Why Fleet Age Is Important To Managing Airline Financial Risk

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Includes: AAL, ALGT, ALK, BA, DAL, HA, JBLU, LUV, SAVE, UAL, VA
by: Three Point Aviation Services LLC

Summary

Despite dropping oil prices, airlines continue to replace aging fleets. How will this affect operating costs?

With cheap oil in play, airlines with older fleets are pulling ahead. Why old aircraft are better positioned for the current environment.

Older aircraft are more expensive to operate, but newer aircraft have a higher annual depreciation expense. Does operating leverage matter?

Overview

Until recently, the price of oil and jet fuel had been on the rise and a major concern for airlines. Even with this year's oil slide, there is still interest in replacing aging fleets. Fuel expense now represents approximately a quarter of most airline operating budgets; therefore, reducing fuel usage remains a priority, even at $55 per barrel. Furthermore, the average life expectancy of new airliners is 25-35 years. Given the current volatility of oil, no one knows where it will be in 2040, and more fuel-efficient planes will reduce the risk associated with future oil prices.

That being said, replacing an entire fleet with new, more fuel-efficient planes may not be the right move. Aging aircraft have something to offer airlines: lower depreciation costs, lower capital investment, and the flexibility to park or replace them at a moment's notice. An entire fleet of older planes, with higher fuel burn, does not necessarily make sense, but a balance of newer and older aircraft can be beneficial. As aircraft age airlines can diversify their expenses and operating leverage by replacing planes in small batches, as they reach retirement age.

Operating Leverage

Assuming that passenger demand will never decrease, the most logical thing to do is purchase new, fuel efficient planes, with low maintenance. However, the risk of future fluctuations in passenger demand creates an incentive to keep older aircraft in the fleet. It comes down to operating leverage. A new, low-cost fleet will prove cost effective when flying on a regular basis. However, if passenger demand shrinks and flights are cut - the cost benefit vanishes. Now the operational savings are less because the planes are flying less, but the cost of capital and age-based depreciation remain the same.

An older fleet would have an advantage in a declining demand scenario. Actual aircraft depreciation occurs on a curve (as opposed to a straight line.) Therefore, older aircraft lose less value on a yearly basis than newer ones. For older planes, the cost of capital would also be lower, because it is based on the remaining value of the asset. The drawback to older aircraft is the higher variable cost incurred every time they fly. However, if it became necessary to reduce schedules or even park excess aircraft, the higher variable cost would matter little. For this reason, it is logical for an airline to retain some older aircraft, which will be the first parked, if necessary.

The chart below displays the average age of several major airlines' fleets, including aircraft on lease and wholly-owned regional aircraft. Note: Fleet change since the release of the 2013 annual reports and the inclusion of leased aircraft here has resulted in a difference between these numbers and the most current numbers. The most current airline fleet data available is included in a table further down.

Source: Three Point Aviation Services LLC

Cash Conversion

A dollar in hand is worth two in Boeing (NYSE:BA). For airlines with excess cash on hand (of which, there are none,) new planes might be a place to stick those funds. For most airlines, cash is rarely excess and must be invested carefully. Buying new aircraft requires the use of cash and/or taking on debt. Even if an aircraft is financed, it will eventually affect the company's cash position, as revenue is used to make debt payments. Cash is important as a safety net for unexpected events, and has intrinsic value. Stashing it in the bank will not yield much at today's rates, but any cash invested in new aircraft is cash not used to pay down debt, or pay dividends. Therefore, an overly young airline fleet may be an over-expenditure.

The graph below provides a general example of two aircraft depreciation methods. The blue line depicts straight-line depreciation, used in financial accounting and generally included in annual reports. The orange line displays an accelerated depreciation, used for tax purposes. The accelerated method is much closer to the actual change in value, which occurs as aircraft age. Actual depreciation and depreciation accounting vary from company to company. This generic example assumes that the aircraft lose 10% when they fly off the sales lot, and have a salvage value of 10% at the end of their life. Data presented here assumes a 30-year useful life. Typical airliner useful life is 25-35 years, depending on the type of aircraft, the use to which it is put, and the applicable airline policy.

Source: Three Point Aviation Services LLC

Future Flexibility

Buying new aircraft at every opportunity is like upgrading a cell phone every time the contract comes up for renewal. The minute that the new phone is received (in exchange for a two-year contract extension) the customer is locked in. If next year's phone is better than this year's - too bad. It'll be another twelve months before the customer can upgrade again without paying the full price of the next phone.

Waiting to purchase new aircraft keeps the powder dry. An airline ready to replace old aircraft can wait to take advantage of new technology, buy when a discount is offered, or defer buying if passenger demand decreases. For this reason, it makes sense for airlines to hold on to at least a few older aircraft (and cash.) If the entire fleet is replaced at every opportunity - there is no flexibility to respond to the unexpected.

Effect of Oil Prices

Lower oil prices largely support the notion of intentional fleet aging. For airlines, one of the biggest considerations for buying a new aircraft is fuel savings. The plane is normally replaced with a newer one, when the potential fuel savings exceed the cost of acquiring the new aircraft. As fuel costs go lower, it becomes more cost effective to continue operating older aircraft, such as the MD-80 series. An airline looking ahead might be concerned with higher fuel prices in the future; but with oil cheap now - there is no rush to replace aircraft.

Measuring Diversity

Retaining a fleet of very new or very old aircraft does not provide much flexibility, and increases risk during an economic downturn (too new,) or fuel price risk (too old.) A mixed group provides balance and flexibility. Average fleet age only measures where an airline is on the new-old scale. Standard deviation of the fleet, on the other hand, provides a measure of fleet diversity.

Airline Fleet Age and Distribution Data (Leased Aircraft and Regional Aircraft Not Included)
Airline Symbol Average Fleet Age Standard Deviation
Alaska Airlines (NYSE:ALK) 8.2 5.8
Allegiant (NASDAQ:ALGT) 23.3 5.0
Delta Air Lines (NYSE:DAL) 18.0 7.2
Hawaiian Airlines (NASDAQ:HA) 10.2 7.6
JetBlue Airways (NASDAQ:JBLU) 6.6 3.6
Southwest Airlines (NYSE:LUV) 11.7 6.9
United Airlines (NYSE:UAL) 11.9 6.5

Source: Three Point Aviation Services LLC

Source: Three Point Aviation Services LLC

Data for the chart above was collected from the FAA database in December of 2014. These numbers only include aircraft owned by the respective airline and exclude leased aircraft, as well as regional aircraft. Hawaiian Airlines had the highest standard deviation, which was the result of a large aircraft batch acquired in 2001 and a second large batch purchased over the last 4 years. Other airlines had a more even distribution, with Delta displaying the highest standard deviation (after Hawaiian.) Several airlines could not be included here due to a lack of available data, including American Airlines (NASDAQ:AAL), Spirit Airlines (NASDAQ:SAVE), and Virgin America (NASDAQ:VA).

Conclusion

Both newer and older fleets have advantages. Newer fleets are more fuel efficient, thereby reducing risk associated with rising fuel prices. New aircraft reduce not only fuel costs but also maintenance costs. On the flipside, older aircraft cost less to retain during reduced schedules, decrease cash allocation, and provide flexibility for future purchases. For many airlines the most advantageous solution is a well-diversified fleet, with aircraft ranging from relatively new to almost retired.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.