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Economic Lives & Depreciation Remain Unchanged for Most Types

The Covid Event has been catastrophic for the aviation industry and has caused long lasting structural changes some of which have led to the question of whether the economic lives of aircraft, particularly widebodies, should be extended thereby changing depreciation policies. The airline industry – and the financial institutions that underpin the financing of assets – have been re-examining depreciation policies and economic lives of aircraft. Such analysis may be the result of a need to improve the bottom line in accounts.

However, ever stricter accounting procedures are requiring constant updating of assumptions such that risk is assessed as the market changes. Depreciation policies can vary considerably depending on the jurisdiction and the individual operator or financial institution. The management of airlines are required to reassess the appropriateness of its depreciation policy at each reporting date, whether there is an impairment or not.

If residual values or useful economic lives have changed airlines should amend their policies such that the depreciation charge to the profit and loss account is adjusted in line with the revised expectations. Impairment of aircraft has also become a major consideration as values of many aircraft have fallen as a result of the COVID Event. Asset impairment reviews may be necessary where a triggering event such as COVID occurs and for a CGU including goodwill are performed at least annually, although this could be more frequent depending on circumstances.

Airlines assess aircraft assets for impairment or consider the appropriateness of their current depreciation policies based on a number of difference factors including: idle assets; making decisions to dispose of aircraft or related assets in advance of their original retirement date; planned fleet replacement or retirement of a class of assets; changes or volatility in resale markets or expected resale value; a CGU (cash generating unit) impairment where aircraft in the CGU may be impaired as a result; changes in technology; economic and market factors. IAG, encompassing British Airways and Iberia, started in their annual report of 2020 that depreciation rates were “specific to aircraft type, based on the Group’s fleet plans, within overall parameters of 23 years and up to 5 per cent residual value for shorthaul aircraft and between 25 and 29 years (depending on aircraft) and up to 5 percent residual value for longhaul aircraft.” Qantas uses up to 25 years for aircraft.

With the problems of the longhaul international market particularly impacting demand for widebodies, there are arguments for considering that the service life of this category of aircraft should be extended. Before the Covid Event, Airbus was advertising for engineers to design a re-engined A350. This has now been delayed perhaps for two years or more. This may lead to the conclusion that the life of the existing fleet needs to be extended as obsolescence has been delayed. Both Airbus and Boeing have also seen delivery rates for widebodies fall by a significant amount although more recently new orders have been placed. The reduction in deliveries suggests that the rollover of the widebody fleet will also be postponed, thereby forcing existing widebody fleets to be retained for that much longer.

However, on the other side of the analysis is the need to meet the environmental pressures and the high cost of fuel. SAF is expensive but appears to be the means of meeting environmental challenges in the short to medium term. Supply of SAF is an issue for a number of years yet but the pressure on the industry to reduce its emissions is something that will only intensify not diminish.

Consequently, in the context of economic lives of widebodies over the long term there will be a need to improve engine technology including being able to use 100 percent SAF. This will cause operators to retire older aircraft. In examining previous events, to some extent a major downturn accelerates the retirement of older widebodies as the availability of newer widebodies is greater and new widebodies act as a replacement for existing older widebodies instead of meeting the need for growth.

During a downturn operators can more readily acquire mid-life widebodies at much lower prices, thereby replacing their older widebodies that they may have intended to retain. The economic life of a widebody is therefore likely to remain at 25 years in a passenger role and 30-35 in a freighter role. As the aviation industry emerges from the Covid Event and international traffic is restored, there will be greater transparency in terms of retirement profiles. Any aircraft that remains in storage for three years is unlikely to be returned to service and therefore should be considered to have been permanently retired.

B737-7 Values Recovering as Market Improves

While delivery rates for the B737-7 remain non-existent values of the variant are improving as the market recovers, the MAX is re-integrated into the fleet and as the market structure undergoes a shift.

When the B737 MAX was launched the B737-7 was to have the same capacity as the preceding B737-700 but in 2016 Boeing announced that two more rows were to be added such that the same wing and landing gear as the B737-8 is used. There are now a pair of overwing exits rather than a single door configuration and fuselage strengthening was undertaken to accommodate the greater length. The extra two rows now allows for a maximum seating capacity of 172 although a high density two class configuration allows for 153 passengers.

This compares with a maximum of 160 seats for the A220-300 and the same number for the A319neo. The range of the B737-7 has been increasing such that 4,500 miles will eventually be possible, longer than the A319neo or the A220-300. Thus far a single example has been built with Boeing using it as a test aircraft with deliveries due to commence this year. Airbus has already tacitly acknowledged that it is considering stretching the A220 into a A220-500 model that will offer capacity more in line with the B737-7. Whereas the A220 is an all new model the B737-7 still has considerable heritage in terms of a design that stretches back to the 1960s.

A number of potential customers are already considering the A220-500. Airbus and Quebec have recently announced a major investment in the A220 program ostensibly aimed at increasing production rates although the stretch now seems increasingly likely to be announced in the near future. Stretching an existing model offers lower seat mile costs and as such both Airbus and Boeing will be seeking to promote their respective types to operators that will be seeking to replace their B737-700s and A319ceos but with a type that meet the expectation of greater traffic.

In terms of orders, there are no absolutes for the B737-7 as Boeing still does not differentiate the orders for the various variants of the B737MAX unlike Airbus with the A220 and A320neo. Some estimates indicate that the orders for the B737-7 number 220 while others suggest more than 300. These estimates compare with only 71 orders for the A319neo and 568 for the A220-300. Four A319neos have been delivered and 143 A220-300s as of the end of 2021.

Some 300 orders for the B737-7 have only originated from a few customers with Allegiant, Ruili Airlines, SkyUp, WestJet and Southwest. Southwest has ordered the majority of those listed as having been placed although United Airlines have previously been reportedly looking at the -7 has a replacement for its ageing B737-700s. The Russian and Chinese markets may not be viewed as primary sources of demand as may have previously been the case due to politico-economic developments in the near term.

In terms of values, those for the B737-7 have suffered as a result of the Covid Event by as much as 20 percent as well as due to the grounding of the MAX model. With the improvement in the market and the rehabilitation of the MAX, there has been some notable increase. The values of the B737-7 are still well below $40 million but this compares to a low value of nearer $30 million as of April 2020.

As the market improves and deliveries of the -7 accelerate, the values of a new example can be expected to increase in the next two years to more equate to the $40 million that was previously expected. The effect of inflation on new aircraft pricing will become ever more notable in the next two years and this will also increase the values of new B737-7s.

Launch of B777-8F Places Spotlight on B777-200F/B747-400F Residuals

The launch of much heralded B777-8F has finally been announced but this raises concern over the medium to long term residual value prospects for the existing B777F.

The order from Qatar comprises 34 firm orders and 16 options. The list price of $400 million will bear no resemblance to the net pricing to Qatar. The current value of a new B777-200F is approximately $135 million which suggests that the larger B777-8F will have a single unit value of more than $150 million. The B777-8F offers 17 percent more volume and ten percent more payload than the current B777-200F. Qatar will have received considerable discounts and credits from Boeing (airlines often receive credits from the airframe and engine manufacturers that they can use again future aircraft or engine orders rather receiving all the discounts off the initial order) such that the unit base price may be less than $120 million per unit.

The issue going forward is that the first B777-8F is not due to be delivered until 2027. The high rate of inflation is expected to persist for at least some two years and this could see a base price of $120 million increase to a possible delivery cost of $160 million if five or six percent per annum escalation is sustained. For a much smaller customer securing an order today at $150 million, the delivery cost could be nearer $200 million.

The B777-8F will be competing with the A350F. In terms of the payload the A350F will be able to carry 240,000lbs versus the 261,000lbs of the B777-8F and the 235,900lbs of the B777-200F. The range of the A350F is however slightly greater than the B777-8F and the Airbus product may have a lower empty weight.

In terms of volume the A350F will have slightly less than B777-8F. The two products are therefore reasonably evenly matched although much depends on the operator’s specific operations. The advantage for the A350F lies in its earlier service entry date of 2025 compared to the 2027 for the B777-8F.

The issue going forward is the effect on the residual values of the B777F and indeed the B747-400F. With regard to the B747-400F, the payload of the B777-8F is that much greater and twin engined economics will be a considerable advantage for the latter - except that the B747-400F will cost some 70 percent less in terms of capital expense. As of 2027, production of the B777-200F will fall foul of new emission regulations such that the type needs to be replaced in any event.

As of 2027, the market will likely have fully recovered (notwithstanding any other issues) with passenger widebodies offering considerable underfloor cargo capacity once more. As of 2027, the first B777- 200Fs will be nearing 20 years of age and while at least another ten years of service will beckon, the combination of much more efficient competition in the form of the A350F and the B777-8F will likely see more B777-200Fs being replaced. The experience of the B747-400F versus the B747-8F and B777-200F in the years leading up to the Covid Event provides a salutary lesson. The values of the B747-400F had tumbled in the face of a weak airfreight market and ready availability of production freighters.

The current airfreight market is experiencing exceptional demand with the B777-300ER and A330s beginning to be converted in numbers. Should a surplus of airfreight capacity emerge once again, then the B747-400F will be once again exposed to be joined by the B777-200F. Instead of exhibiting some stability in the latter years of this decade, values of both models could be exposed to replacement sooner than might currently be expected. Residual value projections always need to consider the future market conditions rather than merely extrapolate from current strength or weakness.