News As Airbus absorbs the C Series and Boeing starts to absorb the E-Jet, we will move from a duopoly to a cartel. Both Airbus and Boeing are even buying up parts of the supply chain. Rather than depend exclusively on third parties, we see the two big OEMs de-risk their supply chain by owning more of it. Analysis A duopoly is where there are two sellers. A cartel is defined as a coalition of political or special-interest groups having a common cause. A cartel is somewhat more sinister than a duopoly. It appears to us that Airbus and Boeing are moving away from a duopoly and making progress to developing into a cartel. For example, Airbus has gone political with Brexit. Airbus Tom Enders has put the future of the company’s UK plants on notice if there is a “hard” Brexit. Boeing has moved aggressively into the supply chain and is about to force suppliers to sign up for the 797 bidding by making them accept conditions for bidding with non-negotiable language. We are seeing the OEMs take a much harder line on the world around them. There appears to be a growing sense that these two firms are so big they can dictate their terms and conditions. Note that Airbus and Boeing have succeeded, through their strategies of raising production of single aisle aircraft, and turning the A320 and 737 into commodities. This is an important moment to consider. Where does this lead? What might be the outcome and how does the market react? Insight As we ponder this situation, consider an aspect that is highly unusual. A duopoly can be expected to act rationally and so can a cartel. What do we expect to see from either a duopoly or cartel? Almost certainly, rational pricing. Yet aircraft prices are sharp. You'd think prices would tighten and OEMs would not rush to increase production. After all, with slower production and high demand, prices would rise, and the OEMs can make more money. Airbus and Boeing shareholders want ROI and that would logically come from extracting the highest prices for the aircraft being delivered. But Airbus and Boeing are raising production. They compete aggressively on price for every deal. Why? This is not rational behavior for a duopoly or cartel. Either these companies are run by smart people who don’t understand they are in a duopoly/cartel or perhaps these people are not as smart as they appear. How smart can these people be when they treat every deal as strategic? It is clear from every presentation the OEM leaders make that they still see every deal as a fight over market share. It is clear this is irrational. Not every deal is strategic. Chasing market share drives down the entire industry and is most certainly not the way to optimize ROI. Moreover, recall how OEMs spoke of “core business” as they sold off parts of their companies? This was going to de-risk their business and improve focus on the core. Vertical integration was a bad thing. Yet here we are, now vertical integration is good and the definition of “core business” now includes parts of the supply chain. Owning the supply chain is now the way to de-risk. These strategic swings show that the smart people may not be so smart after all. They are as uncertain as everyone else and they really don’t know better. The nonsense that “it’s different this time” is as much nonsense as it has been every time people said that. Economic cycles come and go, and no amount of strategy swings prevent the impacts of these swings. The behavior is predictable and it's bad for the business. There are too many aircraft being delivered. The market appears insatiable. One hears of the inevitable and continuing growth in travel demand. This is true, but this demand does not have to be met with hundreds more single aisle aircraft. The world is running out of pilots. Retirements are higher than new entrants coming into the industry. Airlines are poaching pilots (Mesa from Arizona has been hiring in Jordan!) Major airports are running out of runway capacity. As a further proof that we have too many aircraft coming into the market, witness the rise in the number of lessors. Capital markets offer poor returns, whereas commercial aviation has been a great place to invest. Not the highest returns, but also not the lowest. Consequently, commercial aviation has been flooded with new money – driving demand for more aircraft. After all, for a financier an aircraft is a great long-term asset that can be moved from one market to another. A perfect place to invest, right? Except this rush into the market has brought down lease rates. In Dublin we heard about lessors offering deals below 0.5%. These rates are apparently on short term leases of under ten years. A leasing panel said the “real” rate should be 0.7%. What has economic history taught about mismatching investment periods? Mismatch risk lessons are coming to the industry. For investors mismatch risk occurs when an investor chooses investments that are not suitable for the circumstances, risk tolerances or means. The “hot money” flooding into the industry is exciting and supports the notion that the OEMs need to increase production. Mismatching is almost certainly happening – short term investments on long term deals. The assumption is that there is always another airline out there ready to take over the lease may prove to be a mirage when the next shock comes. Those disagreeing with our view will point out how the fleets at failed airlines Monarch, airBerlin and Primera were quickly absorbed. Fair enough, but this happened during the current boom. We are not looking at boom times. We are concerned about the next shock, that inevitably is coming. The new lessors are still learning. Alternative investments are not attractive. So, we party on. However, when the shock comes and firms collapse and heads roll, does this open a path to consolidation? We have seen consolidation across the industry. It will also occur among the financiers. There will be the flight to quality – the older and more established firms have better average fleet costs. The newest firms have paid the highest prices (even in a low-cost commodity world). This means the newest lessors are facing higher risk; aggressively bidding rates to win a share of the business to increasingly risky airlines. Come the next oil shock and airlines with wafer thin margins will start to collapse. The lessors holding aircraft at these airlines will be frantic to place their assets with other airlines. But their rates will be under water. This is the mismatch working its way through the system. Investors will rush for the door, fingers burned. The remaining firms will cherry pick assets. Is it really different this time? No it’s not and it never was and never will be.
