CAPA Live October: BOC Aviation MD & CEO Robert Martin

For the video of this conversation, please link to recording

PH: A Very warm welcome to Robert Martin, an old friend of CAPAs to CAPA live. Robert, welcome. Of course, CEO of BOC Aviation, leading lessor in the region.

RM: "Thanks Peter. It's great to be talking to you again."

PH: It doesn't happen often enough because there's too much going on and we're missing out on all your wisdom in between.

RM: "The right news is we're beginning to travel in the meantime so there's no better reason for not having been talking than getting out there and seeing customers."

PH: Good one. Well talking of travel, let's look first at the IATA forecasts for 2022. They're pretty, pretty chilling in a lot of ways when you look at the intra-Asia level, for example. IATA is forecasting, forecasting not projecting, forecasting a level for the whole of 2022 of 11%, an RPKs of 2019 levels. That's a pretty startling place to start, isn't it?

If you look at the flow through the airports, particularly in Southeast Asia, it's still well into single digits as a percentage of 2019. Not all Asians are alike when it comes to travelling. The first one is North Asia. That's probably the area that we are most optimistic, Japan, Korea, you've already seen sort of flights gradually being opened

RM: "Well, let's first of all think about where we're starting from Peter. We're starting from much lower level in 2021, where most borders are effectively closed for quarantine free travel, in Asia at the moment. If you look at the flow through the airports, particularly in Southeast Asia, it's still well into single digits as a percentage of 2019. And the question in what changes between now and 2022. When we look at Asia, we look at actually five different regions, because I don't think all Asians are alike when it comes to travelling.

The first one is North Asia. That's probably the area that we are most optimistic, Japan, Korea, you've already seen sort of flights gradually being opened. We've just seen sort of Singapore. Korea will open up travel shortly. The second area then is I think India cross border, India is beginning to talk about bringing travellers in from overseas."

Southeast Asia is much more difficult because we have a mixture of very low vaccination rates and high vaccination rates here in Southeast Asia. Singapore is above 80% now. Malaysia is picking up quite quickly. Malaysia will get close to Singapore within the next couple of months so that should begin to open next year, but other countries like Thailand, Indonesia and the Philippines vaccination rates are very low. And so there's going to be a reluctance to open those economies quickly to external travellers

"And so we can see there, traffic numbers may begin to pick up. Southeast Asia is much more difficult because we have a mixture of very low vaccination rates and high vaccination rates here in Southeast Asia. Singapore as you know well above 80% now. Malaysia is picking up quite quickly. Malaysia will get close to Singapore I think within the next couple of months so that should begin to open next year, but other countries like Thailand, Indonesia and the Philippines vaccination rates are very low. And so there's going to be a reluctance to open those economies quickly to external travellers. Australia and New Zealand which you know better than I at the moment, closed other than really only to their own nationals. And the question is, when will they begin to open up internationally? We've seen questions asked and sort of now Australia will open to bring its own nationals back from November, but that doesn't really open the broader intra-Asian travel.

"We really need to see Australia and New Zealand open up, and those are going to be sort of laggard from what we see today due to the government regulations and indeed state regulations in Australia. And so when we look at Asia, unfortunately it's going to be slow and it's going to be pockets of intra-Asian growth, rather the total Trans-Asian growth. And the big market of course, which was a source of a lot of travellers for airlines all over Asia, pre COVID, is China. China outbound and inbound, unfortunately we don't see opening up before the Olympics in February next year. I think it's more realistically going to be second quarter before we see that. And I think that is probably the biggest driver of intra-Asian traffic growth. If that doesn't open up to the second quarter, best we're going to get half a year next year."

PH: Mm-hmm. Yeah. So I mean we're (IATA Forecasts) still talking 90% down on 2019 levels though which is pretty dramatic, but looking at Asia to Europe for example, the IATA forecast there is about 25 or 23% I think. I mean, you're talking quite dramatic impacts on general industry revenues, this is a third of the world's market after all.

RM: "Correct."

PH: How does that flow through in terms of impact financially as well as obviously, tourism?

I suspect IATA's numbers are understated for Asia, Europe for next year. Clearly on the financial side, this is going to impact people's cash flows, and people will use whatever aircraft they were planning to use on those routes, on other route where they actually can have traffic

RM: "So the first thing I'd say, I think... Remember the IATA numbers came out of some of the recent announcements we've seen, the announcement data of Singapore last weekend about opening up travel now without quarantine to a number of European countries, both within the EU and the UK, I think probably means those numbers are probably on the low side compared to where reality will be. And as vaccination rates improve in these countries, once we get above 80%, I think you're going to see these travel routes open.

"So I suspect IATA's numbers are understated for Asia, Europe for next year. Clearly on the financial side, this is going to impact people's cash flows, and people will use whatever aircraft they were planning to use on those routes, on other route where they actually can have traffic. Now bear in mind at the same time, we've begun to see the US open to a number of countries with effect from November. I think this will help stimulate some traffic across transpacific. In particular the northern part of Asia, I think will benefit from that. So I think we have to look at it as a whole rather than just individual regions."

PH: Yes. Even though the North Atlantic, for example, which is obviously opening up faster than most and is such a massive market too, IATA's I think forecasting there I think about two thirds of the 2019 levels. So again, you're looking at a substantial reduction in terms of both airline penetration I guess and the number of airlines operating perhaps. But also, if I could just take that one step further. I mean you've just been talking all around the world for the last few weeks, obviously to a lot of people. One of the big issues on the North Atlantic of course is business travel.

RM: "Correct."

PH: Thoughts on both of those aspects?

Part of the problem with business travel is people are still working from home. And so there's less impetus for them to travel on business when they're working from home. I think that's going to change come November and December this year, and we're going to start seeing a significant pickup in business travel.

RM: "Yeah. So, business travel is very interesting. I was in the US and Canada over the last three weeks and talking to airlines about growth in business traffic. And clearly at the moment it's lagging the VFR traffic, and the balance of carriers. Traffic is more heavily towards VFR, who seem to be less concerned about travelling than the business traveller. I think part of the problem with business travel though, is people are still working from home. And so there's less impetus for them to travel on business when they're working from home. I think that's going to change come November and December this year, and we're going to start seeing a significant pickup in business travel.

"And when you think about business travel, business travel tends to be between trade centres or financial centres. If London-New York or New York-Frankfurt or New York-Paris wasn't open to be able to travel without quarantine, then basically business travellers weren't going to travel for two day trips for the gift of two weeks in quarantine. And so, now that's beginning to change and the most important thing is quarantine free travel. Then I think we're going to see business traffic pick up more quickly than people suspect. So actually, I'm more optimistic than those IATA travel numbers show."

PH: Well, that's good to hear. They're certainly not very optimistic, prima facie anyway. Robert, let's come back into BOC Aviation and it does sort of follow on from what we were just saying too. You're predominantly invested in narrowbody aircraft, I think probably more so than most of the other lessors in fact. And narrowbodies, if I can paraphrase what you might say, narrowbodies are the most viable currency internationally the best for lessors as you can easily reposition them. And they tend to have standard configuration, but that configuration tends to be of course, economy class. Now, is that increasing role of lessors in that market who are taking narrow body aircraft because they're a good currency. Is that going to influence the way the industry evolves, particularly coming off this discussion about business travel too?

In terms of numbers of aircraft, narrowbodies are the largest proportion within our fleet. But in dollars invested actually it's closer to 60/40. 60% narrowbody, 40% widebodies. In terms of the way that lessors access the deliveries of aircraft, the world has been changing over the last five years pre COVID. Where you'll see lessors increase their own orders, but what was more apparent was the number of purchases and lease backs they did with airlines

RM: "Okay. So, first thing you're correct in terms of numbers of aircraft, narrowbodies are the largest proportion within our fleet. But in dollars invested actually it's closer to 60/40. 60% narrowbody, 40% widebodies. In terms of the way that lessors access the deliveries of aircraft, the world has been changing over the last five years pre COVID.
Where you'll see lessors increase their own orders, but what was more apparent was the number of purchases and lease backs they did with airlines. And so we've seen sign significantly more of that going on. And even during the downturn that has continued. And it may surprise you to hear that sort of Chinese owned lessors have maintained roughly 40%, just over 40% of narrowbody deliveries during the downturn. I think Japanese around 15%.

This downturn has been different in one significant way from previous downturns. Most of the lessors were investment grade rated from the rating agencies, have been able to access money from debt capital markets that basically wouldn't have been the case during the global financial crisis, and earlier downturns. And that's significantly changed the market.

"And so people thought a number of those lessors would drop away. They haven't. They've continued to play. And, why? Because this downturn has been different in one significant way from previous downturns. Most of the lessors were investment grade rated from the rating agencies, have been able to access money from debt capital markets that basically wouldn't have been the case during the global financial crisis, and earlier downturns.
And that's significantly changed the market. Now, in terms of the configurations that are being used, those are determined by the airlines, but I think in the narrowbody market, clearly over the last 10 years, there's been a big swing towards low cost carriers. And as you know, even here in Asia-Pacific, if you roll the clock back to around 2000, 70% of the aircraft with then widebody, now significantly more are single aisle. And you think in particular of the explosion of LCCs in Southeast Asia, up in Japan and Korea and as well in India, which has driven that.

"Globally I think that's the case as well. So the proportion of low cost carriers have grown. I would say, US has not grown as fast as the proportion of the market, because they're already a significant part. And that's a much more mature market. But I think certainly in Europe, in Russia and in the areas of Asia I've talked about, that was the case."

PH: And let's assume, I think it's a reasonable assumption, that lessors are going to continue to have an increasingly important role in aircraft acquisitions effectively and therefore in terms of OEM decisions on manufacturing. Is that going to drive increasingly towards the narrowbodies, which are the attractive lower emissions and lower unit cost operations. Is that going to drive us more towards seeing more smaller cities served?

If a passenger has a choice, their strong preference is to fly point to point. And as we come out of the downturn, this is going to be one of the challenges for those airlines that rely on hubbing traffic through a single hub, that we will find that the passengers will prefer directly.

RM: "Absolutely. Absolutely. I'm a big believer, if a passenger has a choice, their strong preference is to fly point to point. And as we come out of the downturn, this is going to be one of the challenges for those airlines that rely on hubbing traffic through a single hub, that we will find that the passengers will prefer directly. And in particular you'll see that at the moment, because the amount for restrictions if you fly through a third country, whether it be in the form of quarantine, whether it just be in terms of moving through the airport there, and the time it takes to move through airports.

And airports have become much more difficult places to travel through now than they were three years ago. I think, you'll find out a choice a passenger will tend to want to fly point to point. Which means, I think we're going to see more LCCs and indeed hub carriers thinking about point to point traffic versus hubbing."

PH: And will that constrain... I'll put it another way around. Will that reduce the average distance flown by tourists and others?

RM: "Well, when you think about it, if you'd fly in a straight line rather than a triangle, then yes."

PH: All right. Now talking about the OEMs we mentioned before, very interesting developments there as the market starts to grind up again; we're seeing, for example, some real pressures on oil prices, not just because of aviation but because of some recovery in the economic situation globally, but that is going to be a pressure obviously. Now there seem to be a lot of other pressures too looming in the background, which have an inflationary impact on pricing.

Jet fuel is not just about price, it's also about availability and people being able to pipeline jet fuel to the right places, because remember we are competing with other industries to move oil based products around. The number of employees coming back into the workforce is smaller than those who originally exited it. And it's causing wage inflation

RM: "Yes. So as we come out of the lower market last year, for those areas that have moved further ahead in terms of getting passengers back flying, in North America in particular, in Europe, we're beginning to see signs of different types of inflation appearing all over the industry. It can be simple things like, there's a shortage of cheese dust in the US to put on your snacks, which is probably why you'll eat pretzels if you fly domestically in the US. You've mentioned jet fuel.

Jet fuel is not just about price, it's also about availability and people being able to pipeline jet fuel to the right places, because remember we are competing with other industries to move oil based products around. And so this has become a problem in two regards. One is the pipeline capabilities to be able to move enough jet fuel for our industry.

"The second thing is also the shortage of lorry drivers. Shortage of lorry drivers, back in my home country of the UK is a much talked about matter now and was seen to be a side effect of Brexit. But it's not just in the UK, we're seeing in other countries, well in North America, this has become a big issue. So I think that's something we need to watch for. In addition, ancillary services. Support services and airports, stuff as simple as baggage handlers, people who push the wheelchairs around at airports. The number of employees coming back into the workforce is smaller than those who originally exited it. And it's causing wage inflation. In some cases as much as a hundred percent rises in basically the cost of people who are being employed in these positions in hourly jobs. And in some cases they just can't get as many people.

"So all of this creates potential log jams in the system. On the OEM side, coming out of previous downturns we tend to see commodity prices going up. This happened back in 2001 to 2003, where we had a couple of years of 6 and 7% escalation built into prices. For 2022 we're seeing the same thing. You could see as much as 8% escalation, in 2022. Purely driven by the producer price index portion of the inflation calculations. Now a lot of people have caps on their escalation, but if they don't, this is probably an unexpected jumping cost they weren't expecting, just as we're coming out of the downturn."

PH: It's not good news. Now, on going down the supply chain of the OEMs, Robert, what's happened at the lower ends of that? I mean, they probably haven't had the opportunity to consolidate. They've maybe gone out of business. There must be quite a lumpy supply chain now.

Basically you'll have staff who have been furloughed or who may have been laid off. And as the manufacturers anticipate at the front end to increase production from 2022 or 2023, they're going to need the parts ready for that being delivered this year and next year. And, to employ that labour back may not be necessarily as easy as it was to let the labour go.

RM: "Yes. So I think all the way down the supply chain there's concerns in, I would say three areas.

"The first one I think this is the most important one is labour. Basically you'll have staff who have been furloughed or who may have been laid off. And as the manufacturers anticipate at the front end to increase production from 2022 or 2023, they're going to need the parts ready for that being delivered this year and next year. And, to employ that labour back may not be necessarily as easy as it was to let the labour go. And so this is clearly causing some log jams.

"The second thing is supply chains. You've seen the well-publicised stories about supply chains with ships out of Shanghai, ships not getting through the Suez Canal. This also has an impact on our industry as well. Particularly for some of the lower cost parts of the supply chain, which is causing some disruption.

"And thirdly, finance. You've got to remember this is a part of the aviation infrastructure that lessors aren't really involved in, financing. It's more back to traditional banks. Banks during the downturn turned negative on the aviation business, and for them to come back in and increase working capital financing for people down the supply chain is a challenge. And so I know this is something that the big aerospace manufacturers at the OEM level, also at the engine level are watching very, very carefully. And you're correct, so far we haven't seen a lot of consolidation, but we may have to see it as we go forwards if manufacturers want to maintain increased in their production rates over the next three years."

PH: Yeah. Well, that's one of the many things that we still have to see the residual impact as it flows down. When you talk about investment, Robert, I mean, obviously we've got this issue of green investment now which comes in at the airline industry from all sorts of different positions. But we've also got an industry that's incredibly highly indebted now.

How do you see investment coming to the airline sector which is not the good model, the good model of course is the leasing business model. How do you see that willingness to invest in airlines being affected?

Clearly there's a very buoyant aircraft financing market out there. Either through leasing companies or indeed through bond markets. Where it's more difficult is where people are looking for investment in other parts of their business, that maybe counterparties don't view as the same in terms of security.

RM: "Okay. So I would say we need to think about it in two ways. The first way to think about it is in terms of what do you need to invest in? If it's investing in aircraft, clearly there's a very buoyant aircraft financing market out there. Either through leasing companies or indeed through bond markets. Where it's more difficult is where people are looking for investment in other parts of their business, that maybe counterparties don't view as the same in terms of security. So building out people's positions at airports, as they take on new slots. Taking on additional labour as they gear up. That part of the working capital traditionally has been done by banks. There isn't really an alternative to it at the moment, unless the people have access to capital markets.

"And that second thing then is access to capital markets. The world is split into North America, China, parts of Europe in terms of the stronger investment graded rated airlines. Obviously Qantas down in Australia, who clearly have access to capital markets for unsecured money. This clearly puts them at a strong advantage to those carriers who don't have the access to the capital markets and are having to find new ways to basically raise working capital. Now during the downturn we've seen some interesting new innovations. One of them is people using their digital footprint, essentially as some form of security for raising money. We've seen that already in North America with people using their frequent flyer programmes. We're not seeing it much in Asia yet. I know there's people trying to do this, but we haven't seen many execution of yields but I believe it's just a matter of time before we get there, because people are going to have to innovate in terms of the new sources of financing that they tap to grow the working capital in businesses."

PH: Well yeah, I mean so what you're saying there Robert is essentially, okay, the big guys can do it because they've got other sources, but if you get down to the next level, and it's not that far down really in terms of large airlines, and at the next level all you've got is the ability to borrow on the back of assets, and that really puts them very much in your hands in a lot of ways if they're doing purchase and lease or sale and lease backs. Is that really going to create a great division?

There will be others in the supply chain that aren't in the strong position that airports are, because you'll have a choice of providing the service to the carrier or frankly, losing their business.

RM: "Or there's another alternative, which has been the reality during the downturn, where they've had to go to different players who're counterparties to them to get deferrals of payments. And this in itself is creating an issue. You'll have heard Willie Walsh talk at IATA about airports, how airports are raising their charges. Frankly because of their monopolistic position they're able to do this. But there will be others in the supply chain that aren't in the strong position that airports are, because you'll have a choice of providing the service to the carrier or frankly, losing their business. But we have seen a lot of deferrals and particularly in some of the emerging markets.

"There's been a lot of debts built up to government owned entities, whether they be airports or some other type of suppliers to the business. But clearly this is an area where there's going to have to be innovation going forwards. We ourselves through bank of China have done sort of quite a lot of receivable financing in the past. And so I see maybe a further extension of that business going on. As you know sort of green finance has become the latest buzzword in the marketplaces. So where people can demonstrate things like their headquarters as being environmentally friendly, they can raise green finance for that. So, we're beginning to see some evolution now but I think it's got a long way to go, particularly in emerging markets."

PH: Mm-hmm (affirmative). Yeah. I'm not sure you quite answered my question there. Except in terms of being a little bit more optimistic perhaps than I was.

Absolutely it's a challenge. But then you've got to look at what are the creditors or alternatives in the event that they don't continue to support their airline customers. And that's why I think we've seen many fewer airlines go bankrupt this time around compared to previous downturns.

RM: "Yeah, but you're right, Peter, to say it's a challenge. Absolutely it's a challenge. But then you've got to look at what are the creditors or alternatives in the event that they don't continue to support their airline customers. And that's why I think we've seen many fewer airlines go bankrupt this time around compared to previous downturns. And in addition, think about it in terms of if 60% of the market on the aircraft financing side is now coming from lessors. They are clearly one of the largest creditors, the airlines, and the days of having banks as the major creditors of airlines, they've been displaced by lessors, but it also means then the lessors who tend to be more accommodating on about when they come to a default situation, they've born the brunt of some of these problems during the downturn. And I think there'll still be a period of that as we come out of the downturn."

PH: Yeah, that talks a lot to the efficacy of the lessor business model, doesn't it? We've talk for many years, as long as I can remember in fact about virtual airlines. Are we taking another big step in that direction of the airlines actually flying lumps of metal and everybody else doing all the interesting parts on the financial side?

All those things that drive their brand, they're not going to outsource. I think those will stay with the airline. And if you think about what is a totally virtual airline, it's really a wet lessee.

RM: "Well, maybe on the financial side you may be correct, but I think when you look at the core competencies of an airline, there's a lot of them they can't really outsource. All those things that drive their brand, they're not going to outsource. I think those will stay with the airline. And if you think about what is a totally virtual airline, it's really a wet lessee. It's someone for whom someone else has provided all their services and I don't think we've moved to that point yet in the marketplace, not for most airlines around the world. I think they still want to hold onto those core branding competencies."

PH: Yeah. And in fact, I guess in many cases at the moment the brand is the greatest asset they actually have, with putting aside the hard mesh side of things. Just, we've only got a few minutes left unfortunately, Robert, because I'd love to talk to you for a couple of hours. It's always fascinating. We're seeing the AerCap-GECAS merger probably going through. Does that presage a flood of mergers in the leasing industry now or is that perhaps where as far as it goes?

Whenever you have sort of an acquisition situation you need a willing seller. Because of the liquidity that we see in the market today, most sellers are not prepared to sell up prices that make sense for the acquirer.

RM: "Okay. So, whenever you have sort of an acquisition situation you need a willing seller. Because of the liquidity that we see in the market today is, most sellers are not prepared to sell up prices that make sense for the acquirer. Now, there will be some consolidation I think going forwards after AerCap-GECAS, but it's more going to be a case of there's so many leasing companies who are in the market. Not all of them, are going to be able to grow at the same pace as the market grows. And so they're going to be faced with an issue of either not being able to grow, or alternatively having to grow by acquisition. And the question is how much stomach do they have to buy companies basically a price to book of greater than one?

"That's never been a model that we've been interested in, but some lessors may just not have a choice. They just won't be able to grow in today's market. And the returns from buying another company may look more attractive than what they're seeing in sort of the purchase and lease back market or the primary aircraft placement market bearing in mind, your Airbus is definitely sold out for the next four years. Boeing's getting close to being sold out for the next four years. So where do they go for their growth? They either move up into the widebody market or they move down into the regional jet market. Unfortunately, as we've seen during this downturn the regional jet guys have not fared well. We see the Nordic situation where maybe looking at the second restructuring, some of the smaller players in that market haven't fared well. And so, you may see M&A through necessity rather than through sort of logic."

PH: Now I was sort of thinking back four or five years ago, there were some highly publicised so-called overpriced purchases being made of leasing companies. I guess the equalising factor there has been that interest rates have gone down so much that these are now like the housing market, not so overpriced.

The one thing we always have to watch is to what extent are people taking a risk for the liability side of their balance sheet? If people have got lots of short term debt, that has always been the Achilles heel of any leasing company

RM: "There's no doubt when you look at sort of the margin they've made they've been helped by particularly floating rates being very low and sort of the fixed end of the curve being below what would expect in the cycle. However, the one thing we always have to watch is to what extent are people taking a risk for the liability side of their balance sheet? If people have got lots of short term debt, that has always been the Achilles heel of any leasing company, you think back to GPA 30 years ago. If you think back to what happened in the global financial crisis with CIT and RFC, relying too much on short term funding. And so, particularly now with the discussion you and I had on potential inflation coming into the marketplace, that could be a riskier strategy going forwards and it's been during the last 10 years."

PH: Right. Well, I'm pleased to see that meanwhile BOC Aviation is pretty much going from strength to strength. You have a terrific first half in the circumstances.

We are trying to find ways to support customers, particularly doing things like using our pre-delivery financing product, which helps them free up working capital for other parts of the business. Whilst they're looking to grow out of the downturn.

RM: "And yes we have, and we're a long term player. And we always have to think of the long term. As you and I have discussed, there's a number of new challenges coming up because next year or two. In particular, some of the inflationary things we've talked about, some of these supply side issues, which could impact on our airline customers operations.

And so we need to be very cognizant of that. But at the same time, we are trying to find ways to support customers, particularly doing things like using our pre-delivery financing product, which helps them free up working capital for other parts of the business. Whilst they're looking to grow out of the downturn."

PH: Good. Well, thank you very much Robert. Always great to talk to you!

Link to video recording