risk management for airlines – financial risks

Aspects of Aircraft Leasing and Financing (LAW 2013) – London City Airport, UK

��

��

‘JOIN THE DEBATE’


RISK MANAGEMENT FOR AIRLINESFINANCIAL RISKS: FASTEN YOUR SEATBELTS

© 2013 1BlueHorizon Group - www.1bluehorizon.com 01BHG | Aeropodium Conference LAW London 27.06.13 Al l r ights reserved

June 2013

The ‘ idea factory ’ th ink ing ahead st rategies www.1bluehorizon.com


The aim of today presentation is to enhance our knowledge about Financial Risks and how to mitigate it within the Airline Industry

F a c t‘Air transportation is a fast growing sector

of most emerging economy’

D i l e m m a s2014 will mark the hundredth year of regular scheduled airline operations. In the last century,


2014 will mark the hundredth year of regular scheduled airline operations. In the last century, we will have served over 65 billion passengers and opened up new forms of family

connections, friendship and business.

The air transport industry supports 58.1 million jobs and US$2.4 trillion in global gross domestic product (GDP) according to a recent study .

Of the 58.1 million jobs, 8.7 million are within the sector itself, working for airlines, at airports, in air traffic management organizations and for the makers of aircraft and engines.

international tourists travelling by air, over 35 million tourism jobs rely on air transport.

Based on current rates of aviation growth, the industry is set to support 103 million jobs and $5.8 trillion in GDP in 20 years, while security and risk management top the list of challenge…


Obviously, the most common methods of financing the purchase of an aircraft are through Direct Purchase or through an Operating Lease

� Under a direct purchase arrangement the airline purchases the plane direct from the manufacturer or vendor, using a secured mortgage loan or structured finance lease. The amount of the advance for the aircraft can vary up to 90% depending on the airline and its available capital. These loans are generally structured with a term up to 12 years with mortgage style amortization and either fixed or floating interest rates. It’s quite common for several lenders to work in a syndicate to provide larger loan packages.

� There are several advantages and disadvantages with direct purchase of an aircraft, they include:

Main Advantages:


Main Advantages:

� Airline builds up equity in the aircraft as it pays down the mortgage or finance lease

� The airline is the owner of the aircraft and so can modify it to its own exact requirements

� As the owner of the aircraft the airline is able to gain significant taxation benefits in most countries

Main Disadvantages:

� The is subject to residual value risk at the end of the term

� Less flexible method of ownership when compared to an operating lease

� Heavily weighs down a company’s balance sheet which may affect other banking covenants

Source: 1BlueHorizon Group | Management Consulting Methodology


� When acquiring an aircraft on an operating lease the airline signs a contract which allows it use of the aircraft for a specified period, for a set specified payment. This payment is known the 'rental'. Payment of this rental grants the airline the use of the aircraft, not the ownership. The entity that leases the aircraft to the airline is the owner of the unit retains title to it after purchasing it from the manufacturer. Leases are usually put in place for shorter terms than a finance contract, generally 3-7 years for narrow body aircraft and possibly longer for wide body units. At the end of the lease the airline simply returns the aircraft to the owner or can make an offer to purchase it (also lease purchase agreement).

� In most cases the airline will be required to provide 3 months rental as a security deposit, which is

returned to the airline once the lease is complete, provided the aircraft is returned in proper order.

Obviously, the most common methods of financing the purchase of an aircraft are through Direct Purchase or through an Operating Lease (cont’d)


returned to the airline once the lease is complete, provided the aircraft is returned in proper order.

Monthly rental costs vary depending on market demand for aircraft though average approximately

1% of the new purchase cost of the unit.

Main Advantages:� Reduction in initial capital requirements� Residual value risk is eliminated as it stays with the owner of the aircraft� The liability stays off balance sheet, having less impact of banking restrictions

Main Disadvantages:� All equity built up in the unit is retained by the Lessee owner� Generally smaller tax advantages are available� Owner of the aircraft may impose onerous restrictions on its use


For sure, it is too late to consider Risk management when you require aircraft funding, finance for airline start-up or airline expansion

� The general requirements to finance an aircraft include your companies last 3 years accountant

prepared financials, evidence of capital and detailed business profile. If you’re attempting to start

an airline the most important item you require is a fully detailed business plan and corresponding

financial model. Without this you’re business won’t get off the ground.

� As with any major financial decision the choice to lease or finance an aircraft should be made with

the help of your professional accounting adviser. Once you've decided on the best option for your

business situation contact an experienced, competent aircraft finance broker that can assist you

further.


Financiers will not only focus as mentioned above fully detailed business plan and corresponding financial model, they will conduct a full Risk

Management Assessment of the airline (new venture or not) with a particular attention on the financial risks…

What are we talking about? – ‘Fasten your seatbelts…’


Before to talk about Risks, a quick appendix for people involved in the Middle East with Islamic Aircraft Financing

� Islamic finance is broadly perceived as a way of managing money by taking into account Islamic

religious requirements – Namely the Shariah. Shariah generally refers to the laws derived from

the Qur’an and the Sunnah and provides guidance to Muslims in the way that they conduct

themselves in their daily lives.

� One of the most important tenets of Islamic finance is the prohibition of ’riba’, which in simple

terms, means ‘extra’ or ‘excess’. This prohibition against excesses has been interpreted by

Islamic scholars to mean a prohibition against the charging or receipt of any interest. As a result,

interest is banned in all types of Islamic transactions.

� Islamic Aircraft Financing in Practice – The Ijarah


� Islamic Aircraft Financing in Practice – The Ijarah

� An Ijarah refers to an arrangement where the owner/lessor enters into an agreement to transfer the right to use a certain asset to another person in consideration for prescribed rental payments. An Ijarah contract is equivalent to a conventional lease agreement and is therefore a popular choice in Islamic aircraft financing.

� Some of the basic principles in an Ijarah contract are, amongst others, that the asset has to be of valuable use, that all risk of ownership is borne by the lessor and all liabilities arising from the use of the asset is borne by the lessee.

Source: © 1BlueHorizon Group | Management Consulting Research & Analysis


Shariah principles are the cornerstone of Islamic finance practices and will be considered in further detail in practice for an Aircraft Financing

3. SPV 1 will then enter into an Ijarah arrangement with the airline in which SPV 1 will execute a lease agreement with the airline to lease back the aircraft to the airline and the airline will pay lease rentals to SPV 1. The lease rentals will be equivalent to the principal and interest on the ‘loan’ obtained by the airline from Islamic financiers to purchase the aircraft.

4. In order to finance the purchase of the beneficial interest in the aircraft, SPV 1 can enter into a mudharabah arrangement with another special purpose vehicle ("SPV 2"). Under themudharabah arrangement, SPV 1 and SPV 2 can agree to share the profits

SPV 1 SPV 2

IslamicFinanciers

MudharabahArrangement

Dividends

InvestmentAgencyAgreement

Dividends

Airline

Lease rentals


and SPV 2 can agree to share the profits derived from the purchase and leaseback of the aircraft at certain agreed ratios. Essentially, the profits to be shared will be the “interest” portion of the “loan” extended to the airline from the Islamic financiers to purchase the aircraft.

5. SPV 2 will then enter into an investment agency agreement with the Islamic financiers wherein the Islamic financiers will appoint SPV 2 as the investment agent in the Mudharabaharrangement.

© 1BlueHorizon Group | Management Consulting

Financiers

Manufacturer

Sell

That illustration of the aircraft transaction may be described as follows:

1. The airline will normally enter into a sale and purchase agreement with the manufacturer for the purchase of a new aircraft at an agreed purchase price (the "Purchase Price").

2. The airline will then enter into a lessor purchase agreement with a special purpose vehicle for the purposes of the financing structure (‘SPV 1’). Under such lessor purchase agreement, the airline will transfer the beneficial interest in the aircraft to SPV 1 for an amount which is equivalent to the Purchase Price.


As per it definition, Risk is the potential of losing something of value, weighed against the potential to gain something of value

� Business Risk

� Financial Risk

– market risk

– credit risk


– credit risk

– liquidity risk

� Operational Risk

� Legal Risk


Risk management in the airline: Good or bad risk management is NOT the same as profits and losses

� Airlines are doing everything to reduce costs

� Some of the risks stem from complex industry structure

� Necessary to reduce the risk


� Much of this risk, however, could be identified and managed

� Effective strategies, adopted by other sectors

� In general, the financial markets do not trust airlines


For the last decade, failure to manage the risks within the airline industry resulted in the evaporation of $46 billion US$ in shareholder value

� Aviation encompasses a full spectrum of risk factors:

�International airline is exposed

�general entrepreneurial risks and

�industry-specific risks.

� Key areas of exposure are


�capacity and utilization risks,

�strategy-related risks,

�political risks,

�operational risks,

�procurement risks,

� labor agreement risks,

�financial and treasury management risks.

Four categories:- Hazard,- Strategic,- Financial, and- Operational


Two main category of Risks: those Externally driven and those Internally



Strategic risks are defined by business choices

� Hazard events safety, liability, and war were the least

� Strategic and financial risks were much more prevalent


Strategic Financial Operational Hazard

49% 22% 18% 11%


Many risks can be lessened through the selection of the business design, Southwest Airlines has designed a business to overcome major risks

� attracts customers in good times and in bad because it issimple operationally and, therefore, cost effective

� use of secondary airports insulates from competitive pressure

� low debt levels make the company less vulnerable to interestrate fluctuations.


rate fluctuations.

� profit sharing and fun culture reduce the chance of labordifficulties.



Airlines are continuing to develop risk management strategies, but a better understanding of the financial implications of a crisis is necessary

� Financial risks involve:

� the management of capital and cash

� including exogenous factors

� affect the predictability of revenue and cash

� Financial solutions may include the design of financial transactions:


of financial transactions:

� structured finance

� derivatives

� insurance

� contingent financing

� debt equity offerings



Kay Operational Risks have also to be very carefully considered

� Operational risks arise from the more tactical aspects:

� crew scheduling,

� accounting and information systems,

� e-commerce activities.

� Operational risks can be mitigated through organizational solutions:


solutions:

� process redesign

� organization structural changes

� improved communication

� contingency planning

� performance measurement and reward systems

� capital allocation and pricing



To mitigate Risks, in the nineties the airlines explore diversification into non-flying businesses - successful for a period of time

� Mitigating strategic risk:

� Lufthansa’s diversification in 1994 by creating four companies (subsidiaries)� Lufthansa Technique� Lufthansa Cargo� Lufthansa Service� Lufthansa Systems.


� Revenue growth has been highest 70 percent in 1996

� Not all of the divisions have been successful.

� Swissair known as a ‘flying bank’ pursued a similar strategy but they couldn't succeed.


To mitigate Risks, some other airlines have contained strategic risk through aggressive cash management

� During the 2001 crisis:

� low-cost airline Ryanair an order for 100 Boeing 737s with 50 options, during a time when most airlines are deferring orders

� They were able to negotiate a low unit price.


� During the Asian financial crisis:

� Singapore Airlines upgrades to their onboard product, for entrenching their leadership position during the later economic upturn.


Impact of Jet Fuel Price increases Jet Fuel Prices (2010-2016)

128127

120

125

130

� Jet fuel accounts for approx. 30% of airlines’ operating expenses

� Airlines have tried to pass on fuel price increases to consumers, but unless all airlines do this simultaneously, those that did it were at a competitive disadvantage

� To minimize the impact of fuel price increases, airlines may cancel low-capacity routes, consolidate routes,

� However, jet fuel prices are expected to decrease further as from 2013 and will thus relieve airlines from increasing cost

pressures (USD 110/bbl by 2016)

119

One of the main concern is to mitigate Risks related to jet fuel by hedging it, the largest portion of airlines’ operating expenses

ACTUALLY

114


110112

114

80

85

90

95

100

105

110

115

2010 2011 2012 2013 2014 2015 2016

may cancel low-capacity routes, consolidate routes,

and use one-engine taxiing at airports.

� Proactively, most airlines engage in financial hedging to protect against fuel cost increases, and may buy newer planes and engines that are more fuel-efficient for a particular type of service.

� Fuel consumption of aircraft varies widely: an Airbus 319 that carries 122 may burn 758 gallons of fuel per hour, while a Boeing 747-400 that carries 369 may burn 3,500 gallons per hour. Because of high fuel costs, newer planes and engines have been designed to be as efficient as possible for a particular type of service

92

Source: BMI Freight Transport Report 2013, 1BlueHorizon Group | Management Consulting Analysis

114


The other one is to mitigate Risks related to the changes in the exchange rate and interest rate due to its operations based on USD$

� There is a natural balance in the foreign currency risk

� Foreign currency sensitivity:

� The sensitivity of any currency* against 10 % change in USD (similar for EURO and British Pound Sterling) exchange rates

� Negative amount demonstrates the such currency in the net profit for the year


year


Even Techniques to mitigate financial risks are the most advanced, if such tools are not further leveraged, earnings will continue to be vulnerable.

� While many airlines were able to maintain profits in the face of price increases, more aggressive strategies could have been used to further improve results.

� There is a large third-party market dedicated to the effort:� including banks

� credit specialists� derivative markets and others


� derivative markets and others

� Hedging is a common way to manage the financial risk: � no airline input is more volatile than fuel� hedging is not a core competency, and

� as long as competitors are not hedged, it will be a level playing field

� When fuel prices rise dramatically, airlines cannot pass all of the cost on to their customers


One of the other well established technique for financial risk management involves guarantees for credit card transactions

� In the new arrangement, a guarantor ‘insures’ the refunds to the bank, which then releases the cash in the escrow account.

Customers BankEscrowAccount

Credit cardpayments

Refunds

Payments

Refunds


Guarantor Airline

Guarantor provides financial guarantee to the bank

Airline receives from the escrow account, a lump sum equal to the guarantee amount

Funds released as customers use tickets


Over a broad risk events analyzed over a period of ten years (2000 – 2010), four main risk management trends emerged

� 60% could have been avoided using the types of approaches discussed above.

� 15% could have been mitigated through traditional means such as insurance or financial derivatives.

� 20% events could have been mitigated by more consistent and


� 20% events could have been mitigated by more consistent and in-depth customer analysis, combined with scenario planning and game theory exercises.

� 5% of the events could have been mitigated through improved merger integration planning and improved execution.

Source: © 1BlueHorizon Group | Management Consulting Research & Analysis,


Risk management is an ongoing process, not a one-time event and over the long-term, the only alternative to it is crisis management

� The risk of interest of companies has two sources:

� The sensitiveness of assets and the sensitiveness of debts to the interests.

� If the companies want to protect themselves on natural ways from the risk of interests,� positive correlation with the changes of interest should prefer the

floating interest debt and


floating interest debt and � negative correlation with the changes of interests should prefer the

fixed interest debt.

� Distribution of foreign money on the revenues and the expenses are care about:� If the cost is low, a part of financing can be done on EURO beside

dominant money US Dollar in aircraft market� Well managed currency provide positive contribution with the

matching distribution of revenues and expenses in the future cash flows.


A formally specified risk management should be available not only for new established airlines but also for legacy carriers and business aviation

� Airline management manages the risks through their decisions and applications:

� A formally specified risk management model is still not enough implemented in particular in Africa, Middle East and Asia

� Corporate risk management model have been aimed there

� Enterprise Risk Management (ERM) also comprise financial,


� Enterprise Risk Management (ERM) also comprise financial, strategic risks which will give many advantage to any airline:

� With formation of ERM it’s planning to� identify risk appetite � risk strategy and create risk transparency � to create a strong risk organization, to inculcate sharing risk culture

and effective risk processes


Talking about Financial Risk Management helps also to understand why financiers are initially always skeptical to consider new airline venture…

Aviation financing is a hot topic and

likely to remain so over the coming years, as the demand for financing

deliveries of new aircraft peaks at a time when long term financing becomes unattractive for some of the incumbent

banks. There are a number of

headwinds in the aircraft finance market which may make these orders more


THANK YOU

which may make these orders more difficult to finance, and potentially, more

expensive.

Conversely, in tough economic times and a low interest rate environment attractive yields are harder to find. Investors are looking for hard assets with good returns.


��

��

MANAGEMENT CONSULTING SOLUTIONS PACK

P R O P R I E TA R Y I N F O R M AT I O N

1BlueHorizon Group | Management Consulting Management Consulting: How assisting management to solve a wide range of critical issues…


A s s e t M a n a g e m e n t | M a n a g e m e n t C o n s u l t i n g | I n t e g r a t e d C o m m u n i c a t i o n

We generate 1B l ueHo r i z on ® out of the Rough... www.1bluehorizon.com

March 2013


1BlueHorizon Group | Management Consulting (MC) from business plan to first flight, or through the transformation of becoming more competitiveEvery month 1BlueHorizon Group senior personnel are invited to look at new airline start up projects or to solve a wide range of critical issues within the airline & Aerospace industry by entrepreneurs, investors and Senior management and board members. In our experience, concepts which look great on paper don’t reflect the reality of taking the business to market, the reason why our turnkey solutions have continuously an implementation focus.

HOW WE CAN HELP – GENERETING THRUST TO PROPEL YOUR BUSINESS FURTHER...

If you want a feasibility study, a business plan or a Due Dilligence to assess the case for an airline start-up or existing burning cash and running into trouble, an airport our MRO facility, or are burning cash, we draw on our experience of assisting the airline & Aerospace industry in Africa, Middle East and Europe, to provide focused analysis and results-oriented decision support. Our team members have worked on the airline start-up of MaximusAir, Fly Dubai, MTMKN (all U.A.E.), Silkroad Cargo (Uzbekistan), Wataniya Airways (Kuwait), Blue Airways (Nepal), Saba Airlines (Yemen), JetGreen (Pakistan), Punto Azul (Guinea Equatorial), for various airlines aiming to



Source: © 1BlueHorizon Group | Management Consulting

Saba Airlines (Yemen), JetGreen (Pakistan), Punto Azul (Guinea Equatorial), for various airlines aiming to restructure a poorly performing business or for airports in need of a strategic business review like N’djili International Airport in Kinshasa (RDC) or technical support for Al Najaf International Airport (Iraq).

Our core team and associates have management expertise in strategy, operations revitalization and restructuring, commercial, asset management, finance, maintenance & engineering across over twenty airlines. As example, we can advise on planning an airline start-up and provide an interim team to launch the business – from AOC through fleet acquisition, negotiations support with financiers, required due diligence, branding & marketing, recruitment, pilot training, IT infrastructure etc. – a full turnkey solution.

We are used to generate 1BlueHorizon® out of the Rough...


‘Big Four’Law firm

Management

1BlueHorizon Group | Management Consulting (MC) is providing clients a comprehensive approach, no matter how complex the issues

Innovative – Hands-on Knowleadge transferconsulting



OperationalImprovement

Creating 1 B l u e H o r i z o n ® to solve a wide range of critical issues

BUSINESSDEVELOPMENT

IMPLEMENTATIONProject Management Office

Source: © 1BlueHorizon Group | Management Consulting Business model


� Do you need help starting a new venture?

� Is it time for a Due Diligence as next step?

� Are you in need of a strategic business review?

� Looking for ways to differentiate from competitors?

� Aiming to restructure a poorly performing business?

� Are you in need of a sound Project Management office?

Illus

trativ

eA

via

tio

n

1BlueHorizon Group|MC senior personnel core competencies lie in Airlines, General Aviation, Airports, Aerospace and Defense and are deployed on-sites



� Are you in need of a sound Project Management office?

In today’s Aviation & Aerospace business environment, the margin of error is thin; clients need and expect seasoned advisors. With their respective disciplines,

1BlueHorizon Group senior personnel have experience in various corner of the world.

1BlueHorizon Group |MC is ready to field a team of relevant aviation and aerospace experts whenever and wherever they are needed

Airlines Air Cargo Corporate Jet Airports MRO GCAA

Source: © 1BlueHorizon Group | Management Consulting Industries & Capabilities – Core competencies Aviation


Project Management Office

According to recent studies, 68% of projects do not meet time/cost/scope targets.The PMO strives to introduce

economies of repetition in the execution of your projects and

Providing innovative solutions, hands-on and knowledge transfer are our difference to maximized value creation - continuously ahead of strategies

Operational Improvement

Our understanding of operational improvement is

quite simple: Whereas restructuring is about

stabilizing a company and fixing how it does things,

operational improvement is

Interim ManagementManagement trainer

Finding talent is difficult even at the best of time. Finding

resources to assist for a short-term assignment of a proven

heavyweight interim executive manager to manage a period

1BlueHorizon Group |MC senior personnel assists - ahead of strategies - stakeholders and management of companies in a variety of sectors who are faced with operating challenges, support of a project management office and/or requesting senior executive interim management support.

Ahead of Strategies

If you want a feasibility study or business plan to assess the case or are burning cash and running into trouble as you approach launch or help the executive teams assess the case for entering immunized



execution of your projects and we participate actively

in Strategic project management as facilitator…

1BlueHorizon Group |MCcan help give comfort and control through our hands-on experience to maximize

value creation…

operational improvement is about seeing a company

through the transformation of becoming more competitive.

1BlueHorizon Group |MCworks side by side with you to maximize the potential of

your people…

manager to manage a period of transition, crisis or change within an organization or to take on critical projects or

senior positions for a limited time is even more difficult.

1BlueHorizon Group |MCquickly understand what you need, with interactive

mentoring if more suitable…

… and our clients well recognize this!

case for entering immunized joint ventures…

1BlueHorizon Group |MCsenior personnel helping to

maximize your potential, thinking ahead of

strategies…


Published books and decisive management theories that facilitate critical dialogue and support 1 B l u e H o r i z o n creation

A short selection of inescapable aviation related books



“Baseline”(Philosophy)

“Low Cost Carriers”

“Courier services” “Various”Airlines’

Turnaround“Air Transport Management”

Partners network - Aviation

Source: © 1BlueHorizon Group | Management Consulting recommended bibliography (non exhaustive)


‘Ahead of ‘Ahead of ‘Ahead of ‘Ahead of strategies…’strategies…’strategies…’strategies…’

LEONARD FAVREManaging DirectorAbu Dhabi (U.A.E.) & Bern (Switzerland)

� 20+ years of professional experience in assisting stakeholders and management of companies in a variety of sectors who are faced with operating challenges, both as management advisor and in senior executive roles (sectors including aviation, aerospace & defense, ports, energy, public sector and family conglomerates - mostly in the Middle East)

� Expert in strategy & organization, cost reduction, restructuring and operational improvement, due diligence screenings, mergers & acquisitions, disinvestment, financial advisory, PMO, economic development (clusters) and interim management

� Fluent in French, English and German with good command of Italian and beginner Arabic

� Education: MBA in Management INSEAD & IDHEAP



Note: References upon request

Professional background

� Chief Restructuring Officer for a Family conglomerate with aviation focus base din the U,A,E,

� Director by AlixPartners , restructuring and operational revitalization – Interim Management

� President & CEO advisor and Vice-President Strategy and Business Development for Maximus Air (Cargo Airline) in Abu Dhabi

� Executive Director Investments promotion and marketing for an Economic development agency based in Abu Dhabi

� Senior Associate by Booz Allen Hamilton for 7 years -mostly in the Middle East

� CEO of a Swiss Economic development agency

� CFO of the Swiss Ministry of Defense

� Regular contributor to conferences and forums and his vision of airline industry is always a valuable and knowledgeable input.

M a n a g e m e n t - S t r a t e g y


Contact: LEONARD FAVREPartner, Managing Director

Email: [email protected]

1 BlueHorizon Group| Ma n a g e m ent Co n s u l t i n g |P.O. Box 34154

Abu Dhabi, United Arab Emirates

M: +971 50 6164 007 (U.A.E.)

M: +41 79 2080 256 (Switzerland)

S: leof007


risk management for airlines – financial risks

Leadership & Management

makers of aircraft

narrow body aircraft

financing law

airline signs

london city airport

airline industry f

bluehorizon group

operating lease contd