Airlines feel squeeze as plane leasing groups raise rents
Scarcity of aircraft and surging borrowing costs ripple through commercial aviation market
Airlines are flying back into profitability after racking up big losses during the pandemic. There is a cloud on the horizon, however: sharp increases in the cost to rent a plane.
More than half of the world’s commercial aircraft are owned or managed by leasing companies, and their rates are rising. For Airbus’s A320neo and Boeing’s 737 Max — the most sought-after single-aisle aircraft — lease rates have respectively risen 14 per cent and 20 per cent since the lows of the pandemic, according to IBA, an aviation consultancy.
The jump in rental fees is another consequence of global central banks’ push to raise interest rates as surging inflation ends an era of cheap finance. Higher interest rates mean that the specialist companies that own and hire out aircraft fleets have more costly debt. Lessors must calculate how to pass on these borrowing costs to carriers that are already dealing with ballooning higher fuel and labour expenses.
Air Lease, a Los Angeles-based lessor, last week raised $700mn through a bond offering at an interest rate of 5.85 per cent — roughly double the rate of a similar bond issuance in January.
The deal, the first such bond offering since Russia’s war in Ukraine, is “somewhat of a bellwether,” said Philip Baggaley, analyst at S&P Global. “They had to pay a lot more than they used to borrow at, but that’s the market reality.”
Air Lease executive chair Steven Udvar-Házy said he had not seen the cost of capital increase this quickly since the 1970s, when inflation was rampant.
The rapidity of the rise makes it harder to pass higher financing costs on to airlines, but Udvar-Házy said Air Lease has started already. Airlines, whose lease rates had already risen owing to scarce aircraft supplies and strong demand, are resisting.
“Airlines are always pushing back,” he said. “I’ve never had an airline say that our lease rates are too low. It’s like a big Istanbul grand bazaar: The leasing company says 100, the airline says 80, and we hope to negotiate at 99 and a half.”
Many airlines asked lessors for financial relief during the pandemic. But they are back in the black as air travel has roared back. “So it’s very hard to plead poverty,” Udvar-Házy said. “Yes, we’re going to work with our customers, but they read the newspapers, they see what’s going on. The cost of financing is going up.”
Several airlines referred to rising interest rates with regard to leases in their recent earnings calls.
Wizz Air of Hungary told investors last month that it benefited from having “fixed interest rate structures financing 94 per cent of its existing fleet”. In the US, Frontier Airlines chief financial officer Jimmy Dempsey said it had financed 35 out of its next 37 aircraft deliveries, “and we’ve done it in a way that has capped interest rate exposure on a lot of these leases”.
Andy Cronin, chief executive of Irish leasing company Avolon, said lease rates were moving upwards for both new and used aircraft in response to the undersupply of aircraft in the market, rising interest rates and the withdrawal from the market of certain lessors, in particular some from Asia.
Surging interest rates have hit the market for bonds composed by bundles of plane leases. The value of deals for such asset-backed securities is expected to total $1.1bn in 2022 compared to $9.2bn last year, revealing a changed market, said Ishka Global aviation consultant Paul O’Driscoll.
“Nobody wants to buy a package of leased aircraft because they have [quantitative-easing] era leases, while investors can get [quantitative-tightening] era yields by providing capital for new lease transactions,” he said, referring to central banks’ sudden move to tighten monetary policy.
Tense bargaining between lessors and airlines will be limited somewhat because only 15 to 20 per cent of a lessors’ fleet comes up for lease renewal in any given year.
“Current market lease rates for new aircraft are up 5 to 10 per cent. But that is not the 30 per cent that might be required given the interest rate increases we have seen this year. Lessors will therefore face some [profit] margin compression,” said Rob Morris, head of global consultancy at Ascend by Cirium.
As they enter into negotiations, leasing executives point out that airlines have not hesitated to raise prices for their own customers. Average US airfares were up 22 per cent year on year in the second quarter of 2022, government data show.
“Airlines are under tremendous cost increase pressure, but they’ve been able to pass it on to the traveller in higher ticket prices,” Udvar-Házy said. “So Air Lease is not a sinner in this respect. We’re simply trying to deal with economic realities.”
A close Suisse shave
Credit Suisse’s rollercoaster rights issue shows risks even for a Justice League of underwriters
Yesterday Credit Suisse announced that its shareholders subscribed to 98.2 per cent of its rights issue. That’s an impressive level of take-up, but it was nail-biting suspense until the end.
The CS share price fell so much during the rights issue period that late last week it looked like the underwriters might end up owning a significant chunk of the Swiss bank’s stock. This would have been a nasty shock to everyone involved, including the market.
In the end, the shares rebounded and the rights issue completed successfully. But the close shave has exposed some unresolved and perhaps unresolvable issues that arise when investment banks underwrite capital-raises for companies.
Launched as part of a SFr4bn capital increase and organisational overhaul, Credit Suisse’s SFr2.24bn rights issue should have been smooth sailing. For one thing, the new shares were being offered at SFr2.52 per share, a meaty 32 per cent discount to the dilution-adjusted price (aka “theoretical ex-rights price” or TERP).
Moreover, CS was able to assemble a massive syndicate of 19 banks to underwrite the fundraise at SFr2.52. The rights issue was also accompanied by a SFr1.76bn share placement to investors, mostly the Saudi National Bank, with a further commitment from those investors to exercise their rights to buy shares.
So this capital increase had the building blocks for success: (1) a deep discount to ensure that shareholders exercise the rights to buy shares, (2) a Justice League-strength underwriting syndicate, and (3) the presence of a cornerstone investor.
Yet the rights issue caused some sweaty palms. Battered by client outflows and a profit warning, Credit Suisse shares tumbled from the late October announcement. On 1st December the shares skidded to SFr2.667, meaning the discount to buy shares in the rights issue had contracted from 32 per cent to just 5.5 per cent. That’s waaaay too close for comfort.
The vast majority of rights issues are anticlimaxes. As long as the shares stay well above the subscription price, shareholders have every incentive to exercise the right and buy shares at a discount. And since the underwriting banks aren’t actually selling shares, there is none of the stress or uncertainty of collecting orders and building a book of investor demand, as there is in an IPO or share placement.
What matters is that the share price does not get too close to the underwritten price. It can drift or drop a bit, but not crumble or crater. A 32 per cent discount is a big cushion, and such a sizeable discount is why some investors disparage the fees that banks earn for underwriting as “money for old rope”: the underwriters are pocketing a fee for taking on the very remote risk of being stuck with shares.
Yet rights issue underwriting has two features that can turn money for old rope into a noose around the neck of underwriters.
First, it exemplifies what Nassim Taleb and others call “picking up pennies in front of a steamroller.” The underwriters collect fees of around 2 per cent, but in the extraordinarily unlikely event that the share price collapses, they could be left with a big position in a stock they don’t want to hold.
The “pennies in front of a steamroller” situation typically arises when a party writes (sells) a low-value derivative, such as a deeply out-of-the-money option or a credit default swap. That party collects the premium, and there is little chance of the option ever being exercised or the CDS being triggered. But in the extreme case it is exercised, the party can find itself nursing big losses.
To be clear, the underwriters did not enter into an actual derivative contract with Credit Suisse. There was no ISDA documentation, and the exposure never sat in a derivatives book. But by underwriting at the deep discount, the banks sold Credit Suisse the functional equivalent of a short-expiry, deeply out-of-the-money put. If shareholders hadn’t bought shares in the rights issue, then CS could have “put” shares to the underwriters at SFr2.52 per share.
Thus the underwriting has the substance, but not the form, of a derivative option. And the size of that de facto derivative is enormous as a percentage of market capitalisation or trading volume. There is no way to buy an equivalent out-of-the-money put in such size in the regular trading market. And no market counterparty would ever write one, either.
A second, albeit related problem, is that there is virtually no way to hedge the underwriting of Credit Suisse shares either. When writing an option, most market players hedge their positions. But here it’s practically impossible.
For one thing, shorting CS shares is likely prohibited in the underwriting agreement and in any case would be self-defeating as a hedge, as you would be pushing the share price down — it would be akin to an animal eating its own tail to feed itself.
For another, shorting a basket of other peer stocks will create mismatches (known as “basis risk”): in the middle of a major corporate event, Credit Suisse shares had their own dynamic, and they could not be expected to closely correlate to UBS or other European banking shares.
Buying Credit Suisse credit default swaps would also have been difficult as a hedge, given the illiquidity and idiosyncrasies of that market, and it may have been barred in the underwriting agreement anyway.
The underwriters of a rights issue can hedge against a market crash via index options, but not a stock-specific one. An index hedge here might have generated significant losses, because the broader market rallied hard from the time of the deal’s announcement.
So when shares get perilously close to the subscription price, what can the underwriters do to manage their risk?
Not much. You can stare at the terminal screen to will the shares higher, but if Uri Geller couldn’t stop Brexit with his telepathy, an investment banker won’t have more sway even if they are doing God’s work. More practically, you can lob in communication advice to management, but at such a late stage it’s usually like screaming in a wind tunnel.
Fortunately, a sharp rally in Credit Suisse came in the nick of time, lifting the share price above SFr3 last Friday after chair Axel Lehmann said that outflows had stopped. This good news was followed by weekend media reports about possible investments by the Saudi Crown Prince and Bob Diamond’s Atlas Merchant Capital into its First Boston investment bank spin-off. As FT Alphaville wrote: “Timing’s pretty convenient.”
But you can’t always count on such deux ex machina to save the day. It is extremely rare, but rights issues can leave underwriters stuck with an outsized rump of stock. The cumulative underwriting losses on July’s €2bn rights issue for Italian oilfield services firm Saipem may have exceeded €100mn.
In the end, the underwriters will have made money on the Credit Suisse rights issue. But the close shave is a reminder that rights issues expose underwriters to equity risk that is both unhedgeable and many times larger than their reward.
Closing Stock Market SummaryThere was a positive bias in today's trade coming off a weak start to December for the stock market. The S&P 500 closed in the red eight out of the last nine sessions and has logged five straight losses to begin December. According to Bloomberg, that is the worst start to a month for the S&P 500 since 2011.
Things got started on an upbeat note today before the S&P 500 faded back to test yesterday's closing level (3,933.92). Buyers stepped in, however, and defended that line, which aided investor sentiment.
The market hit an air pocket in the afternoon trade, though, following the news that the FTC is seeking to block Microsoft's (MSFT 247.40, +3.03, +1.2%) acquisition of Activision Blizzard (ATVI 74.76, -1.17, -1.5%). Again, buyers showed up to help stabilize the market and the main indices ultimately closed around the levels seen before the Microsoft news emerged.
Broad buying interest left most of the S&P 500 sectors in positive territory by the close. Communication services (-0.5%) lagged due to a weak showing from Alphabet (GOOG 93.95, -1.20, -1.3%) and the energy sector (-0.5%) felt the pinch of falling oil prices ($71.40/bbl, -0.89, -1.2%).
On the flip side, the information technology (+1.6%) and consumer discretionary (+1.1%) sectors sat atop the leaderboard. The latter was boosted in part by casino stocks trading up on the news that Macau is easing COVID-19 testing requirements, according to Reuters. Las Vegas Sands (LVS 48.31, +1.18, +2.5%) and Wynn Resorts (WYNN 86.43, +1.47, +1.7%) were winning standouts for the group.
Tesla (TSLA 173.44, -0.60, -0.3%) was an individual story stock of note today. It lost ground again on news that Elon Musk's bankers could provide him with new margin loans supported by Tesla stock to replace high interest Twitter debt, according to Bloomberg. The company is also aiming to shorten shifts in Shanghai and delay hiring, according to CNBC.
Treasury yields moved higher today. The 2-yr note yield rose eight basis points to 4.32% and the 10-yr note yield rose eight basis points to 3.49%.
- Dow Jones Industrial Average: -7.0% YTD
- S&P Midcap 400: -12.2% YTD
- Russell 2000: -19.0% YTD
- S&P 500: -16.8% YTD
- Nasdaq Composite: -29.2% YTD
Reviewing today's economic data:
- Initial claims for the week ending December 3 increased by 4,000 to 230,000 (consensus 220,000) and continuing claims for the week ending November 26 increased by 62,000 to 1.671 million.
- The key takeaway from the report is that continuing jobless claims hit their highest level since February 2022, suggesting perhaps that it is becoming more difficult to find a job as employers are taking a more cautious-minded approach with their hiring plans.
- Weekly EIA Natural Gas Inventories showed a draw of 21 bcf versus a draw of 81 bcf last week
Looking ahead to Friday, market participants will be focused on the November Producer Price Index ( consensus 0.2%; prior 0.2%) and core-Produce Price Index ( consensus 0.2%; prior 0.0%) at 8:30 a.m. ET. Other data out tomorrow includes:
- 10:00 a.m. ET: Preliminary December University of Michigan Consumer Sentiment ( consensus 57.0; prior 56.8)
- 10:00 a.m. ET: October Wholesale Inventories (prior 0.6%)
After Hours Summary: DOCU +8.6%, AVGO +3.2%, RH +2.8% higher on earnings; COO -9.1%, LULU -6.1%, CHWY -2.4% lower on earnings;After Hours Gainers:
Companies trading higher in after hours in reaction to earnings/guidance: DOCU +8.6%, CMTL +6.4%, AVGO +3.2%, RH +2.8% (also acquires Dmitriy & Co and Jeup), PHR +2.5%, MTN +1.7%
Companies trading higher in after hours in reaction to news: BBWI +5.2% (Third Point discloses 6.02% stake), UTZ +2.7% (increases dividend), DNUT +2.3% (names new CFO), FG +2.2% (declares inaugural dividend), EXEL +1.7% (CONTACT-01 study did not meet its primary endpoint), PENN +1.6% (authorizes $750 mln increase to existing share repurchase program), EXK +1.6% (announces initial mineral resource estimate), TRN +1.5% (authorizes new $250 mln share repurchase program; also increases dividend), WPC +0.8% (increases dividend), GH +0.8% (GH to collaborate with AZN on Guardant360 CDx), WM +0.7% (announces a new share repurchase auth of $1.5 bln; also increases dividend), BHR +0.6% (increases dividend; also authorizes stock repurchase program of up to $25 mln), AMBC +0.4% (says media report re discussions to acquire a financial guarantee co is inaccurate), MDT +0.3% (increases dividend), VRTV +0.1% (names new CEO), CNS +0.1% (reports Nov AUM), LMT +0.1% (awarded $2.22 bln U.S. Navy contract modification)
After Hours Losers:
Companies trading lower in after hours in reaction to earnings/guidance: COO -9.1%, LULU -6.1%, CHWY -2.4%, DOMO -1%, CURV -0.5%, COST -0.2%, MANU -0.1%
Companies trading lower in after hours in reaction to news: AUTL -20.4% (pivotal Phase 2 FELIX trial meets primary endpoint; also ADS offering), ZTS -2.8% (increases dividend), NRDY -2% (completes 17% workforce reduction), ECL -1.9% (increases dividend), CMRX -1.3% (launches ONC201 Phase 3 ACTION Study), ALNY -1.2% (submits sNDA to FDA for ONPATTRO), AZN -0.5% (GH to collaborate with AZN on Guardant360 CDx), BMY -0.2% (increases dividend), BKD -0.2% (reports Nov operating data), ACA -0.1% (renews $50 mln share repurchase auth)
Numis/Peel Hunt: brokers try to look on the bright side of deal freeze
The London market is frosty right now, with equity capital transactions at their lowest level in a decade
Stockbrokers in the UK can be forgiven for feeling uneasy when contemplating the year of dealmaking ahead in 2023.
At City outfit Numis, a one-third decline in revenues in the 12 months to September 30 is striking. Yet in the context of sparse equity financings, that decline could have been even worse. The broker’s claim that it is successfully diversifying its business deserves attention.
The London market is exceedingly frosty right now. Equity capital transactions are at their lowest level in a decade. Rising interest rates and geopolitical uncertainty have put a stop to new investment. Balance sheets at many UK companies are full of cash raised in the frenzy of the past two years. Add this to the waning attractions of London as a global listing location and it is little wonder brokers are feeling down.
Reflecting the chill, Numis shares have halved from last year’s peak. They now trade close to the decade lows experienced at the start of the Covid-19 pandemic.
On the bright side, at least that performance beats rival Peel Hunt, whose shares have lost almost two-thirds of their value over the same period. Last week, the smaller broker said its half-year revenues were down 40 per cent.
Unilever: slimming down ice-cream brands could improve slow performance
The company has stagnated in recent years and needs to shed more assets that fail to meet expectation
A trip to the ice-cream parlour can leave consumers overwhelmed by the variety of flavours on offer. Unilever seems keen to opt out of the paradox of choice. The consumer goods company is reported to be mulling a sale of certain ice-cream brands.
Jettisoning smaller names in order to focus on leading brands can be part of a healthy and balanced strategy. A slimmer, higher performing business will probably be welcomed by whoever takes over from outgoing chief executive Alan Jope.
Ice-cream is the smallest of Unilever’s units, with turnover of €7bn in 2021. Performance varies. Three of the company’s 12 brands with sales of over €1bn are ice-cream. In an analyst presentation on Thursday, Unilever said that it would focus on “big brands”, such as Ben and Jerry’s and Magnum. Smaller brands are notable by their absence.
The company has not been shy to remove assets that fail to meet expectations in the past. Its decision to end its decades-old dual listing structure makes it easier to dispose of assets quickly. Last November it unloaded its tea business to CVC Partners.
More of these measures are required to revitalise a business that has stagnated in recent years. Unilever is currently trading at 18 times expected earnings, according to data from S&P Global. While shares have recovered somewhat from Jope’s ill-fated effort to acquire GSK’s spinout Haleon, they are down around 1 per cent over the past five years.
Compare that to Procter & Gamble, which trades at close to 26 times forecast earnings. Its share price has risen 66 per cent over the same period.
Unilever investors can take heart that P&G’s turn-around reflects activist Nelson Peltz’s playbook during his time on the board. This year, Peltz joined the board of Unilever.
Restructuring will not solve all of the challenges facing Jope’s successor. An internal fight with Ben & Jerry’s over the sale of products in the occupied Palestinian territories rumbles on. But a diet plan that cuts down on unnecessary treats is the right way to bolster Unilever’s strength.