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The Challenges of Financing Freighter Aircraft
- DJ Ghosh, President, American Friendship World Air Cargo Corporation

Most business gurus and authors of self-help textbooks will tell you that the key to succeeding in business and in life is a burning desire to succeed backed up by an iron clad determination and persistence. They will tell you that with this state of mind, you can beat all the odds and emerge a winner, outpacing the most educated and qualified. After all, in the race of life, unrewarded talent, genius and education is so
commonplace, that the world is awash with the detritus of talented and educated geniuses. Persistence and determination alone are omnipotent.

While all of this is inspiration for the soul, the realities of the business of financing aircraft are a lot more complex. In the heady days of the post-World War II era, a tightly regulated airline environment insured that almost every airline in the country and in most parts of the world made a respectable, if not handsome, return on capital, with enough money left over to buy new planes. Fast forward this scenario to the late
eighties and nineties and the first decade of this century, and we find ourselves in a business with very little profits if any, and an overt dependence on external financing structures that reflect the poor balance sheets of airlines and their almost total dependence on the markets for capital.
DJ Ghosh

Most passenger airlines, excluding the dying breed of state sponsored carriers, have tottered through the last few decades of their existence on almost full life support, trudging perilously from one quarter to the next. Strapped to their seats by high legacy costs, they have watched aghast, as the new breed of low cost carriers with brand new aircraft have eaten their lunch, one market at a time. They have responded by cutting costs, filing for bankruptcy, and in more recent times, devouring one another.

Strangely enough, through all this period, passenger volumes have exploded, and cargo volumes carried in passenger bellies have grown, so large, that a whole new industry has evolved around their movement on dedicated freighter aircraft. Power Point presentations by Boeing and Airbus at various cargo trade shows and conferences have indicated that the air cargo pie may now be evenly split, with 50% of the freight moving on passenger bellies and the remaining 50% moving onto the main decks of dedicated freighter aircraft.

While the large bellies of passenger aircraft like the B777 and the A340 may still provide a steady supply of cargo capacity to the cargo departments of passenger carriers, they will be dependent on the route structures of the passenger airlines and will thus have some built in inflexibility for the air cargo trade. While cargo carrying passenger bellies, are part of a passenger airline’s fleet and thus governed by the
financing structures put in place by passenger airline CFO’s, dedicated freighter aircraft operators will have to live and die by a new set of rules. Exceptions are, dedicated freighter aircraft owned and operated by passenger airlines such as Emirates, Cathay Pacific, Singapore Airlines, Korean and Lan Chile, which are usually financed under the umbrella financing structures in place for their corporate parents, and which can ride on their coat-tails while enjoying their stronger credit ratings. Another notable exception is an airline like British Airways, which wet leases aircraft from a lessor like Atlas Air, thus taking the onus of ownership off its balance sheets.

Outside of this old boys club, the financing for dedicated freighter operators gets very muddy indeed. All of a sudden, new freighter operators become “highly risky”, brand new businesses, with very little legacy airline operating experience that nobody wants to invest in. They usually have no track record, and no proverbial “rich uncles” or “corporate parents” to support them in their dreams and aspirations. Add to this list, the absence of a bankable credit history.

It is not surprising that aircraft financiers continue to ignore this market year after year, even though they do make their token appearances at a few industry forums. The fact of the matter is, that in spite of what they profess to know, they have done little or no research to understand the dynamics of this exploding market segment. Senior officers in the aircraft lending departments of leading banks in the US, Europe and Asia, refuse to discuss this subject. While most of the world’s largest operating lessors play it very safe by sticking to their easily marketable B737’s and A320’s with their stable lease rates, very few dare to enter the cargo market, unless they “defensively” have to convert an aging aircraft which has no further use in their passenger fleets. The story of freighter financing therefore has been more of an afterthought rather than a planned course of action.

The captains of the freighter aircraft leasing divisions of giants like GECAS or Guggenheim Aviation Partners are likely to differ, citing their large orders for B747 and B777 deliveries as proof that aircraft financiers understand this market and have committed the resources to pursue it. They will counter any skeptics by arguing that the leasing model is ideal for startup cargo airlines that need the proverbial “off balance sheet” financing, that is both sustainable and which provides a new business with the flexibility to upsize and downsize with the rise and fall of world trade, and induct different types of aircraft at a moment’s notice.

The reality is a little more startling. Most freighter leasing activity is concentrated around the “old boys’ network” with legacy passenger carriers or with dedicated freighter airlines which have been around for a significant period of time. The aircraft financing community, represented by the likes of the GECAS’s and Guggenheim’s of the world have failed miserably in providing innovative financing structures and solutions that can spur the creation of new freighter operators. The high failure rates of new startup carriers speak volumes about how aircraft financiers have failed to understand and provide sustainability and innovation in this volatile business. In fact, not only do they continue to “superimpose” their outdated passenger driven leasing models onto the cargo sector, but they routinely avoid contact with aspiring air cargo entrepreneurs at air finance forums.

When all is said and done, aircraft financiers like any other industry specialists need to innovate their products. Their fundamental assumption that “metal is metal”, whether it be used and financed in the passenger or cargo sector is fundamentally flawed. While the rest of the air cargo industry continues to move forward with research and innovations to build air cargo into a dedicated and sustainable science, distinct from the passenger business, aircraft financiers continue to foist outdated passenger driven financing structures onto the cargo sector. If they refuse to innovate, they could soon become the “dinosaurs” of this business.

Dedicated research into the air cargo business model will provide the curious to discover why this business is so different from the passenger side, even though the airframes that they use are very similar. For one, while most passenger traffic is fairly homogeneous and easily classifiable into first class, business class or economy class segments, the air cargo business moves thousands of different items, each with its own characteristics and dynamics. While many industry veterans have tried to mistakenly consolidate many of these items into a single general classification of “general cargo”, either through ignorance or sheer laziness, the fact is that distinct pricing structures and revenue opportunities exist by segregating commodities for special treatment rather than by consolidating them. The special classifications for
“pharmaceutical products” and for “dangerous goods” are prime examples of how air cargo carriers can profit handsomely by offering a bespoke transportation solution.

Secondly, most passenger airlines are able to deal directly with the final customer, the passenger, either through the internet or through the services of a travel agent. Thus it can be said, that their “revenue opportunity risk” is low and fairly well diversified. Cargo carriers, on the other hand, have a much more risky customer profile, since on most flights, five or six large air cargo forwarders buy up over 75% of all the space through “block space” agreements with the airline. Unfortunately, while aircraft financing contracts are usually for duration of 7-10 years, these forwarder contracts can be as short as 3-6 months, making running an all-cargo airline inherently risky.

Forwarders can achieve this” cartel style” booking by acting as consolidators for smaller shippers with less pricing power. The end result of this “block spacing” is that cargo airlines have little or no pricing power compared to the forwarders, who have a greater say in how these airlines are operated. A newer and more innovative revenue model that passes down the risk to the forwarder’s customer, the final shipper, while
creating a long term revenue stream for the airline to pay its leasing costs seems to be more appropriate.

Perhaps, financiers need to research ways in which small shippers could enter into “micro forward contracts”, which can mitigate their risks, while insuring that they are guaranteed space whenever required. Unused space or contracts can then be traded on an exchange.

Consolidating these “micro contracts” through a technology platform could provide a longer term revenue stream that could provide the stability for cargo carriers. Re-aligning shipping contracts to match the length of aircraft financing contracts is the key to providing the much needed stability to make the cargo airline business model work.

A third issue that financiers need to be cognizant of, is that unlike the passenger business, where a passenger who flies out, usually flies back on the return leg, in the cargo business, most cargo flows are uni-directional. Thus in many sectors, cargo aircraft fly back virtually empty. Add to this the fact that the trade cycles of the cargo business are very different from that of their passenger counterparts. Aircraft financiers
have discreetly avoided studying these differences in business cycles, or getting their hands dirty probing around warehouses and container stations, thus establishing their ignorance in this area.

While traditional aircraft financiers might shrug these off as problems that the air cargo industry must solve on its own, the innovative financier, if one exists at all, will find opportunity in this adversity. After all, despite all the world’s problems, air cargo has grown on an average of 3-5% a year with revenues of almost US$70 billion, more than 10% of all airline revenue, and as IATA’s Cargo Head likes to point out, more than all first class passenger revenue worldwide.

The problem with this industry is not in the business itself, which has evolved and grown by leaps and bounds, and will continue to outpace the passenger business in the future. The challenge for aircraft financiers is to develop models that can help re-align and re-balance the way this business is conducted, providing cargo airline operators with the necessary stability to innovate their business while inducting many new players into the game. At the end of the day, while perseverance is a key ingredient to success, it never hurts to have an intelligent long term financier by our side.

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© 2011 American Friendship World Air Cargo Corporation. All Rights Reserved.