Utilizing Alternative Collateral: Spare Parts

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Alternative Collateral

In order to raise capital, many airlines issue debt or secured bonds backed by their aircraft and engines, but most airlines are sitting on another underutilized form of collateral: spare parts.  Spare parts are a widely-accepted form of collateral, but few airlines have used this often appreciating asset-to-issue debt.

There have been few instances of aircraft spare parts being used as collateral for secured debt in recent years, highlighting the underutilization of spare parts.  mba has found only US$1.1bn of outstanding debt tied to spare parts that has been publicly listed, which pales in comparison to the tens of billions of dollars of outstanding debt tied to aircraft and engines.  This excludes credit facilities that were undrawn as of December 2016.  It also excludes any privately-held airlines where financial information is not publically available and parts debt issued by Republic totaling US$139.7mn due to Republic’s bankruptcy and subsequent removal from the NYSE.  Cash-rich airlines have paid down debt in recent years, so there may be limited need to issue new debt, however due to the cyclical nature of the aviation industry, the time will come when airlines will need to issue debt once again.

Spare Part Classification and Condition Overview

There are three (3) main types of aircraft spares: rotable, repairable, and expendable parts.  Rotable items are parts that can be repeatedly rehabilitated to a fully serviceable condition over a period of time approximating the life of the flight equipment to which it is related.  Examples of rotable items include avionics, landing gear, and major engine accessories. Repairable items can be rehabilitated to a fully-serviceable condition over a period of time less than the life of the flight equipment to which it is related.  Examples of repairable items include engine blades, some tires, seats, and galleys.  Expendable items are parts for which no authorized repair procedure exists, and for which the cost of repair would exceed that of replacement.  Examples of expendable items include nuts, bolts and rivets. Rotable items are usually the most valuable items in any operator’s inventory, and although they may make up 10.0% of a particular inventory, they will normally make up over 90.0% of an inventory’s value.  On the other hand, expendable components make up a large portion of the inventory but have a smaller percentage of value.

Part condition plays a major role in the value of a particular component.  Spare parts in aviation use a rather unique set of condition descriptions.  The most common part conditions are: New, As Removed, Serviceable, Unserviceable, and Overhauled.  When a part is removed from an aircraft during a part-out process, that part is considered to be in “as removed” condition.  These parts do not have the necessary paperwork that will allow them to be put into use in an operator’s fleet, and therefore are considered by the market to be less valuable.

In order for a part to be considered “serviceable,” spare parts must be accompanied by certifying documents, such as an FAA 8130-3 or EASA Form One, prior to installation on an aircraft.  The most cost-effective method to achieve this certification is for an authorized repair station to conduct what is known as a “bench-check” to confirm the serviceability of a particular component.  Components that are determined to be “unserviceable” must be repaired or overhauled in order to receive a certifying document.  Overhauled components are components that have been disassembled and returned as close as possible to new specifications, and therefore command a higher price in the market than components that are determined to be serviceable.

Spare Part Valuations

A market-based approach is typically used to value spare parts, as values for spares are more volatile than aircraft and engine values.  Data points from a year ago may not tell an accurate story of the Current Market Value of a particular part due to market variations, which may occur more rapidly on a supply and demand basis in the spare parts market than the aircraft market.  A current snapshot of the market for each individual part number needs to be obtained at the time of valuation.  Values may then be adjusted based on the market availability and component condition to reach a Current Market Value for each line item in the stated condition.  One way to value components is on an individual component basis which assumes that each part in a particular inventory will be sold individually with no time restrictions for the sale.  In order to determine the value of an inventory that needed to be sold in its entirety within a specified time period, an Orderly Liquidation Value or Forced Liquidation Value should be provided for a specific “lot” of components or an entire inventory, creating another valuation basis for an appraisal.

An aircraft or engine that is in high demand will naturally have spare parts that are in high demand, and will be priced accordingly.  However, unlike aircraft, spare parts do not necessarily depreciate over time.  Spare parts that service a particular aircraft will depreciate at first as the aircraft platform enters service and supply of parts is predominantly provided by the manufacturer of the components at what many would consider “list prices.”  Then, as the secondary parts market becomes more active, the market value of components will usually appreciate modestly until the remainder of the platform’s production life.  Once production of a particular aircraft is ceased and a considerable number of aircraft remain in service, the market value may begin to appreciate at an even greater rate as part scarcity starts to increase and demand remains constant.  This typically drives the entrance of part-out companies in greater numbers which acquire and disassemble aircraft to service this market. This leads to a period of stability in value before entering a period of volatility in which values are directly correlated to the supply and demand ratio for the specific component.  The following graph illustrates the life-cycle of spare parts value.

Monetizing Spare Parts

Spare parts trade rather easily on the secondary market, as there is always a demand for parts to keep in-service aircraft flying.  There are several platforms on which sellers can market their parts including several online services such as ILS and Parts Base, where sellers can post the parts they are looking to liquidate.  When monetizing inventories, sellers looking to maximize yield typically list their spare parts on the market individually, yielding the highest value over a long period.  Those who own larger inventories that require monetization in shorter periods of time may require a ‘lot sale.’  Lot sales have lower yields than selling each part individually, but they have higher sale rates and allow for the sale of parts in greater numbers.  Another option for part sales is auctioning, during which the seller packages entire spare part inventories for liquidation. This alternative often results in the fastest turnaround for sale on the market, but provides the lowest yield overall.

 

*Backed by a team of five ISTAT certified appraisers, mba’s trusted valuation team offers a wide range of valuation services, including the valuation of alternative collateral and spare parts as defined in this article. For more information or questions, please email valuations@redbook.aero. 

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Monetizing Slots, Gates and Routes

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Slots, Gates and Routes – Monetizing Intangible Assets

Slots, Gates and Routes (SGR) are immensely valuable assets for airlines, referred to commonly as “intangible” assets for valuation and collateralization. For operators, SGR assets represent strategic long-term competitive advantages and their value helps to raise additional capital for airlines, predominantly based in North America. mba estimates that close to $8.0bn US of debt was outstanding as of December 2016 utilizing slots, gates and routes as collateral. Despite the numbers, large-scale collateralization of SGR to raise capital remains largely untapped in non-US markets.

The use of SGR as collateral for funding purposes relies primarily on lenders’ and investors’ confidence in the enforceability of the asset; concern is focused on such enforceability in the event of default, as well as maintaining contractually agreed-upon loan-to-value (LTV) ratios. Detailed in the contracts, an independent initial request to provide the appraised asset value serves the joint purposes of calculating initial LTV ratios and subsequent calculations of maintenance of these ratios.

SGR Defined – What Falls Into the Asset Class?

Slots

Generally speaking, the term airport slot covers the range of actions and access an operator may have at a given airport, including land and takeoff and use of related facilities on a schedule basis. The term slot is interchangeable with slot-pair as the use includes time scheduled to land and depart. The International Air Transport Association (IATA) defines an airport slot as “a permission given by a coordinator for a planned operation to use the full range of airport infrastructure necessary to arrive or depart at a Level 3 airport on a specific date and time.[1]” Airports are classified by IATA as a Level 1, Level 2 or Level 3 based on the capacity of the facilities and the demand for access or use. Level 1 airports’ capacity generally meet the demand at all times whereas a Level 3 airport’s demand for slots significantly exceeds the capacity at the airport and therefore slot allocation requires a coordinator out of necessity. Although most airports in the U.S. are categorized as ­Level 1 airports under the IATA Worldwide Slot Guidelines (WSG), the Federal Aviation Administration (FAA) has imposed Level 3 slot controls by rule at John F Kennedy International Airport (JFK), LaGuardia Airport (LGA), and Ronald Reagan Washington National Airport (DCA).

 

Routes

Routes are defined as the right to operate scheduled air service between specified airports. The route authority is governed by multilateral agreements between countries, and are subject to capacity restrictions at each airport and also between countries. In the United States, the Department of Transportation (DOT) processes requests by U.S. airlines for authority to serve foreign markets. If more carriers seek frequencies than are available, the DOT must allocate the frequencies among the U.S. carriers using comparative selection procedures.

A Brief Look at the Market

A vast majority of outstanding SGR secured debt consists of bank loans between airline and a lending bank. Although the use of slots, gates and routes as collateral in debt financing is common among large North American airlines, it still represents a minority share of total debt financing for these airlines, with the exception of Virgin Atlantic.

 

In December 2015, Virgin Atlantic used its slots at London Heathrow Airport (LHR) as collateral for a private placement bond, raising £225 million ($260 million US) of debt financing, the largest non-bank related debt financing arrangement with SGR as collateral, with proceeds used to finance new aircraft orders. In January 2017, Virgin Atlantic announced it had secured another £32 million ($40 million) of financing on the back off the same slot portfolio. The Virgin Atlantic deal represented the first, and (to this date) only, funding deal where slots outside of US airports were used as collateral in non-bank lending, although British Airways’ parent IAG previously attempted in 2012, but proved unsuccessful due to the timing issues, and that transaction’s  specific complexity.

In addition to providing an additional source of funding for airlines and thereby diversifying the funding base, the cost of SGR related debt is relatively beneficial compared with other common sources of aviation financing. The chart below depicts the average publicly disclosed interest rates on debt facilities secured by SGR collateral and the average LTV for the same facilities, in comparison to recent aircraft ABS and airline EETC transactions. On average, interest rates on SGR secured debt facilities are comparable to A-tranches in aircraft ABS and EETCs.

 

 

Regulatory Impact on SGR Assets

While investor confidence to enforceability plays a large role in arranging SGR debt financing, the regulatory environment in various jurisdictions often dictates the starting point for valuing SGR assets. Changes in regulations can have a significant impact on the value of these assets.

In the US, the Department of Justice (DOJ) can mandate divestitures when there are competition concerns as a result of mergers between airlines. Following their merger in 2013, US Airways and American divested a total of 17 slot pairs at LGA and 52 slot pairs at DCA to gain DOJ approval. Private auctions for these slots at LGA and DCA, respectively, were limited to Low-Cost Carriers. Ultimately, at DCA, Southwest Airlines won six pairs plus five pairs it was already leasing from American, while Virgin America won bids for six slot pairs. At DCA, Southwest Airlines won 28 pairs, JetBlue Airways won 12 pairs, plus eight they were already leasing, and Virgin America won four pairs.

The US Department of Transportation (DOT) also plays a role in the management of SGR. It granted antitrust immunity in 2016 for the proposed alliance agreements submitted by Delta Air Lines and Aeroméxico. This was on the condition that the carriers divest takeoff and landing slots to support 24 new daily transborder services from Mexico City and four new daily transborder services from New York JFK, to be operated by competing airlines. The American and Delta examples above illustrate the impact regulatory actions have on competitive environment and SGR values.

Beyond North America, regulation can, in addition to evaluating slots for competition, impact the distribution of trans-ocean routes. In December 2016, the DOT finalized its decision to award American Airlines route authority between Los Angeles and Beijing. Delta Airlines had also filed an application, however the DOT determined that American Airlines’ superior connectivity (resulting in a higher number of U.S. travelers benefitting from one-stop connections over Los Angeles) was significant enough of a factor to award the route to American.

Asset Enforceability and Transferability

As SGR is considered an intangible asset, establishing parties’ legal rights and generally market interests are together the center piece to demonstrate discernable value for the parties transacting, the relatively small number of completed sales transactions make benchmarking difficult, and attracting investment using these assets is complicated by lack of information. However, there are indicators of the inherent value, enforceability and transferability of the asset worth reviewing.

Although sales of SGR assets occur less frequently, several examples of slots and routes transactions are notable. The table below contains slot sales at London Heathrow Airport, LaGuardia Airport, and Ronald Reagan Washington National Airport over the past decade, their value being shown in the market demand.

 

Sales of routes occur less frequently than slots, however multiple transactions between 1982 and 1992 are informative to value and opportunity. Approximately $3.0bn worth of route transactions occurred during this period as shown in the following table. A majority of these sales were a result of bankruptcy proceedings.

The legal view of SGR collateral is equally up to benchmarking the asset value in the market, and the use of slots, gates and routes as collateral has been supported by several US courts. In the American Airlines bankruptcy case, the route authorities and gate leaseholds that had been used as collateral in certain of its lending agreements were deemed as valid. Ultimately, American Airlines prepaid these loans early and the creditors received full payout, with no impairment of their security interest. Another example where the validity of SGR assets was upheld in court is the case of Monarch versus Airport Coordination Limited. The court ruled that Monarch in fact had the right to its slots for the 2018 summer season at London Gatwick airport, despite having had its Air Operator Certificate revoked (see: How Monarch Monetized Gatwick Slots Post-Collapse). The right to sell an asset out of Bankruptcy as ruled by the court in the Monarch case provides further validity to the use of SGR assets as collateral.

Finally, even in instances where sales of SGR are prohibited by regulation and transferability of the asset cannot take place, there is inherent intangible value in the asset. This is because airlines can lease the asset to a partner airline rather than sell it in order to obtain long term rights to the slot. In fact, slot leasing is more common than slot sales as airlines prefer to retain the long term rights to the asset. Therefore, where sales are prohibited, it is possible to generate a return on the asset while maintaining long term ownership rights.

Conclusion

Large North American Airlines have successfully monetized their slots, gates and routes to raise financing. That said, SGR secured debt still represents a minority share of an airline’s overall debt funding and remains a relatively new concept among airlines outside of North America. The regulatory environment can have a significant impact on the value of SGR assets, as illustrated above. However, regulation tends to change infrequently and the long term nature of these assets means their value is less susceptible to short term fluctuations in the economic environment. Moreover, the validity of slots, gates, and routes as collateral has been upheld in several court cases predominantly in North America, but also more recently in the UK. While the Monarch ruling should improve investor confidence in SGR assets, large-scale monetization of slots, gates and routes outside of North America remains a significant source of untapped capital.

[1] https://www.hamburg-convention.com/en/hamburg/stories/iata-slots-conference

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