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CAPA Live: Air Lease Executive Chairman Steven Udvar-Házy

Analysis

Talking at the CAPA Live on 12-May-2021, Air Lease Corporation’s executive chairman Steven Udvar-Házy spoke with CAPA’s chairman emeritus Peter Harbison.

The verbatim transcript follows. Some of the highlights:

- "Many airlines have mortgaged everything, their planes, their slots, their airport terminals, their ground facilities, their frequent flyer programmes....I believe that a significant part of airline loans will either have to be forgiven by government agencies or converted to some kind of equity.

- "There's venture money that's available. There's good young used aircraft at reasonable prices, and there's plenty of pilots and flight attendants that are looking for work. That's a temptation to start a new airline...I think we would limit the size of our exposure to startups to maybe 5%, 6% of our total portfolio.

- "The lease rates Norse have worked out on the same aircraft are significantly lower than Norwegian. If you can save USD4-500,000 a month on renting the airplane you've got between USD5 and USD6 million a year delta between the fixed costs of what Norwegian had to endure or what Norse has to live with.

- "We have certainly reduced our MAX exposure, and Boeing needs to get their act together and get these airplanes back in service and provide the economic incentives for the airlines to stay with the programme.”

PH: A big welcome to Steve Udvar-Hazy, who's the Executive Chairman of Air Lease Corporation, as if I needed to say. Steve, a great warm welcome to CAPA Live. Great to have you back with us. We last spoke in, I think, June or July last year, and it's been a pretty interesting period in between. Purely from an aviation point of view, what are the big things that have changed in the meantime? Obviously everybody's lost money, but structurally, how do you see things have changed?

SH: "Politicians have tried to change the psychology of human beings about travelling. They somehow have made the issue that there's a risk to travelling, although we have not seen any demonstration of that risk from a health point of view. A vast majority of the population has been influenced by this sense of fear but I do believe that with the increasing amount of vaccines coming online, hopefully that sense of fear will fully dissipate and people will try to get back to normalcy."

“Well, if we put the economic consequences aside, I think what has changed is that none of us in the airline industry anticipated back in March, April of last year, when this whole pandemic began to take on its course, none of us anticipated that here we are 14, 15 months later, and we still don't have a totally clear path of recovery. We do have some recovery and some optimism, but it seems like every time we think we're on the right track, there's another version of the virus and government authorities are very quick to impose restrictions, which makes it very difficult for the airlines to plan ahead.

“I think the second thing that has changed is that politicians have tried to change the psychology of human beings about travelling. They somehow have made the issue that there's a risk to travelling, although we have not seen any demonstration of that risk from a health point of view. It's not any more risky than staying in your home town or village. So I think a vast majority of the population has been influenced by this sense of fear and also what could happen at your destination, and maybe you can't come back to where you came from or what additional restrictions you might face.

“But I do believe that with the increasing amount of vaccines coming online, hopefully that sense of fear will fully dissipate and people will try to get back to normalcy. But it's been very hard for the airlines to do any kind of reasonable network planning or schedule planning, because everything is on a very short-term horizon.”

PH: You're seeing a pretty good recovery domestically in the US hopefully. With a bit of a tail wind from vaccinations, presumably.

SH: “The Trump administration threw a tremendous amount of resources and billions of dollars to the drug companies to develop not only these vaccines, but also the massive manufacturing of these vaccines by the hundreds of millions of doses. And we began to see effects of that starting in like November, December, and then very quickly thereafter. But look, we have almost 350 million people, and the rest of the world has many billions, so it's not something that can happen overnight. But we are seeing good trends in the US. We've seen some good trends in China.

"We've even seen some good numbers out of, say, Russia domestic last month, in April. And there are countries like Israel that have moved ahead very rapidly on vaccinations, but a lot of the third world, as we can see, or less developed world like India and Africa, they are really struggling, and we haven't seen the worst yet. Very sad. Very, very sad.”

PH: Steve, going back to the industry structure, whenever we quite emerge from this, and it's obviously going to be a gradual process, the airlines are going to come out very heavily indebted, with credit ratings which have lots of Cs and Ds with them. At the same time, of course, the lessors have really stepped up, because they've got good credit ratings, they're well cashed up. So we have seen, I think, and I think you've probably talked about this before too, something of a shift in the power balance between lessors and airlines. Is that an accurate description of the way you'd see it?

SH: The airline industry as a whole on a global level has lost everything they've earned since World War II. Many airlines have mortgaged everything, their planes, their slots, their airport terminals, their ground facilities, their frequent flyer programmes. They've borrowed against every possible asset or even virtual assets that they don't even have. At the end of last year, we crossed the threshold where more than 50% of the aircraft are leased

“Well, I think you summed it up well. The airline industry as a whole on a global level has lost everything they've earned since World War II. I mean, everything, all the profits that were hard-earned are gone. If it was not for government support, either in the forms of guarantees, equity, loans, all kinds of medicine government agencies have put forth, the airline industry would have been crippled. So you're right.

"The balance sheets of airlines today compared to where they were, say, 18 months ago are vastly different. And many, many airlines have mortgaged everything, their planes, their slots, their airport terminals, their ground facilities, their frequent flyer programmes. They've borrowed against every possible asset or even virtual assets that they don't even have.

“What that has caused is that airlines more than ever need third parties, such as the leasing community, to be able to continue this fleet modernisation, fleet replacement. At the end of last year, we crossed that threshold where more than 50% of the aircraft are leased, either on an operating lease or a finance lease or on a sale-leaseback. That is a huge change from where we were even five years ago. And so we continue to see the leasing community being really a much more critical component of the airline industry, being able to finance expensive capital goods, that airlines are going to have limitations on how much money they can borrow. And of course we borrow at a much lower rate than the airlines.”

Air Lease Corporation’s executive chairman Steven Udvar-Házy speaking at CAPA Live on 12-May-2021

PH: So what do you see the implications of that being, looking three or four years out, Steve?

SH: I believe that a significant part of airline loans will either have to be forgiven by government agencies or converted to some kind of equity, because it's difficult to see that airlines can generate enough profits in the next five years, when most of these things become due, how they can pay it off from cashflow. Otherwise, they'll be paralysed for as long as a decade or 12 years to be able to get fresh capital

“Well, I think the implications are that if you look at the balance sheets of the airlines, I believe that a significant part of their loans will either have to be forgiven by government agencies or converted to some kind of equity, because it's difficult to see that airlines can generate enough profits in the timeframe, say the next five years, when most of these things become due, how they can pay it off from cashflow. So either they have to borrow new money to pay off the existing debts or have some of the lenders convert these securities into more of an equity style transactions rather than keeping them as debt. Otherwise, they'll be paralysed for as long as a decade or 12 years to be able to get fresh capital.”

PH: That does sort of imply that we're winding the clock back in terms of government involvement in airlines. There's a high likelihood, in terms of just, say, even through the protectionism, protecting national airlines and looking at the whole regulatory structure.

What we see now is that governments will take a greater interest in these airlines that they've helped out, at least until they're paid back or the majority of their debts are paid back. This is a phenomenon I think we have to live with for the next two or three years

“Well, as you remember in the '70s, '80s, and '90s, a lot of these national airlines were privatised or substantially privatised, where government sold off their shares, or in many cases they just kept a very small minority position. What we see now is that could potentially reverse itself and that governments will take a greater interest in these airlines that they've helped out, at least until they're paid back or the majority of their debts are paid back. So it's almost going the other way. We saw more privatisation of national carriers. Now we're going to see a greater government involvement. And recently you saw the French government subscribe to a larger chunk of Air France scale of capital. This is a phenomenon I think we have to live with for the next two or three years.”

PH: And probably more perhaps, in those terms... Yes, that's a massive change in a lot of ways, particularly in the relationship between the leasing companies and the airlines, though, Steve. If I look at the profile of your fleet, the aircraft that you both own and have on order, there's a very low proportion which are wide-bodies and an even lower proportion which are wide-bodies in the aircraft you've got on order. Is that something that's going to shape the way airlines operate as well, if the leasing companies have now got a lot more clout?

SH: The widebody situation has changed a lot, because for a while there was this fear that there would be slot restrictions and the only way an airline can grow is to have a larger gauge at each departure. Now the pendulum has gone the other way, where a smaller widebody is more beautiful, because an airline can use that smaller widebody on a big part of their network. How long this trend will continue, it's kind of hard to tell, but it's certainly been a setback for Airbus and also for the 777X

“I think the widebody situation has changed a lot, because for a while there was this fear in the airline industry, if we go back like 10, 15 years ago, that at major international hub airports like Heathrow, Charles de Gaulle, Frankfurt, Amsterdam, Tokyo, and so forth, there would be slot restrictions. And the only way an airline can grow is to have a larger gauge at each departure. That led to the A380, the 747-8, so big was sort of the way to go, because it was the only way to allow airlines to offer more capacity with frequency limitations at a lot of these airports.

“Now the pendulum has gone the other way, where a smaller widebody is more beautiful, because an airline can use that smaller widebody, a 250-seat, 300-seat widebody, on a big part of their network, whereas the very large widebodies that were like the 500-seat category, they could only use it on a few of their premier routes. I think airlines have realised that a 787 or an A350-900 has more utility in this environment, in terms of its size and operating costs, than a larger gauged airplane. Now, how long this trend will continue, it's kind of hard to tell, but it's certainly been a setback for Airbus and also for the 777X.”

PH: Steve, looking at it through your eyes though, as a lessor, the aircraft that are much more attractive because they're more easily placeable at the end of the lease term are narrowbodies. They tend to have a much more standard configuration, so they're much more attractive to you. And I think without knowing exactly or quoting the exact numbers, I think of 400 aircraft you've got on order, probably no more than about 25 or 30 are widebodies.

SH: “That is correct.”

PH: Given this increasing power of the leasing companies, like it or not, is that really going to influence a lot the way airlines themselves recreate their networks, because they're going to be relying on your aircraft?

SH: A lot depends on the success of an airplane like the A321 XLR, because if those airplanes catch on and can operate more of these sectors that are near six, seven, eight hours, and operate maybe higher frequencies, a more flexible schedule compared to a widebody, that will change the whole pattern of what's going on. On the converse side, we've seen a huge boom in cargo, a lot of that is because there's not enough belly capacity. So widebodies are not going anywhere, but the proportion of widebodies in the overall global fleet may actually come down a little bit for the next three or four years.

“It depends a lot on the success of an airplane like the A321 XLR, because if those airplanes catch on and can operate more of these sectors that are near six, seven, eight hours, and operate maybe higher frequencies, a more flexible schedule compared to a widebody, that will change the whole pattern of what's going on, for example, in the North Atlantic, between the US and Latin America, between Europe and parts of Africa, intra-Asia. So I think the jury's still out. We think the A321LR and XLR will have a role in that, but if they prove to be successful, it does mean that some airlines will down-gauge and reduce the risk.

“Now, on the converse side, we've seen a huge boom in cargo, yields have improved, but of course, a lot of that is because there's not enough belly capacity. So widebodies are not going anywhere, but the proportion of widebodies in the overall global fleet may actually come down a little bit for the next three or four years. And you can see that on the production rates. Boeing was going to go to 14 787s a month. Now they're like down to five. A350 was going to be 10, 11 a month. Who knows where it'll be? Maybe three a month; A330neo, one and a half to two a month. Those are massive decreases in the production rates of new widebodies, and I think airlines right now are a little heavy on widebodies. We'll have to see how the international traffic emerges in the next 12 months.”

PH: But there's a bit of push and pull in that, isn't there, Steve? The market will go where the market can go, so if an airline is offering a narrowbody service on a medium to long haul route, it'll go on that, particularly if the prices are cheaper. And you play a big role in determining that as a lessor.

“We've introduced a number of airlines on the transatlantic, like Aer Lingus was a good example, where they substituted A321neo LRs where there were A330s. We just delivered our first A321LR to SAS Scandinavian, so they'll operate like Copenhagen to Boston. They'll be able to go from Stockholm to New York with an A321LR. And particularly in the winter time, in the off season, it's a good airplane that fills the mission. So I think we're going to see more of this. We're going to see JetBlue start service to London from both New York and Boston using the A321. And Boeing doesn't really have a product that can compete with that right now. So it's an interesting market, between the single aisle and the widebodies. It's almost like in the 757 category in terms of payload, range, performance.”

PH: A great aircraft too.
You might have heard of AerCap. It's one of your competitors out there.

SH: “I've heard of this company, and most of their fleet is ILFC planes.”

PH: They must be good. They're on the record as saying that they believe there are about 90 would-be startup airlines out there. I noticed that you've placed some aircraft with a few of those startups. What do you see the future in this market for startups?

SH: Today we have relatively easy access to capital. There's venture money that's available. There's good young used aircraft at reasonable prices, and there's plenty of pilots and flight attendants that are looking for work. That's a temptation to start a new airline

“Well, what are the raw materials, ingredients to make a new airline? Cheap money, capital, cheap aircraft, and pilots. When everything is booming, capital is constrained because the good airlines consume it all. But good airplanes are in short supply, because the airlines want to keep what they have, and there's a pilot shortage. Today we have relatively easy access to capital. There's venture money that's available. There's good young used aircraft at reasonable prices, and there's plenty of pilots and flight attendants that are looking for work. That's a temptation to start a new airline.

“Now, how many of those new airlines will remain? It reminds me of deregulation in 1978, when, as you recall, the US deregulated, the CAB went away, and I forget how many airlines started, but I think it was 120 airlines. And I think when everything was said and done, there were only two or three left. Now, maybe things won't be that bad, but there's a great temptation now to start a new airline, with a young workforce that's not unionised, at a much lower labour cost, and relatively young used aircraft like A320s, 737-800s, in some cases Embraers or A220s. The jury's still out. Now, some of these airlines will probably do okay. Maybe at some point they'll merge with somebody else. But it's going to be very interesting to watch in the next 12 months, how many more startups get going.”

PH: Well, you're more than an interested bystander, of course. You're actually putting some aircraft with some of these airlines. So what do you look at when you're considering doing that for a startup?

SH: Before supporting a start up we look at the competitive landscape. Who do these airlines have to compete with, and can their competitors simply allocate a certain percentage of their seat capacity and just match their fares and offer all the other perks like frequent flyer miles and so forth? We would limit the size of our exposure to startups to maybe 5%, 6% of our total portfolio. To put it in perspective, right now we have about USD25 billion worth of planes, so I wouldn't want to have more than a little over a billion dollars of assets allocated to these startups

“I think we look at their management team. We look at the competitive landscape. Who do these airlines have to compete with, and can their competitors simply allocate a certain percentage of their seat capacity and just match their fares and offer all the other perks like frequent flyer miles and so forth? We look at the economics of their route structure. We look at whether they selected the right aircraft type, whether there's a platform to grow, or are they going to be just limited to certain niche markets? And we look at their capital structure to make sure they have enough money to get through that initial developmental period where every airline loses money at the beginning. Many fail, not because they don't have a good business plan, they just run out of money. They run out of resources.

PH: I think, maybe I haven't counted them all, but you've invested or engaged with three of them, at least.

SH: “Yes.”

PH: Would you be prepared to go to 20 startups, if they fulfill those criteria?

SH: “I think we would limit the size of our exposure to startups to maybe 5%, 6% of our total portfolio. To put it in perspective, right now we have about USD25 billion worth of planes, so I wouldn't want to have more than a little over a billion dollars of assets allocated to these startups, because some of them will not survive. Some of them may actually have difficulty, so we have to be very careful.”

PH: By definition, too, they're probably almost all going to be narrowbody startups?

SH: I see some widebody adventures, such as the new airline in Norway. There’s another one that wants to operate A330s from the UK to India and Pakistan. So there are several situations that are evolving that could involve widebody aircraft, but I would say the predominant startup business case is using primarily A320s and 737s.

“Yes, although I see some widebody adventures, such as the new airline in Norway. There's another one that wants to operate A330s from the UK to India and Pakistan. So there are several situations that are evolving that could involve widebody aircraft, but I would say the predominant startup business case is using primarily A320s and 737s. That's the bulk of the startups.”

PH: Steve, when you mentioned Norse, the startup in the North Atlantic, obviously Norwegian made a few mistakes, but also maybe the environment wasn't right for it at the time. Norse is basically mini-Norwegian. Do you think the market conditions have changed sufficiently to make Norse a success now?

SH: The lease rates Norse have worked out on the same aircraft are significantly lower than Norwegian. If you can save USD4-500,000 a month on renting the airplane you've got between USD5 and USD6 million a year delta between the fixed costs of what Norwegian had to endure or what Norse has to live with. You have to make the assumption that they've learned a lot from the 787 experiment, and now with the lower cost aircraft, they can pick the best of what Norwegian's long haul routes were and not try to be everything to everybody

“Well, the lease rates that they've worked out with AerCap on the same aircraft, the 787s, is significantly lower. I'll give you an example. If you can save USD400,000 or USD500,000 a month on renting the airplane, versus what Norwegian was paying, you've got between USD5 and USD6 million a year delta between the fixed costs of what Norwegian had to endure or what Norse has to live with. So your breakeven load factor goes down, and at least during the introductory phase, you bleed less cash.

“I assume that the management team there, well I know for a fact, has learned a lot of hard lessons, which markets might make sense and what markets are not going to be profitable because the yields are so low and the breakeven load factor may be in excess of 100%. You have to make the assumption that they've learned a lot from the 787 experiment, and now with the lower cost aircraft, they can pick the best of what Norwegian's long haul routes were and not try to be everything to everybody. But Norwegian did lose its way in that transition from being a profitable domestic and European short haul airline to becoming an intercontinental carrier. So we'll see, but you know, it's really tough to be a low cost long haul airline. It's very tough.”

PH: Well, that was really what I was getting at. In this new environment with the changed profile, let's assume for a moment that the business traffic is not going to come back very quickly, with that changed market profile, is it going to be easier for a long haul low cost operator to compete effectively?

SH: Competing is going to be hard because the big network airlines are much smarter now, and they have yield management tools that they can allocate on a per-flight basis a certain number of seats, and basically either even duplicate or undercut the newcomer. In the long haul business, you don't have some of the operating efficiency advantages that you have in a short haul

“It's going to be hard, because I think the big network airlines are much smarter now, and they have yield management tools that they can allocate on a per-flight basis a certain number of seats, and basically either even duplicate or undercut the newcomer. So in today's world with digital technology and yield management, the large airlines have learned to compete much more effectively with the LCCs and ULCCs. And as you know, in the long haul business, you don't have some of the operating efficiency advantages that you have in a short haul, like quick turnarounds, lower crew costs, because if you have overnights and hotels.

“A lot of the same cost characteristics of a long haul intercontinental operator will permeate a low cost airline as well. There's certain things you just can't avoid, because the regulatory environment on rest periods and how many hours a pilot can fly, those are, they are what they are. I don't think the level of incremental cost improvement for a long haul operator in this regime is as good as in the short haul environment.”

PH: Right, right. Steve, I've only got a couple of minutes left, but I can't let you go without asking you about the MAX. Where do you see it going and where do you see yourselves going with it?

SH: We originally had orders for almost 200 MAXs. We've stepped away from some of them that were more than 12 months late. We thought that the momentum for redeploying the 737 MAXs would pick up steam as we got into this spring 2021 period but here we are, five, six weeks later, and we don't have a resolution. Boeing needs to get their act together and get these airplanes back in service

“Well, we originally had orders for almost 200 MAXs. We've stepped away from some of them that were more than 12 months late. This latest grounding has been a huge disappointment to us and the airlines that have been affected by it, more than 100 aircraft, because we thought that the momentum for redeploying the 737 MAXs would pick up steam as we got into this spring 2021 period. Instead, on April 9th, we got the news that there was a problem with the airplane, at least the airplanes that Boeing recently finalised manufacturing of, and it's been a huge setback.

“And here we are, five, six weeks later, and we don't have a resolution. Look, the airplane does offer incremental economic improvements in operating costs, mainly on fuel. We're not 100% convinced whether there's going to be a maintenance reduction, because whereas there will be on the airframe and some of the airframe components, we're not yet convinced that the CFM LEAP engine will be as cost-effective on the maintenance side as the CFM56 was on the 737-800. That's yet to be determined.

“The airplane is very, very popular if we can get them back in the air, and we think the passenger perception will evaporate concerning the fact that it's a MAX. I think most travellers are not really concerned with that. And time is a healer, so hopefully that perception issue will go away. But we have certainly reduced our MAX exposure, and Boeing needs to get their act together and get these airplanes back in service and provide the economic incentives for the airlines to stay with the programme.”

PH: I think we all need, particularly you and the airlines need, two manufacturers in the business who are going to be competitive. It's obviously important to you and to the industry overall to have two competitive manufacturers, particularly in this narrow-body end of the market, I guess.

SH: “Yes. Two healthy competitors.”

PH: I guess that goes without saying, but let's hope the MAX does get back, because I think there are a lot of airlines relying on that very heavily.

SH: One huge advantage for the MAX is the installed base of 737s by the thousands. And for most airlines the MAX is the logical next step. But we are seeing some airlines that could defect or will defect to the Airbus, and usually the A321neo will be the catalyst for that. For an airline that needs aircraft in the 200 seat or 200 seat-plus category and can operate a mixed fleet of A320s and A321s, that is where I think Boeing right now has an Achilles heel.

“I think one huge advantage for the MAX is the installed base of 737s by the thousands, whether it's 737 classic, 700s, 800s, 900s, there's a huge installed fleet of 737s operating throughout the world. And for most airlines, the transition, the next step, the MAX is the logical next step. But we are seeing some airlines that could defect or will defect to the Airbus, and usually the A321neo will be the catalyst for that. Not so much A320, because the direct operating cost of the A320-200 and the 737-8, they're almost neck and neck.

“But for an airline that needs aircraft in the 200 seat or 200 seat plus category and can operate a mixed fleet of A320s and A321s, that is where I think Boeing right now has an Achilles heel, because the 737-10 is not an A321 direct competitor. It just doesn't quite have the same capabilities as the A321 in many areas, whether it's cargo, range, seating capacity. It doesn't quite match up.

“So I'm sure the 737-10 will have many customers, including some US domestics, but the A321neo has run away with winning that category. That's something that Boeing cannot really address unless they develop a brand new airplane, and then that's seven, eight years away. So for the time being, I think we see Airbus having a 60/65% market share in the single aisle. And now you've got the 220 family, which is gaining momentum. We've ordered 50 of those, and we have 25 options that we're discussing with Airbus to exercise. That's another competitive tool that Airbus has right now at the smaller end.”

PH: So all they have to do is produce them.

SH: “But they have two production lines now, Montreal and Mobile. There's still challenges on the production efficiencies, particularly in Montreal. We are a big supporter of the 737-8, 737-9, but it's lost a little bit of its shine because of the accidents and groundings, and many airlines have had airplanes on the ground now for more than two years.

“For example, we have an airline called S7 in Russia, the largest private airline in Russia. We delivered a MAX-8 to them before the grounding, but because there's no Russian certification of a 737 MAX, that airplane is just sitting. It's now been 26 months that airline has not been able to use that aircraft, and we don't know when the Russian authorities will certify the MAX. China has not certified the MAX. Korea has not certified the MAX. And there's a number of other countries that have been reluctant to just say, if the FAA did it, EASA did it, we're just check-marked, signed off. So that is another issue for Boeing, because a number of regions in the world currently do not allow the MAX, and Boeing has to struggle with that.”

 PH: Steve, thankyou very much, always a pleasure talking to you!

SH: Thankyou Peter.

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