:: April 2020 Letter ::
How bad are things? Bad enough that I feel the need to write a monthly letter with nothing but good news. I like being a contrarian, and we could all stand some good news right now. The situation is the grimmest I’ve seen in thirtysomething years of aviation market analysis, but here’s what I’ve got by way of positive thinking:
Airlines are in the best of all possible worlds. Almost. One oddity of the current situation is that, except for the market, airlines now have everything they’ve ever wanted. Fuel is about as cheap as ever. Great, efficient jets are available at fantastic discounts. There’s generous government support, at least in the US and many other key markets. The cost of capital (which remains available, per below) is back down near nothing. And crew costs will stay low for some time – there’s certainly no risk of a “pilot shortage” anytime soon.
Okay, traffic is mostly gone. And yes, social distancing procedures will suppress profitability until there’s a vaccine. But when we start digging out of this mess, whether it’s in 2021 or 2022, airlines will most likely have these great conditions. They will be able to choose whether to stimulate traffic with low fares, focus on profitability, or some of each.
We’re a much bigger industry than in previous downturns, which provides a degree of insulation from the bottom. If a $55 billion a year industry suffers a 28% drop, it’s just a $39 billion a year industry (this was the case in the last downturn, 2001-2003, in today’s dollars). But a $115 billion industry (the 2018 peak, before the MAX shutdown) suffering a 35% drop is a $75 billion industry (that’s our current forecast). A larger industry means a lot more people employed, and a better starting point for resumed growth.
Financial system intact. Unlike in the great recession of 2008, the financial system today is intact and not melting down. This may seem like a mere consolation prize when the non-financial economy is in a medically-induced coma (as Paul Krugman put it), but it’s actually very important. There’s a lot of liquidity out there, looking for a good home, and aviation is a good long-term home (even if it can be a frightening sector for investors right now). Boeing’s move this month to access $25 billion in loans depends on this robust financial sector. Endangered aerospace supplier companies will increasingly rely on private equity as they merge, restructure, or try to survive as-is. Meanwhile, since airlines aren’t exactly flush with cash, they’ll depend on financiers for sale and leaseback (SLB) transactions and occasional lease holidays. This brings me to my next good news item:
Long-term thinking rewarded. As Warren Buffett said, “Only when the tide goes out do you discover who's been swimming naked.” To look at it from an optimistic angle, when the tide goes out you discover who’s swimming in a fashionable yet sensible suit. In other words, we’ll soon find out which jet lessors, financiers, investors, and other players are in this industry for the long haul. Those who stick with it, and even double down, will be rewarded with greater market share, and then greater profits. Those who are not will be forced to sell at a loss.
I guess I should mention that yes, Buffett’s recent decision to dump his very large airline holdings was a demotivational moment for me, and for the industry. But keep in mind that he’s 89. I’m 56, and I’m expecting a nice upturn before I hit 60. Long-term thinking looks very different when you’re 89.
Much bigger defense budget. The FY 2001 defense budget, which was the basis for disbursements in the 2002 commercial downturn, funded $54 billion in weapons procurement. The FY 2020 procurement budget is about $150 billion. The primes are enjoying good times, but more crucially that’s a lot more money for beleaguered suppliers, who are threatened by the commercial downturn. The long-term debt taken on by the government during this crisis might well pressure defense downward in the long run, but for the length of this economic crisis there might even be a defense upside – historically, in crises, Congress views defense as a kind of shovel-ready stimulus spending package. Export markets look strong too -- only South Korea has announced meaningful budget cuts. The oil-exporting country markets are at risk, however, if oil prices don’t recover in a few years.
It also helps that DoD is perhaps one of the few corners of the US Government where industrial policy is not a dirty term. The services, and DoD, are each accelerating contracts and payments with an emphasis on cash trickling down through the supply chain. They will also be looking to step in when needed to prevent supplier company failures or unwanted acquisitions.
Less frothy bizjets. The 2008 business jet collapse was fueled, in part, by speculative purchases, aided by very generous financing, resulting in weak order books. This was primarily true for small and medium cabin jets. Not everyone in the market was overaggressive, and only a few really aspired to flip their jets at a profit, but that part of the market fell by 57% and never recovered. So, today, small and medium cabin backlogs and production rates look a lot more reasonable and conservative compared with 2008. There are reasons to be concerned about the large cabin segments, which are positively correlated to oil prices, but even those have seen decent resiliency over the past decade or so.
Globalization Resurgent. The aviation industry will come back online in fits and starts, with some regions leading the way – Asia is already seeing tiny green shoots, for example. The US is merely 15% of the market, and Europe not much more. Trade barriers and conflicts will be barriers to jetmakers, and to suppliers hoping to recover along with these regional opportunities. Other sectors of the economy will function the same. Rather than closing borders and pandering to nationalist sentiment, perhaps global thinking should reassert itself, particularly since closed borders will be associated with the logistical nightmares of the pandemic, and not with sound economic policies. At some point, it will become glaringly obvious that the best way out of this economic mess is to replace Trade Wars with a Trade Peace.
So, that’s what I’ve got. We’re clearly heading in to a multi-year commercial market downturn. But the dark clouds aren’t completely devoid of silver linings.
Yours, ‘Til The Beforetimes Return,
© Richard Aboulafia 1997-2006, All rights reserved.