Strategy

Aviation industry: Wing and a prayer

Is the high-flying aviation industry in for a bumpy landing?

It’s a Monday afternoon in Orlando, and inside the cavernous Orange County Convention Center, the world’s top gathering of the jet set is underway. The 61st annual National Business Aviation Association convention has brought billionaires, CEOs and flight directors for Fortune 500 companies to check the latest merchandise from luxury aircraft makers, such as industry leader Bombardier Inc. of Montreal. The bling factor is at cruising altitude. Aside from offering the latest in on-board plasma-screen TVs or leather seats that turn into beds, every third booth seems to be giving away cars, motorcycles, Sea-Doos, iPods, Wii game consoles or leather jackets. Guests can enjoy free massages and cholesterol tests, while cigars are rolled on the spot for a lineup of men in golf shirts and sharp suits at the stall of a Caribbean aviation-services company. For a break, aircraft-services giant Jet Aviation offers a complimentary silver-service meal of marinated Kobe beef and seafood manicotti served by French chef Guy Gateau (his real name) on the roof of its booth. Keep an eye out for Harrison Ford, movie star and Cessna pilot, who is hanging around the aircraft maker’s showcase.

Yet amid this unabashed display of wealth and privilege, nobody can ignore the storm outside — literally and figuratively. A late-afternoon shower pelts the roof, loud enough to overwhelm the rock music and announcements emanating from the 1,183 exhibits. And this day, Oct. 6, 2008, will soon be known for kicking off a historic week for stock market losses amid a worsening credit crisis. Even Han Solo is worried. “Well, it’s affecting everybody, everybody,” Ford tells Canadian Business, before a press conference to launch the Citation Special Olympics Airlift (he’s honorary chairman). “It’s taken the wind out of business’s sails, and people are feeling it.”

The timing for a market meltdown and possible economic crash couldn’t be worse for this most rarefied of industries. The business — which has a strong Canadian contingent, including flight simulator giant CAE, engine maker Pratt & Whitney Canada, and buyout firm Onex Corp., 50% owner of plane builder Hawker Beechcraft Corp. — is coming off a dozen years of monumental growth. Billings by private-plane manufacturers more than tripled from 1995 to 2001, peaking at US$13.3 billion. Then, after a post-9/11 recessionary tumble, they soared anew, hitting a record US$21.9 billion in 2007. Honeywell Aerospace, headquartered in Phoenix, now forecasts US$300 billion worth of deliveries in the next 10 years — US$30 billion per year on average.

The growth has been fed by a number of factors: an expansion over the past decade of charter companies, air-taxi services, “jet cards” offering flights by the hour, and “fractional ownership” programs — essentially, time-shares for planes. These have broadened the use of executive private-jet travel. And, more recently, the commodities boom and low U.S. dollar have kindled unprecedented global demand. The U.S. has traditionally accounted for 70% of orders. Now, international orders account for up to that amount, some plane makers say.

Across the industry, billions of dollars have been invested to crank up production, open new finishing centres, and keep up with service for the expanding global fleet. Everyone has at least one new plane in development — and in the case of Embraer of Brazil, five. The business has attracted newcomers, including Honda and Indian industrial powerhouse Tata Group. Manufacturers are working from backlogs stretching out for years: order a long-range Bombardier Global Express XRS (list price: US$50.1 million) today, and the company will promise only a 2014 delivery — without a completed interior.

Though anticipating a brief pullback in 2010 and 2011, many companies have invested heavily on the assumption that the boom times would continue. That was before the crisis. What if demand drops off — sharply — for a prolonged period?

As the rain pours down, it’s a question aviation executives just don’t know how to answer. “Every day it’s changing,” Joe Lombardo, president of Gulfstream Aerospace, Bombardier’s Savannah, Ga.–based archrival, says. “There’s very little predictability. It would be difficult to forecast or even give an opinion what’s going to happen a week from now. I’ve never seen anything quite like this.” Jack Pelton, CEO of Cessna Aircraft Co., based in Wichita, Kan., offers no solace, either; a month ago, he iced plans to hire another 1,000 workers. “At the end of the day, we don’t know what we’re heading into,” he says. “This is clearly uncharted territory for all of us in this industry.”

As Han Solo might say, “I’ve got a bad feeling about this.”

Mark Hewlett is window-shopping for planes. As director of aviation for a group of Georgia-based companies affiliated with W. C. Bradley, an heir to the Coca-Cola fortune, he oversees a fleet of two Learjet 45XRs and a King Air 350. He’s at the Orlando Executive Airport, where 139 planes are parked nose-to-wingtip at the convention’s “static” display. “Welcome to the mall of airplanes” he says.

Hewlett is eyeing Bombardier’s new Learjet 85 — which is being unveiled in mock-up form with a complete cabin for the first time here. With a price tag of US$20.5 million, its 25-foot-long cabin can seat eight, and the first model is expected to be ready for delivery by 2012. Hewlett says he’s thinking about buying one “eventually. … We’re just holding off to see where the economy is going.”

That is the story of this year’s NBAA convention. Orders had remained strong through the first half of 2008, but have cooled considerably since summer, as buyers take a wait-and-see approach. “We have started to see people postpone decisions,” says John Rosanvallon, chief executive of Dassault Falcon Jet Corp. of Peterboro, N.J.

The slowdown is drawing out shrewd ultra-wealthy buyers. Steven Hill, president of Boeing Co.’s business jet division — which sells tricked-out VIP versions of its airliners — says his phone is ringing off the hook with customers eager to find out if anyone has cancelled an order, opening a slot on the production schedule for an earlier delivery. “This is probably going to be the way we sell airplanes until the crunch is over.” Adds David Newman, an analyst with National Bank Financial in Toronto: “No doubt, orders will drop off.”

Other indicators are pointing to a slowdown. Aviation-fuel sellers say volumes are down 5% to 15% this year in North America, and flat most other places. Planes are also flying less. Used jet prices — an indicator of those for new planes — are falling, as the inventory for sale has jumped to 2,300 units in September from less than 1,700 through most of 2007. “Let there be no doubt, the used market is rapidly falling apart,” JP Morgan Chase said in a September report. Meanwhile, business at charter services is down by 20% to 40% — due in part to less spillover business from overbooked fractional-ownership networks. And the convention itself is quieter this year — with 30,811 registered guests, traffic is down 7% from 2006’s high. At a VIP event for the launch of Gulfstream’s new G250 plane, 150 place cards remain unclaimed at night’s end, says Peter Bromby, vice-president of sales with SkyService Business Aviation in Montreal.

Industry players say they’re in as good shape as they can be for a downturn. Aviation is a cyclical business — sales have traditionally tracked U.S. GDP growth and corporate profitability. Unlike the last downturn, from 2001 to 2003, plane makers have huge backlogs — US$63 billion at the end of 2007 — that translate into an average of three years of production. And they have been careful about managing those backlogs. “In 2001, you had to react very fast, because you had a 12-month backlog and suddenly you had no orders, and had to start reducing production and adjust,” says Jahid Fazal Karim, former senior vice-president of worldwide sales with Bombardier’s business jet division, and current co-owner of Jetcraft Corp. “This time, everybody’s in the same position. As long as everybody stays cool and doesn’t panic, it should be OK.”

Manufacturers say they’ve recently done tail-by-tail analyses of every plane in their backlog to ensure orders will hold up. “It’s a very real backlog,” says T. K. Kallenbach, vice-president, marketing and project management with Honeywell Aerospace. If anything, he says, orders for smaller planes will be at greater risk. But, so far, companies report cancellations have remained low.

Still, deeply troubling questions hang over the industry. The world could be heading into its worst economic trough since the 1930s. The business-aviation market hasn’t been around that long, so it’s possible none of the old rules for managing recessions apply. Some corporate flight departments have already been shut or downsized. And while manufacturers boast of huge, sturdy backlogs, nobody can be sure how well orders will hold up. Buyers typically put up no more than 30% of the cost of a plane before taking delivery (the down payment is higher for larger planes). But say your company has ordered a US$21-million Challenger 300 and paid US$6 million so far. Not only do you need to find the last US$15 million to take delivery, but if you’re an average user, your costs will run US$1.7 million a year, a third of that fixed. If your business is falling apart or you have difficulty with financing, would you rather take on that plane or walk away from your deposit? “To be flying along assuming the world is well because you have a US$16-billion backlog is foolhardy,” Jack Pelton, CEO of Cessna, admits, referring to his own firm’s orders. “My gut tells me there will be a significant piece of our backlog that will probably go away as a result of the financial crisis. I think that will make 2009 very difficult to be able to deliver what we have committed.”

The other scary thing for manufacturers is that this is the first time business-jet makers have been so exposed to international markets. When buyers were largely based in the U.S., it was relatively straightforward to manage the cycle — and even then many hit hard times. If there is a global recession, what happens to all the orders that now come from young, affluent markets, such as Russia? With heavy losses on the stock market there in recent weeks, questions have arisen about how heavily leveraged the Russian oligarchs are. As well, many orders have come from western Europe, which stands to suffer at least as bad a recession as the U.S.

The coming turbulence, of course, means opportunity for some. Well-positioned charter companies could benefit as corporations downsize their flight departments. And John Martin, a former “recovery” specialist for U.S. Bank’s aviation fuel-card portfolio, has just hung out his shingle, in partnership witha lawyer friend, as a “debt collection and asset-recovery agency” to pursue aircraft operators unable to pay their fuel and other bills. He’s one of the few people walking the convention floor with a big smile. “People owe you, they don’t pay you, we’ll go get it for you,” says Martin, based in Aurora, Ill. “I think business will be great by January. We have a fear this thing will grow faster than we can keep up with it.”

But as grim as things could get, Onex managing director Nigel Wright says, “I continue to believe in our medium- and long-term thesis” for buying Hawker. (Onex and GS Capital Partners paid $3.8 billion for it in 2007.) “Business aviation will grow medium and longer term faster than GDP. There is cultural acceptance in Europe, the wealth effect in the Middle East, throughout Asia and the Indian subcontinent, and Latin America.” Most of those places have a fraction of the amount of business jets per capita as the U.S., Wright argues, and they only stand to get wealthier over time. To the average stressed-out citizen worried about his job or shrinking investment portfolio this may not exactly be cause for jubilation. But as a long-term opportunity for a savvy Canadian buyout firm, says Wright, “‘it’s like filling up an empty tank.”

But first, everyone is praying that rainstorm doesn’t turn into a deluge. “A lot of peoples’ net worth has gone down substantially, the value of their companies has decreased,” says Gulfstream’s Joe Lombardo. “I’d like to think many of these companies we’ve been dealing with are strategic in their viewpoint, that they know that there’s a storm coming, that they’ve been there and they can weather it. And we’re hopeful that our backlog will do the same.”