial statements. Page 17 of the Air Canada IFRS presentation shows the impact on key financial and Non-GAAP measures.
While Air Canada saw its Leverage Ratio drop from 2.1x to 1.6x, a significant drop I might add, some US legacy carriers saw their leverage ratio rise, in one case from 3.5x to 4.2x! Air Canada’s drop in leverage ratio under the new rules is a positive indicator of a successful change in financing strategy with respect to fleet; that is, the average age of the operating leases is decreasing (below 7).
Here’s a quote from McKinsey’s Pathway to Value Creation: A perspective on how transportation and logistics businesses can increase their economic profit (available on the internet). Key messages are in bold.
Resolve the asset dilemma
Transportation and logistics companies face a number of challenges arising directly from the asset intensity of their businesses and the asset deflation described under megatrend “the race for efficiency” in chapter 2. A typical answer to this “asset dilemma” has been for transportation and logistics companies to lease some or all of their fleet. Whether or not this strategy is optimal comes down to whether greater flexibility and access to technology justifies the premium companies pay for leases – 10 to 15 percent for aircraft or trucks, and up to 25 percent for ships. McKinsey analysis suggests that the premium paid is often 3 to 7 percent higher than the benefits in flexibility that a lease brings, implying that many transport companies could outperform competitors by owning a larger part of their core fleet.
This is significant for investors to understand and take into consideration in their decision to invest.
Concerning Air Canada’s fleet renewal program involving new aircraft, which began in 2013, 38 of 44 wide-body aircraft are owned. The six Boeing 787-9 aircraft that are leased are for fleet flexibility. A medium-term operating lease, for example, enables the Airline the option to upgauge, if demand warrants, to a stretched -10, an aircraft that only recently entered service. The narrow body fleet, acquired at significant discounts from the two manufacturers, will be 100 percent owned. All 82 of the remaining new narrow-body aircraft to be delivered over the next few years will not require financing, as the Company grows its free cash flow stream. An amazing accomplishment!
To put all this into context, consider the following: From the period 1995 to 2003, when Air Canada entered CCAA, the airline financed a major part of its 1995-98 expansion by leasing rather than owning aircraft. The expansion was followed by the merger with Canadian airlines, and the assumption of additional leases. In 1994, aircraft rent charges represented 5.7% of total revenue. By 2003, aircraft rental charges had increased to 12% of total revenue! Leasing companies took the proverbial ‘haircut’ during restructuring; and aircraft rent, after exiting CCAA, was reduced to 6.8% of total revenue. But by end-2018, aircraft rent represented only 2.4% of total revenue, and this percentage will continue to decrease over the next few years, as leased aircraft are replaced with owned aircraft.
Impact on Return on Invested Capital
The race for efficiency, the subject of a previous post, and resolving the asset dilemma will be the two main drivers of healthy ROICs for Air Canada for many years to come.
Impact on Risk Profile
The race for efficiency, resolving the asset dilemma, and the reduction in financial leverage are primary drivers in reducing the overall risk profile of Air Canada. The first two reduces operating leverage; the third reduces financial leverage. The historical boom/busts in the airline industry are the result of the risk that results from the harmful interaction of both types of leverage that, when combined, adversely impacts earnings in an extremely powerful and negative way.
The climb to cruising altitude has only just begun!