Pratt & Whitney: Selling Aircraft Engines

Gokhan, can you just lay out how you’re looking at the chaos that’s unfolding in the aircraft and airline industry today?

As you know, there is the coronavirus right now, which is affecting the whole commercial airline industry. What I mean by that is the cargo operators and the passenger operators. I exclude business jet operators, so these are not the subject of the conversation today. As of today, what we know is, there is $250 billion lost already, in the aviation industry. You can see Delta is grounding aircraft and they are now using around 13 different airports, all over the US, to park and to use some of their wide-body aircrafts for cargo operators. Also, you can see EasyJet, for example, one of the low-cost carriers, are grounding all of their aircraft. This means, the impact from coronavirus is not only affecting flag carriers, like Turkish Airlines, British Airways, Delta. But it is also affecting the low-cost carrier business, as well.

The low-cost carrier models usually have one type of aircraft, which are usually narrow bodies, A320s or 737s. Their business model is to carry passengers for as low a cost as possible and make a quick turnaround time. That means they fly from, let’s say, Istanbul to Ankara, a two-hour flight and then they only have 45 minutes turnaround time. They unload the passengers; they load passengers and then they fly back again. With that business model, they have to use brand new aircraft. When you look at the fleets of low-cost carriers, they are not older than six years old. Right now, these brand-new aircraft are already grounded. All low-cost carriers, which includes EasyJet, Ryanair, Pegasus Airlines, Spirit Airways, Northwest Airlines, have the cash available to only continue for three months, on average. That means if any airline, any low-cost carrier, may be able to go on for six months, without flying, and the other low-cost carriers can continue for maybe only two months. So this virus is game changing.

When I look at the market today and think about the future, we are hearing about a lot of cancellation orders, from the OEMs. I’m going to share a couple of numbers with you. In the news, the Avolon leasing company have just cancelled 75 737 MAX orders. But the point is that there is a walk away for the airlines. The typical wording in all OEM and airlines contracts includes that a customer will be able to walk away from orders, without penalty, due to material adverse change clauses that kick in, if the plane maker fails to deliver within a year of the delivery date.

MAX is not an aircraft that is flying. We already know that it has been grounded for almost a year now. Any airline now, if the aircraft is not delivered in one year, they can say, you know what, there is no penalty and I can walk away. But right now, it is not the only case. Because MAX is not flying, because other aircraft are not flying also, airlines will start cancelling their own orders. When you look at the history, you can see a lot of over-ordered numbers. We can speak about flydubai, for example. I think they already have 234 orders from Boeing. Right now, they are not willing to take any of them, because their order was already 200 more than they were supposed to get. Flydubai is a low market; they don’t need 234 aircraft. Or Malaysia, Lion Air, Air Asia, they don’t need these aircraft.

Think about that. Right now, we are in the position where OEMs are over-producing aircraft, but now there are no customers to sell them to, which will possibly affect the future of the early-retirement aircraft. Speaking about EasyJet or Ryanair or the low-cost carrier business model, when you look at them, their air fleet is already younger. Now five and six-year-old aircraft are parked. The hotels are already empty. There is no hotel now that is accepting any clients. This is a different road now, we are facing. It’s a challenging industry now. I don’t know how it will come back but, of course, we need these OEMs in our industry. From my side, what I would say is, OEMs must still surround the market. Yes, there are a lot of aircraft parked outside, without customers. But I think the plan is going to be, for engine OEMs and aircraft OEMs, to let these aircraft that are already in the air, which are maybe 10 or 16 years old, to be retired and call it early retirement. They’re going to be retired and maybe they will be purchased by the OEMs, as trade-in options. That can happen. You give them unserviceable parts, which is called an exchange and then you get serviceable parts.

A couple of years ago, CFM was using that model, for their CFM56-3C aircraft, which powers 737 classic aircraft. They said, okay, if you let outside investors purchase this aircraft, then they will control the market, for parts. So what they did was, they called the CFM56-3C operators, when the engine was due for overhaul and said, bring me your engines. I will give you another green-time engine. They would get a usable engine, from their line and they would give a serviceable, green-time engine to the airline. We might see the same business model now, for aircraft in the future, because there are already too many aircraft parked, not flying. Also there are too many aircraft already produced and waiting, in a parked line, not flying. That’s why it’s going to change.

What we can say is, what could be the next step? Maybe exchange options or buying the aircraft with trade-in options, etc. I think, in the near future, we might see some of the aircraft, regional jets, might come into the game, because they still are still powered by engines, like GTF, for example, or Embraer E195 engines and Airbus A220 engines, still longer nautical miles, quiet engines and the cabin carries less passengers. Maybe 120, 125, 140 passengers. Isolation is going to be one of the major subjects, for all of us, today. Even today, if I see an announcement in the paper, saying that, you know what, coronavirus, there is no danger now; you can fly to Italy. You wouldn’t fly to Italy tomorrow. Would you? I would not, either, because of the isolation. This isolation is going to affect the regional jet market, in a positive way and possibly, the business jet market, in a positive way.

Speaking about the narrow-body aircraft, I don’t know how optimistic we can be. We also think about the wide-body aircraft, like 777 and 787 and we know that Boeing is the number one. That is the biggest plane in the industry. Think about that now. They are not only affected by 737 MAX issues, but also all the intercontinental flights, where wide-bodies are flying, and are all cancelled now. A typical airline average is around $20 billion, in traffic. Next year, we can already see that, in the numbers, Boeing and Airbus are going to cut around maybe 30% to 40% of their production of new aircraft and possibly, for wide-body aircraft, it is going to be a lot more. Some people say, especially financial analysis firms, declare that there is going to be about 53% of wide-body production cuts in Boeing. Airbus will have some cuts. But Airbus never had as many wide-body orders as Boeing. It’s going to be different and challenging now. Let’s see what happens.

I just want to return to the point you made about this oversupply of aircraft that we’re going to see. Airlines will cancel their orders, we’re going to see, typically, the older aircraft that you mentioned, be retired, so we’re going to see more younger aircraft in the industry. What impact is this oversupply of aircraft going to have on the pricing of planes and their residual value?

I think, what I could tell you is, the pricing is going to be win-win position. If anyone wants to replace their aircraft, because of early retirement – you are not flying, so you don’t need these aircraft, but you have to keep operating – so what could possibly be done is, maybe, some reasonable discounts on new aircraft sales, by getting the used aircraft, in trade. That way, first of all, you get rid of your backlog; there are too many parked aircraft. You are asking to get their five used Boeing 737 NG aircraft, you take them in and you give them, maybe, four or six MAX aircraft. That way, you don’t let the third-party business, come for your parts of your spare parts program. This is the only way. You can sell the engine or the aircraft once. But if you cannot control the servicing of that, then you won’t be in the game. There will be a lot of opportunistic people now, too many banks, investors, leasing firms, maybe, who would like to purchase these early-retired aircraft, because there is a good time on that, less flown hours, good landing gear, AP is good, engines are good. They good pay to get them and maybe scrub them out or pump them out and then sell them to the airlines, for spare parts.

So the OEM has no control over that. The only way for OEMs to take control and to keep their current aircraft in a value position, is to control the other aircraft, so they’re going to get them. Also the engine side, as well. They will get them in, replace them with the newer aircraft, give them a certain discount. It’s the same thing when you want to go and trade in your car. You always get more money than trying to sell outside, because there are trade-in options. This is the same thing. Otherwise, the control of the spare parts will not be on the OEM side.

You’re saying the OEMs will go to the airlines or go to the market and say, right, let me retire these old aircraft you have; I’ll give you the new aircraft we’ve manufactured and then I have the old aircraft and I keep the spare parts and the servicing revenue, when I then sell that on to someone else?

Exactly. Especially for engine OEMs, there are too many MROs, other than operated by OEMs. In Turkey, there is the Turkish Engine Center. 51% belongs to Pratt & Whitney; 49% belongs to Turkish Airlines. So Turkish Airlines, a couple of years ago, ordered 200 GTF engines, which were already attached to a market service contract and also, certain discounts on V2500 engines, part material. They discovered part material agreements. That means, if Turkish Airlines is going to replace any part on their V2500 engines, which are powered the A320 classic engine options, CEO aircraft, any part, Turkish Airlines will not go outside and look for used parts. They will get 15% to 20% or some other percentage, discounted, brand new parts, from the OEM. Think about the value of that. They are selling the contract, they are selling the engines, but also they are selling the service with them. In order to sell the service, you have to control the material itself.

In today’s world, I think we have around 18,000 commercial aircraft. If excluding cargo aircraft, of which there are around 3,000 or 4,000, we already have 14,000 aircraft flying. But right now, 95% of them are not flying. This 5% is already used as additional for cargo. There are some passenger aircraft, used by Delta and Turkish Airlines, which are being used for cargo, right now. If these aircraft don’t fly, what’s going to happen in the next couple of years? How many low-cost carriers do you think can survive like that?

Take the example of Turkish Airlines. You mentioned that they’ve ordered 200 GTF engines. What is the contract structure, when they purchase those engines? Clearly, they don’t need them all right now. Can they give them back? What can they do?

For Turkish Airlines, they’ve already got a couple of deliveries of the aircraft. If you are buying 737 MAX aircraft, there is no option. You have to buy a LEAP engine; a LEAP-1B engine. But if you are a client of Airbus, you have the option. For the Airbus NEO, new engine option, you could get either a LEAP-1A engine or a GTF engine. If your engine sells, your position, for the airline, is only for when the airline is buying Airbus aircraft. Let’s say that you know a company is already purchasing Airbus orders and you are just kicking in, against the LEAP engine, what you should do is, first of all, you have to know what is the current order; how many do they need? What is the delivery time, in years? They ordered them a couple of years ago, but they have only got 10 or 12 of them right now. There are still, I think, around 180 more to be delivered to them. If this corona impact continues, if today is the first day of the new GTF engine, with the aircraft, for Turkish Airlines, one year later, if this engine, with the aircraft, is not delivered, then according to the contract, the airline has a right to walk away, without paying any penalty. That’s why this is critical timing. Of course, it depends on the purchase time. You always have to keep around 10% as your spare engines. You order 200 engines, basically, you could say, 18 or 20 of them are the spare engines. Spare engines mean, a type of engine that is not delivered with the aircraft. They are delivered separately. The aircraft can be delivered with the engine, next year, but in the same month, you could also get one or two more engines, from the OEM, as your spare engines.

Right now, I don’t know how this contract would work, because the delay is not only due to the engine itself, but there is also delay due to the airline OEM. But is it going to be called force majeure? There will be a lot of lawyers who will be busy.

What do you think is going to happen? Do you think that these airlines will just wait until that year finishes, before they start cancelling these orders?

I think my answer today will be different from if you ask me in a month. Right now, this pandemic is all around the world and most of the airlines are even cancelling domestic flights. EasyJet is not really flying now. They have grounded most of their aircraft. Maybe they are using them for cargo or something else, but there are no passengers. The bail-out plan depends on the countries, of course. We know that Japan, just recently, announced that they are putting out about $1 trillion, $988 billion, and most of that will go to airlines. The Turkish government is putting some money in. The UK has invested a lot of money in that. The US is putting around $2 trillion, to save the companies. Yes, the Turkish government might save Turkish Airlines, but I don’t know how generous they are going to be in saving low-cost carriers. In the end, there will be a lot of aircraft available for sale.