Aircraft Leasing vs. Buying: Financial Analysis for Airlines

Introduction

The emergence of low-cost carriers has marked a shift in the aircraft industry away from owning aircraft and toward leasing and subleasing. National and legacy carriers have long struggled with profitability, and their business model is partly responsible for this. Low-cost carriers have attempted to resolve the business problems of heavy debt burden and excess capacity by leasing aircraft rather than owning them. There are other advantages to aircraft leasing as well, including a reduction in maintenance costs. Aircraft leasing has become a core element of the low-cost carrier business model. This paper examines aircraft leasing with particular attention to the financial considerations, and draws a conclusion regarding whether leasing is recommended for airlines today.

Overview of the Industry

The aviation industry is one of the world's largest businesses, worth an estimated 7.5% of global GDP (Investec, 2010). Traditionally, airlines purchased aircraft, often with financing from the manufacturer. In 1994, only 18% of commercial aircraft were leased. Since that time, fueled by the rise of low-cost carriers, leased aircraft now account for 40% of the global commercial aircraft fleet, and this figure is expected to continue rising (Ibid). Lessors tend to be financial institutions or subsidiaries thereof. They enter the business because they can finance aircraft at very low rates and then lease them out at rates that are profitable yet still competitive for airlines. Low-cost carriers in particular were attracted to aircraft leases because they were unable to secure sufficient credit to purchase planes and expand rapidly enough to meet their business objectives. Low-cost carriers soon identified additional benefits of leasing as well.

The air travel industry is considered cyclical and has suffered two major demand-side shocks in the past ten years. The first came in the wake of the September 11th terrorist attacks in the United States; the second came during the global economic downturn. The industry is now growing again, led by air travel in the Asia-Pacific market and the success of Middle Eastern carriers. There are now double the number of aircraft in the skies compared with 1990 (Investec, 2010). The low-cost carrier model is spreading around the world, with the concept being introduced in Southeast Asia, China, India, and the Middle East. This has fueled growth in leasing. It was expected that in 2011 there would be over 7,200 leased planes. There are even indications that legacy carriers are increasing the proportion of leased aircraft in their fleets, mindful of the benefits of leasing (A.T. Kearney, 2011). Evidence also suggests that more companies are entering the leasing industry and that aircraft leasing is becoming increasingly capitalized (Investec, 2010).

There are four main benefits to leasing aircraft instead of buying: financial liquidity, capacity flexibility, rapid expansion, fleet consistency, and reduced maintenance costs. Financial liquidity has been critical for low-cost carriers, but this benefit can accrue to any firm in the industry. Traditional aircraft purchases are typically financed with debt, and this is reflected on the balance sheets of many airlines. These debt obligations are long-term. The airline then has to fill that capacity while remaining highly leveraged, leaving only a very small portion of earnings available as profit. This results in a low level of liquidity. It is also worth considering that the main financial benefit of purchasing over leasing — owning the aircraft outright — materializes only after the purchase is paid off, which can take upwards of twenty years. A net present value calculation would indicate that cash flows twenty years in the future are worth relatively little. Furthermore, the aircraft may not even be serviceable, or at least not efficiently so, by that point.

Benefits of Leasing

A related benefit is increased capacity flexibility. Leasing gives an airline greater ability to manage its cash flow obligations. When the industry experiences a demand shock — as it has twice in the past ten years — most airlines lose money because they must meet those obligations regardless of actual revenue earned. From an operational standpoint, reduced load factors become a serious problem. If the airline were able to reduce its schedule, it could improve load factors. When aircraft are purchased, such reductions leave planes idle but still being paid for. Under a lease arrangement, the airline has more flexibility to manage capacity by cutting flights and returning planes simultaneously. This allows load factors to be maintained as weak routes are cut during demand shocks, and cash flow obligations are reduced to match operating cuts.

The financial flexibility afforded by aircraft leasing also enables rapid expansion. Airlines typically issue some equity but depend primarily on debt. For newer airlines, the poor financial track record of legacy carriers makes it all the more difficult to raise the capital needed for quick growth. Rapid expansion is nevertheless necessary because building a large route network is essential for generating traffic and for supporting loyalty programs. With debt financing unavailable, leasing becomes the only viable option for many airlines seeking to expand their coverage quickly (Jeremiah, 2011).

Fleet consistency is another issue that leasing can help resolve. Many low-cost carriers operate uniform fleets, which allows them to reduce training and maintenance costs considerably and to maintain parts stores for minor repairs. While larger, older carriers must maintain a variety of aircraft types, smaller airlines can often operate just one type — particularly if they are leasing. Because major aircraft manufacturers often have production backlogs, achieving fleet consistency may require acquiring aircraft on the secondary market, where leasing and subleasing are the most practical means of doing so.

Low operating costs are essential to airline profitability, and leasing contributes to this strategy in several ways. First, fleet consistency reduces the complexity of the maintenance function, thereby lowering its cost. Second, leasing allows major repairs to be offloaded to the aircraft owner, subject to the specific terms of the lease contract and the airline's insurance coverage. Third, leasing enables airlines to maintain a low average fleet age. A younger fleet benefits the airline not only through lower direct maintenance costs but also through improved fuel efficiency, as newer aircraft incorporate more advanced design and are less prone to mechanical failure.