2013-02 Avolon - Transitioning to Neo and Max

Transitioning to Neo and Max An Investor’s Guide

Dick Forsberg & Lucas Mollan

February, 2013

Dick Forsberg Head of Strategy Dick Forsberg has over 40 years’ aviation industry experience working in a variety of roles with airlines, operating lessors, arrangers and capital providers in the areas of business strategy, industry analysis and forecasting, asset valuation, portfolio risk management and airline credit assessment. Prior to joining Avolon as a founding executive, he was Head of Strategy at RBS Aviation Capital, where responsibilities included defining the trading cycle of the business, creating and maintaining an asset valuation capability, setting portfolio risk management criteria and determining capital allocation targets. Prior to RBS, Dick worked with IAMG, GECAS and GPA following a 20‐year career in the UK airline industry. Dick has a Diploma in Business Studies and in Marketing from the UK Institute of Marketing and is a member of the Royal Aeronautical Society. Dick is also a Director of the Board of ISTAT (The International Society of Transport Aircraft Trading). Lucas Mollan Chief Technical Officer Lucas Mollan has 29 years of experience in technical management. He previously served as Managing Director of Thomas Cook Aircraft Engineering where he was responsible for the provision of in house maintenance and engineering support to the various Thomas Cook Airline fleets, totalling over 60 aircraft. He was also responsible for the purchasing and management of outsourced MRO services such as engine overhaul, component support services and heavy maintenance, and for the provision of aircraft maintenance and technical support services to third party airline customers. Prior to this, Lucas served in senior technical roles for several UK airlines, including Air 2000, JMC Airlines and MyTravel Airways. Lucas has also previously worked for Airbus, assisting airlines to introduce new Airbus aircraft into their fleet. Lucas has a Bachelor of Science (Hons) in Aeronautical Engineering from Bristol University and is also a licensed UK CAA Aircraft Maintenance Engineer.

Avolon Avolon is an international aircraft leasing company. Headquartered in Ireland, with offices in Stamford CT, Hong Kong, Shanghai, Singapore and Dubai, Avolon provides aircraft leasing and lease management services. Avolon’s investors include three of the world’s leading private equity firms Cinven, CVC Capital Partners and Oak Hill Capital Partners and one of the world’s leading sovereign wealth funds, Government of Singapore Investment Corporation (GIC). Avolon has established itself as one of the leading global players in the aircraft leasing sector, leveraging off the strong financial backing of its owners and the extensive trading history and senior industry relationships of its management team. Avolon has a committed fleet of 163 owned aircraft, including direct orders for 20 A320neo and 20 Boeing 737Max aircraft. See www.avolon.aero Acknowledgement The authors would like to thank Ascend and Avitas whose databases are the source of much of the fleet and values data in this analysis. Disclaimer This document and any other materials contained in or accompanying this document (collectively, the “Materials”) are provided for general information purposes only. The Materials are provided without any guarantee, condition, representation or warranty (express or implied) as to their adequacy, correctness or completeness. Any opinions, estimates, commentary or conclusions contained in the Materials represent the judgement of Avolon as at the date of the Materials and are subject to change without notice. The Materials are not intended to amount to advice on which any reliance should be placed and Avolon disclaims all liability and responsibility arising from any reliance placed on the Materials.

http://www.avolon.aero/

Transitioning to Neo & Max – An Investor’s Guide

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Contents

Page Executive Summary 2 Key Findings 3 Transitioning to Neo and Max – Detailed Analysis 4

1. Macro capacity trends 4

2. Background to the “new” products 5

3. Neo and Max production milestones 7

4. Neo and Max order status 8

5. Neo and Max production and delivery ramp‐up 10

6. Avolon’s single aisle fleet forecast 10

7. A320 and 737 backlogs 11

8. Single aisle fleet evolution and replacement trends 12

9. Asset value considerations 14

10. Where will today’s used aircraft go? 16

Conclusions 18


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Executive Summary

The transition of production from a highly successful current generation of aircraft to more efficient successors is a subject with considerable topicality. Avolon’s second white paper on industry issues considers how the transition from A320ceo and 737NG to Neo and Max will influence the single aisle landscape over the rest of the decade and beyond. The anticipated benefits offered by the new models are examined, as are the challenges involved in bringing them to market.

This paper incorporates Avolon’s current forecast of aircraft deliveries and capacity growth over the coming years and analyses the impact that the introduction of re‐engined aircraft families will have on existing fleets, both in terms of their future operation and their residual values. How quickly will the installed fleets of the new models grow? When will current production end? Which in service fleets will be replaced first by the new variants? How will values of “last off the line” aircraft perform?

At a broader level, the analysis examines the total amount of new capacity delivering into the market over the coming years. How will new deliveries be allocated between growth and replacement? To what extent is there excess capacity and what are the implications? Will the liquidity of current production aircraft be impaired?

The successors to current generation A320ceos and 737NGs will deliver fuel efficiency advantages deriving from advances in engine technology, with no other material changes to structures or performance, and are further evolutions of the current models rather than fundamentally new types. As such, Neo and Max do not pose a disruptive threat to the long‐standing competitive balance between the two families. Indeed, Boeing’s decision to proceed with Max has ensured that the status quo will be maintained at least until the end of the next decade.

Clearly, there are execution risks associated with both programs, however the level of continuity with current models and their production processes significantly reduces the potential scale of program slippage compared to recent widebody introductions and the airframe and engine OEMs can bring extensive resources and experience to bear on the technological challenges presented by the programs and their timescales.

The pattern of customer orders confirms that there is still plenty of demand for the current models, which bodes well for their continued liquidity and attractiveness to investors. The scale of their embedded fleets and operator bases are substantially greater than those of previous generations of transitioning aircraft, which will also protect them from premature value loss.

The level of single aisle capacity delivering over the coming decade can be absorbed by a combination of market growth and fleet replacement, but this will only happen if the OEMs remain disciplined and prudent in their production rate planning. Under such circumstances, we believe that the transition to Neo and Max will be orderly, achieved with little disruption to the investor and operator environment and undertaken broadly within the timescales identified by the OEMs. At the same time, current generation A320 and 737 variants will continue to benefit from strong liquidity metrics that will support placement of used equipment by lessors through the transition period and beyond.


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Key Findings

Neo and Max represent the next evolutionary development of the A320 and 737 families and the transition process is therefore expected to be orderly and stable. At their stated performance levels, they will deliver real economic benefits to operators at oil prices at or above $65 per barrel.

Many of the execution risks associated with the Neo and Max programs lie with the engine manufacturers, who are nevertheless well equipped and resourced to meet these challenges.

Whilst Neo and Max values are still finding their equilibrium in the market, a meaningful premium over current generation equivalents is achievable based on stated performance targets and operating economics.

Narrowbody deliveries for the coming decade can be absorbed by the combined market requirements for growth and fleet replacement. However, continued discipline on the part of the OEMs with respect to production rates is a critical factor in maintaining the supply and demand balance.

Sufficient mature aircraft will be available to absorb the replacement element of new single aisle deliveries over the next decade. As with previous transitions, prior generations of technology will be retired ahead of current production models.

The number of narrowbody aircraft ordered by airlines in each region, as a percentage of the installed fleet in those regions, remains substantially below the rate of traffic growth predicted over the next ten years, indicating a deep reservoir of unsatisfied demand for additional aircraft, both new and used

Current production types will continue to be in demand from operators and retain high levels of liquidity during and beyond the transition period, following the pattern of earlier generations. Demand for new and used equipment will be underpinned by strong growth in emerging markets and the continued development of low cost business models backed by market liberalisation.

It will take more than 8 years from service entry for Max and Neo to build a critical mass within their respective family fleets and they are consequently not expected to directly impact values of current generation types for a number of years.

Strong demand, large installed fleets and operator bases, limited changes to payload/range capabilities and a deep cushion of earlier generation retirement candidates all mitigate the “last off the line” effect on values of aircraft delivering close to the end of their production cycle and support value retention for current A320s and 737NGs.

The appropriate treatment of aircraft acquired within the last off the line timeframe will be informed by the expertise of the investor’s asset management team, their market intimacy and their experience of investment and trading through previous cycles and aircraft family transitions.


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Transitioning to Neo and Max – Detailed Analysis

1. Macro capacity trends

Avolon has analysed aircraft deliveries made over the past 40 years, matching new capacity inducted into the system with stored aircraft and retirements leaving the system. The ebb and flow of seat growth can be seen in Exhibit 1, which highlights both the cyclical rise and fall of seat growth and the long‐term slowing trend, from almost 8% in the early 1970s to between 4% and 6% today and a forecast continuation around that trend line for the next ten years. The use of storage to relieve periodic cyclical stresses can also be clearly seen, including during the forecast period, where we assume that the next cyclical downturn will reach its lowest point in 2019/20.

In a similar fashion, the allocation of additional capacity between growth and replacement also follows a cyclical rhythm (Exhibit 2), with growth accounting for between 35% and 80% over the past 20 years, with an average of 64%. The past four years has seen replacement averaging 40% with a peak close to 50%. This safety valve, supported by a growing fleet of ageing aircraft, many of them in North America, that fall within what Ed Greenslet calls “the killing zone”, will remain an important swing factor throughout the remainder of the decade (Avolon’s forecast for the period is shown in red), reflecting the delivery boom that began in the late 1980s. Single aisle retirement rates, which have averaged 2.2% of the installed fleet over the past five years, are forecast to increase gradually, to 2.5% over the next five years, and to 2.6% out to the end of the decade.

At the currently anticipated levels of new narrowbody production, detailed below in the section “Avolon’s World Fleet Forecast”, we expect supply and demand, as expressed by net additional seats versus passenger traffic growth, to be broadly in sync over the next 10 years. Subject to cyclical fluctuations, Avolon forecasts traffic growth to average slightly less than 5.5% per annum over the next ten years, whilst single aisle capacity will increase at a little over 5.5%. Exhibit 3 shows how supply and demand components have tracked one another over the past 12 years and where they are expected to go in the coming years.

‐6%

‐4%

‐2%

0%

2%

4%

6%

8%

10%

12%

1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010 2014 2018 2022

Exhibit 1: Narrowbody Seat Growth

Gross capacty growth Capacity growth net of storage Trend

Forecast

Source: Ascend

0%10%20%30%40%50%60%70%80%90%

100%

Exhibit 2: Replacement share of NB delivery capacity

Growth % Replacement %

50

100

150

200

250

300

350

Exhibit 3: Single Aisle Supply & Demand Growth Indices

NB RPM Index NB Capacity indexSource: Avolon


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It is into this environment of broadly balanced supply and demand that the new Max and Neo products will begin to deliver in the second half of the decade and their introduction, per se, does not represent a disruptive element within the overall market dynamic. How the OEMs deal with their overall levels of production, however, will very much influence the outcome over the next decade and without their restraint in managing the supply/demand balance, the picture could look very different.

2. Background to the “new” products

The launch and subsequent sales success of both Neo and Max have been enabled by the development of new, or, at least, improved, engine technology delivering greater fuel efficiency than current models to a significantly greater degree than the underlying ½ ‐ 1% annual increments that the industry can routinely deliver. Quantification of that step‐wise efficiency improvement continues to be debated, not least by the OEMs in their marketing pitches to customers, and in reality will not be known for sure until the new aircraft have entered service. However, the gains are expected to be in the high single digit to low double digit range which, in the context of sustained high fuel prices, makes the proposition attractive to many, though not all, airlines.

Unlike most previous new or upgraded models, Neo and Max were not developed in response to specific shortfalls in payload/range performance, though some variants will be improved during the upgrade process. Nor do their manufacturers claim compelling maintenance cost benefits. Their advantage lies almost exclusively in their fuel efficiency, which the airframers seek, in their pricing strategies, to share more or less equally between themselves and the airlines. A comparative cost and revenue analysis carried out by Avolon indicates that oil prices above $65 per barrel ‐ a level that consensus oil price forecasts suggest will be comfortably exceeded on a long‐term trend (see Exhibit 4) ‐ will support the economics of new technology products at a price premium that reflects 50/50 value sharing on the part of the OEMs.

Because the changes are limited to those features that deliver the improved fuel efficiency, airlines will not face the usual challenges and costs associated with a “traditional” fleet roll‐over programme and instead will be able to bleed these new models into their existing A320ceo and 737NG fleets, crew complements, networks and maintenance programs far more easily than has been the case with any previous transition. This avoidance of expenditure and disruption will both encourage operators to sign up to the new products and at the same time not precipitate wholesale early fleet replacements.

The enhanced engine performance is currently being offered by two power‐plant manufacturers ‐ Pratt & Whitney and CFM. The former, whose share of the single aisle market has been in decline since the 737‐200 ended production in 1988, created the opportunity for Neo and Max to become a reality when they announced the development of a geared fan 2‐shaft (or “2½ shaft”) engine capable of powering aircraft at least up to A321 size (30,000lbs‐plus thrust) and, having secured launch applications on the Mitsubishi MRJ and Bombardier C‐Series, were able to demonstrate the

Exhibit 4: Oil Price Forecast

Brent WTI Std Dev (WTI)2013 107.62 93.82 12.322014 110.06 99.43 13.872015 109.17 99.84 14.292016 108.27 102.67 17.692017 109.76 103.72 18.722018‐22 115.48 106.05 21.37Source: Consensus Economics Inc.

Consensus of 22 analysts (US$ per BBL)


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effectiveness of their engine design and architecture during 2008 in static tests and on test flights, including a series performed by Airbus.

Having won over the sceptics (including, critically, Airbus) and demonstrated strong fuel burn improvement and noise credentials, the cat was out of the metaphorical bag and it became increasingly difficult for the airframers to maintain their comfortable single‐aisle duopoly by arguing that the lack of advancement in engine technology was preventing new models from being developed. Airbus announced the launch of the Neo in November 2010 and, given the existing dual engine offering on A320s, it was incumbent on CFM to provide a competing engine. The engine they offered was the LEAP‐X, which had already been launched on the C919 program in 2009 having grown out of an existing CFM development program, LEAP56, which dates back to 2005. The LEAP‐X engine will use advanced materials and a two‐stage HPT design to achieve similar performance improvements relative to current in service engines. CFM’s commitment to the LEAP also supported Boeing’s decision, in July 2011, to proceed with the 737Max family following a protracted period of review, analysis and soul‐searching. In the end, the Neo proposition was too powerful for Boeing to ignore and the American Airlines Neo order announced soon after the 2011 Paris Air Show triggered the launch of the 737Max, restoring market equilibrium and the single aisle status quo between the two manufacturers.

Both aircraft programs come with not insignificant execution risk, although the OEMs position their products as evolutionary, not revolutionary. Neither airframe will undergo major reworking, although the 737 has been the more challenging of the two to modify, with tighter ground clearances for the engines in particular. The A320 family is already undergoing structural modifications to accommodate Sharklets and, although further wing strengthening will be needed to take the heavier engines, little else is required beyond the obvious changes to engine pylons and nacelles.

Whilst initially the P&W Geared Turbofan was thought to present greater engineering risks than the new LEAP engine, extensive testing and development work removed many of the concerns over the reliability and robustness of the geared turbofan architecture and even GE, who were amongst the loudest critics of gearbox technology, appear to have softened their criticism. However, the new geared shaft arrangement is still to be tested in service. Beyond the gearbox, the rest of the GTF engine is fairly conventional and, indeed, has fewer parts than similar designs, removing weight and cost.

CFM will incorporate significant new technology in the LEAP, which will enable the engine to produce similar fuel savings. This includes a new composite fan system which is both light and highly efficient. A significant amount of this technology has already been developed for larger GE engines such as the GE90 and GEnx, and will be scaled down to the 20‐30,000 lb thrust category. Since CFM agreed final design parameters with the airframe OEMs and launched the engines for A320 and 737 some two years after P&W, they will also be later to market ‐ 9 to 12 months after the GTF on the A320 and as sole source on the 737Max in 2017.

Each of the engine manufacturers is producing a family of related engines for different applications with different thrust requirements (Exhibit 5), however the development and evolution of these families carry different levels of risk. The PW1000G family of engines is being developed in four variants, for the MRJ, C‐Series, MC‐21 and Neo, each of which is, in reality, a different engine despite


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the similarities in architecture and design features. In addition, the recently announced PW1700G and 1900G applications for the proposed re‐engined E‐Jets family will use basically the same cores as the 1200G and 1500G, although they will have different fuel and vane schedules and other specifics to reflect airframe installation changes. The added complexity of managing several parallel programs should not be under‐estimated.

In contrast, the various LEAP engines are all in a similar thrust class and the core hardware for both the ‐1A and ‐1C will be identical, according to CFM, whilst the ‐1B will have a smaller core, tailored to the smaller fan size required on the 737. This lower number of variants should give CFM an advantage over P&W in respect of production ramp for the high volume of engines they will need to produce for the major airframers.

3. Neo and Max production milestones

Milestones for the 737Max include a firm configuration freeze in mid‐‘13, start of major assembly in early 2015, first flight in the second half of 2016 and EIS for the ‐8 in mid‐2017, with the ‐9 and ‐7 following at 9 to 12 month intervals.

Neo development is running around half a year ahead of Max, with service entry targeted for October 2015. However, whilst Airbus plans to move into final assembly within about 12 months of design freeze, Boeing is scheduling a longer gap, presumably linked to the lag in development of the LEAP engine, which is therefore a pacing item in the critical path for Max. Boeing is also showing a longer elapsed time for major assembly, but this is likely to be due to the different production methods applied, with Boeing undertaking much more of the 737 fabrication in‐house compared to the A320 final assembly line (“FAL”) where completed major structures are joined.

Exhibit 6 sets out the planned project development timelines for each of the products.

Service entry of the smaller and larger family members has been indicated by the OEMs, but will ultimately be dictated not only by the status of the programs but also by the profile of the order books, which currently look to favour advancement of the larger models. Airbus has commitments from three airlines for 35 A319s, with potentially more within AMR’s Neo order, however Boeing has booked no specific ‐7Max orders and their recent announcement of a BBJ Max program included the ‐8 and ‐9, but with no mention of a ‐7. In comparison, the A321neo has over 300 commitments and the 737‐9Max 150+.

20192018201720162015201420132012

A320neo

Design freeze

Concept freeze

Commence Major AssemblyFirst Flight

FETT

EIS

737 Max

PW1100

LEAP‐1A

LEAP‐1B

320 319 321

‐8 ‐9 ‐7

Exhibit 6: Neo & Max Major Milestones

Exhibit 5: Engine Family Applications

PW1000G FamilyEngine Application Thrust Class Fan Diam.PW1200G MRJ 15-17,000 lbs. 56"PW1500G CSeries 19-24,000 lbs. 73"PW1100G A320neo 24-33,000 lbs. 81"PW1400G Irkut MC-21 28-31,000 lbs. 81"PW1700G* E175G2 15,000 lbs. 56"PW1900G* E190/195G2 19-22,000 lbs. 73"*Subject to Embraer launch approval

LEAP FamilyEngine Application Thrust Class Fan Diam.LEAP-1A A320neo 24-33,000 lbs. 78"LEAP-1B 737MAX 20-28,000 lbs. 68.4"LEAP-1C C919 28-30,000 lbs. 75"


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Whilst the performance of CFM in delivering the LEAP engine into production is clearly crucial for the on‐time service entry of Max, it is no less important for Neo’s CFM customers, the first of which are scheduled to take delivery of aircraft from March 2016 onwards.

Also critical is the performance of P&W for the launch of the Neo program. Their engine will doubtless benefit from the earlier on‐wing experience gained on C‐Series and MRJ aircraft, although programme slippage means that the extent of in service data collection will be less than the manufacturer had originally hoped for. Nevertheless, the benefits of early performance telemetry should translate directly into the PW1100G, where the first engine build has been completed and entered the test program, with test flights on schedule to commence in Spring 2013.

On balance, we believe that the production ramp‐up challenge for CFM is greater than for P&W because of the larger numbers involved as the supplier for both Neo and Max and also the technology going into these engines. For example, whilst there is no concern that CFM will be able to produce composite fan blades, as they have done so very successfully for the GE90 and GEnx, the volume requirement is dramatically greater. CFM will establish two Fan Blade production facilities, one in the US and one in France to mitigate this. Greater use of additive manufacturing (3‐D printing) will require additional production facilities, which GE/CFM are addressing by bringing some supply chain partners in‐house. The use of CMCs (Ceramic Matrix Composites) in the LEAP engine, although already in use in military engines, drives a ground‐breaking increase in manufacturing volume which will require similar innovative solutions.

4. Neo and Max order status

Both Neo and Max have enjoyed very strong initial sales success, with commitments running significantly higher than their predecessors achieved at the same stage of introduction (Exhibit 7). Even when annual commitments are measured as a proportion of the in service narrowbody fleet, which normalises for the underlying growth in the market (Exhibit 8), these models are performing very strongly, with the effects of Airbus’s early sales strategy particularly clear to see. Indeed, the A320neo has become the most successful product launch to date, outstripping even the 787.

By mid‐February 2013, Airbus had secured almost 1900 commitments for the Neo family (Exhibit 9), whilst Boeing had passed 1200 Max commitments. Airbus secured an early lead over Boeing in the tally of orders due to their earlier launch and an extremely successful high intensity campaign in the lead up to the 2011 Paris Air Show, where they announced over 600 new Neo commitments

0200400600800100012001400160018002000

0 1 2 3 4 5 6 7

Cumulative commitm

ents

Years since launch

Exhibit 7: Cumulative commitments since launch

737 (CFMI) 737 (NG) 737 Max A320ceo A320neo

Source:Ascend 0%

2%

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6%

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12%

14%

0 1 2 3 4 5 6 7

Percen

t of in‐service fle

et

Years since launch737 (CFMI) 737 (NG) 737 Max A320ceo A320neo

Source:Ascend

Exhibit 8: Annual commitments as % of in service NB fleet


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comprising 2/3rds of the show total. The Neo customer base now includes 29 airlines and 9 lessors, the latter accounting for 23% of the backlog. With the Neo program firmly established from a demand perspective, Airbus’ primary objective in 2012 was to ensure that additional A320ceo sales were booked to support production through the transition period. Their sales efforts have been rewarded with a very solid skyline which, when near‐term over‐booking is taken into consideration, leaves them with very manageable levels of unsold capacity through to the end of the decade (estimated at less than 500 units across Ceo and Neo).

Although Boeing’s early Max campaigns were hampered by the lack of a firm design freeze, performance data and pricing information, sales activity stepped up significantly in 2012. Limited information around detailed design and performance data may explain why 40% of the Boeing backlog of over 1200 aircraft is currently not assigned to a specific model (Exhibit 10). Customers include 12 airlines and 6 lessors, with lessors also taking 23% of the backlog. Boeing also has a strong backlog of NGs, but a significantly larger proportion of unsold production than Airbus heading into the transition period (see section 7 below, “A320 and 737 backlog”).

The lion’s share of commitments to date has been for the “flagship” A320neo and 737‐8Max models, with still muted demand for the larger variants and seemingly low interest in the smaller family members. This distribution reflects the current market trend towards up‐scaling, with several traditional A319 and 737‐700 operators now taking incremental A320ceos and 737‐800s in a move to reduce seat‐mile costs, the industry having largely proven its ability to fill marginal additional seats through more efficient and powerful inventory management technology. This trend is expected to be maintained and future sales of smaller family members can be expected to be below the ratios achieved on the current models. In addition, the additional weight of Neo and Max arising from the larger engines will have a greater impact on the smallest family members, which should logically deliver the smallest fuel burn improvement.

Whilst CFM has sole supplier status on the 737Max, the two engine providers have been running effective campaigns to secure market share on the Neo program, with each currently at close to 50% of both orders and customers (Exhibit 11). This balanced market is likely to be maintained, assuming that the performance of both engine types proves to be comparable, with both OEMs regarding their campaigns as having moved beyond the start‐up phase.

35

1557

305

Exhibit 9: Neo Commitments

A319 A320 A321Source: Ascend

568

643

651

P&W CFM tbaSource: Ascend

Exhibit 11: Neo Engine Commitments

558

154

516

Exhibit 10: Max Commitments

737‐8 737‐9 tbaSource: Ascend


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An important point to note is that, since the launch of Neo in November 2010, Airbus has secured more than 850 further Ceo commitments (including 300 in 2012), whilst over 600 additional 737NGs have also been ordered since the first Max commitment from American Airlines some 18 months ago. These are significant numbers that make a strong statement in support of the current generation aircraft. They also maintain an historic trend – almost 350 737 Classics were ordered following the launch of the NG and similar proportions (over 15%) of the total delivered Ceo and NG fleets are expected to be ordered between the launch of the successor and the end of production.

5. Neo and Max production and delivery ramp‐up

Current OEM plans for service entry of the various new models assume a moderate ramp‐up over three to four years, with a corresponding decline in output of current types. Airbus anticipates the first A320neos entering service in late 2015, with A321neos and A319neos following over the course of 2016. The current process of transitioning Ceo production to the modified wing design required for sharklets would suggest that A320 and A319 introduction will be linked due to their common wing structure, with the A321neo the last to enter service due to its requirement for separate wing jigs. However, countering that assumption is the probability that the A321neo will have significantly greater demand than the A319, pushing for an earlier EIS.

Boeing has indicated that Max deliveries will commence in 2017, initially with the ‐8, followed in 9‐12 month intervals by the ‐9 and ‐7. With a common wing installation, the industrial phasing issues facing the A320 family do not apply and it is most likely that the ‐9 will follow the ‐8, assuming that no order for ‐7s (from Southwest, for example) creates a customer requirement for the smaller model that outweighs the current expectation that the ‐9 will be the stronger seller.

Whilst the ramp‐up of recent new widebody models from both Airbus and Boeing might suggest that transition could take significantly longer than three or four years, the fact that both Neo and Max are developments of current production types will minimise manufacturing, supply chain and assembly line issues. If, as both airframers contend, they succeed in keeping engineering changes to a minimum beyond what is required to accommodate the new engines, this should be borne out in fact, with the engine providers placed under greatest pressure to meet their contracted output levels.

Neither CFM nor P&W has suggested other than that they will be fully ready to meet the production transition and ramp‐up rates guided by the airframers and both are expected to have supply chain and production capacity available to meet demand for new engines and, in the case of CFM, also maintain the required level of CFM56 deliveries across the transition of both competing types.

6. Avolon’s single aisle fleet forecast

Avolon regularly undertakes detailed market forecasts of commercial jet supply and demand looking out over a 20 year time horizon and has developed a proprietary World Fleet Forecast model (“WFF”) to support a range of business decisions. The model considers order, delivery, storage, retirement and conversion activity across close to 100 individual aircraft types including in‐production, out of production and future planned production models. The WFF, which supports


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much of the forward‐looking analysis in this paper, includes transitions from current to new generation A320s and 737s over a three to four year period towards the end of this decade, as currently signalled by the OEMs and supported by order backlogs. The WFF also considers the extent to which new deliveries, of all types both current and new, will meet market requirements for capacity growth versus operator requirements for fleet replacement, recognising that the balance between the two will be influenced not only by the availability of new aircraft but also the wider industry cycle. This is determined by macro‐economic assumptions, including a ten year average global GDP growth rate of 3.2%. On the output side of the analysis, underlying passenger growth averages 5.4% and capacity (ASMs) 5.7% over the same timeframe, with an average narrowbody retirement rate equivalent to 2.6% of the installed fleet and an average retirement age of 25.8 years.

The issue of overall production rates is also considered and appropriate assumptions made. Over the past 12 months, the more combative OEM predictions of future rate increases have been moderated, due the sustained global economic weakness and a more prudent view of the potential supply chain and manufacturing risks that may occur in the run up to and during the transition period. In our view, it would make sense for the OEMs to plan to book and build fewer current generation A320s and 737s as they approach the end of their production, for several reasons:

first, customers will sense that they have additional pricing power for current generation models if the OEMs are determined to keep output at 42 aircraft a month throughout, versus tapering to a lower number;

second, any production issues that do arise would be more easily mitigated by having the larger buffer that would derive from building fewer aircraft overall;

third, pricing of new models will not have the benefit of fully amortised development costs and the required premium will be more achievable if the comparison is not with discounted end of line current models;

fourth, investors and lenders are increasingly taking potential last off the line value effects into their calculations and the proportion of lessor commitments in A320ceo and 737NG backlogs falls away from the middle of the decade, leaving a widening financing gap for others, including the OEMs, to bridge.

Avolon, in its delivery forecasts, which are summarised for the A320 and 737 fleets in Exhibit 12, expects both Airbus and Boeing to stay at or below 42 single aisle aircraft per month, through to the end of the decade, with an element of current model reduction likely during the transition period as a way of managing production risk. Beyond 2020, rates are expected to rise in tandem with underlying market demand. 7. A320 and 737 backlogs

Both Airbus and Boeing are sitting on record levels of order backlog, fuelled by strong demand from airlines and lessors to secure capacity for growth and fleet replacement. Such is the apparent demand for delivery slots that an element of speculative ordering by airlines has started to appear,

0

100

200

300

400

500

600

2013 2014 2015 2016 2017 2018 2019 2020 2021 2022

Exhibit 12: Avolon A320 & 737 Annual Delivery Forecast

A320ceo 737NG A320neo 737 Max

2013 2014 2015 2016 2017 2018 2019 2020 2021 2022


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increasing the risk of excess capacity being built. This risk has been recognised by the OEMs, which have been deliberately over‐booking their production since the onset of the down‐turn in order to reduce the risk of building unsold aircraft (“white‐tails”). The process of over‐booking has been allied with the development of sophisticated processes for monitoring and managing near‐term delivery slots, which in Airbus is dubbed the “Watchtower” process. This on‐going granular review of production allows the manufacturers to move delivery positions around in the 18 month window prior to build completion, accelerating some customer positions whilst deferring and, in a few cases, cancelling others.

The position today, as reported by Ascend and shown in Exhibits 13 and 14, is that both Airbus and Boeing are over‐sold in the near term, with a subsequent easing of the backlog out to the transition into the new products, whereupon the level of firm orders and commitments increases once again. As noted earlier, Airbus signed up 300 additional A320ceo family aircraft in 2012 alone, whilst Boeing has received commitments for over 600 737NGs since launching Max. Consequently, the order deficit for current generation types is not as great as might have been expected, leaving Airbus in particular with a very manageable sales task for the current models.

The lessor direct order component of the single aisle backlog also falls beyond 2014/15, but recovers following service entry of the new variants before falling away again as the time horizon stretches into the next decade, beyond the limit of when most investors would be prepared to commit (Exhibit 15). Nevertheless, as additional commitments are made by airlines and lessors alike, the lessor shares of both backlogs are expected to return to and stabilise around the 20%‐25% range by the end of the decade.

8. Single aisle fleet evolution and replacement trends

Historically, it has taken many years for new models to establish a dominant share of the installed fleet and to begin to replace their immediate predecessors. Attrition of earlier generation fleets through the natural retirement process occurs first, as can be seen from Exhibit 16, which also shows how the rate of retirement of the 1st generation fleet (Trident, 727, 1‐11, etc) accelerated following

0%

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35%

2013 2014 2015 2016 2017 2018 2019 2020 2021

Exhibit 15: Lessor Share of Current Backlog

Lessor share of A320s Lessor share of 737sSource: Ascend, Avolon estimates

Commitments as at mid‐Feb '13

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2013 2014 2015 2016 2017 2018 2019 2020

Exhibit 14: 737 Delivery Skyline

Headroom (@42pm) NG MaxSource:Ascend Over‐booking

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Exhibit 13: A320 Delivery Skyline

Headroom (@42pm) CEO NEOSource:Ascend Over‐booking


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the introduction of the 3rd generation (737NG, A320ceo), with 2nd generation (737 Classic, MD80) retirals only picking up velocity after 10 years or more. In the case of Neo and Max, parallels can be drawn with the introduction of earlier versions of the 737 family, where successive “replacement” variants operated alongside a virtually undiminished fleet of previous generation aircraft for a number of years. In the case of Max and Neo, the transition impact on the current generation will be further diluted by the significantly larger installed fleet compared to previous such transitions. When the 737 Classic entered service, 1100 737‐1/200s had been ordered, of which 1000 had delivered. When the NG entered service 13 years later, 1800 Classics had been delivered out of 2000 orders, almost double the size of the 737‐200 fleet at the same point. By the time that the Max enters service, more than 6000 NGs will have been delivered, almost all of which will still be active, and over 6000 A320ceo family aircraft will be also in service out of a likely total order book of 6700. These levels are three times larger than the installed base at the start of current generation fleet operations, as Exhibits 17 and 18 illustrate.

Looked at another way, it took 5 years for the 737 Classic fleet to achieve a 35% share of the 737 market (considered to be the point at which values of the previous generation begin to be impacted) and 7 years for NGs to do the same. Avolon forecasts that it will take 8 years, until 2025, for the 737Max to account for 35% of the 737 operating fleet and also 8 years, until 2023, for Neos to make up 35% of the installed A320 fleet (see Exhibit 19).

These fleet shares are built up through a combination of new deliveries and installed fleet retirements. As noted earlier, more retirement candidates than ever before will be reaching an appropriate age through the rest of this decade, reflecting the surge in orders and deliveries of the late 1980s. As shown in Exhibit

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1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010

In se

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Exhibit 16: History of In Service Fleet Evolution

3rd Generation 2nd Generation 1st Generation

1st Gen: Trident, Caravelle, 727, 737‐200, F28, DC9, 1‐11

2nd Gen: 737 Classic, A320feo*, F100, MD80, 757, BAe146, Avro RJ

3rd Gen: 737NG, A320ceo, MD90, B717, E190/195

* A320feo denotes pre 1996 models

0100020003000400050006000700080009000

10000

1967 1972 1977 1982 1987 1992 1997 2002 2007 2012 2017 2022

In se

rvice jet fleet

Exhibit 17: In‐service 737 fleet evolution

737‐200 737 Classic 737NG 737 Max

737-200 1100 orders

1000 in service

737 Classic 2000 orders

1800 in service

737NG ~6700 orders

~ 6200 in service

Source: Ascend

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Exhibit 20: NB Retirement Candidates (>22 years)

Others 737‐200 MD80/90 737 Classic 757 A320 737NGSource: Ascend, Avolon WFF

0%10%20%30%40%50%60%70%80%

1 2 3 4 5 6 7 8 9 10Years since EIS

Exhibit 19: Fleet Share Trends From Service Entry

Classic share of 737s NG Share of 737s Ceo share of A320sMax share of 737s Neo share of A320s

Source: Ascend

0100020003000400050006000700080009000

100001100012000

1987 1991 1995 1999 2003 2007 2011 2015 2019 2023 2027 2031

In se

rvice jet fleet

Exhibit 18: In‐service A320 fleet evolution

A320feo* A320ceo A320neo

A320feo 500 orders

460 in service

A320ceo ~6700 orders

~6000 in service

* feo = first engine option Source: Ascend


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20, there are currently more than 3,000 single aisle aircraft that will be over 22 years old by 2016 and thus at the forefront of the replacement process. This number, which will grow with the passage of time to more than 4000 by the beginning of the next decade, includes 737 Classics, MD80s, 757s and some early A320s. At the same time, as the new Neo and Max models start to deliver in greater numbers, more than 60% of them on average will be required to meet market growth requirements.

The pool of eligible retirement candidates will therefore remain deep enough to absorb the remaining 30‐40% of new deliveries and, as greater quantities of A320s and 737NGs start to hit 25 years themselves in the first half of the next decade, the pipeline of suitably aged feedstock will be further replenished, avoiding the cannibalisation of younger aircraft fleets (Exhibit 21).

Avolon’s forecast of fleet development through the transition period is shown in Exhibit 22, which echoes the earlier patterns of fleet evolution in the years to come. The very large installed base of current generation aircraft, more than double the “cushion” in place when the last fleet transition took place, provides a natural protection from mass premature retirement and will support a smoother transition for the Ceo and NG than was the case for earlier aircraft types.

9. Asset value considerations

The point at which the values of current and past generation fleets start to be impacted by the new technology being introduced is the subject of wide debate. However, the lessons of previous transitions are clear and provide strong guidance for the coming years. Exhibits 23 and 24 show the market value trends of a number of in service aircraft types during the period when their successors were launched and subsequently entered service.

The first exhibit considers the impact on seven year old examples of aircraft in service when the 737 Classic family was announced in 1981 and entered service in 1984, where a strong upward value trend continued across the installed fleet types. The second exhibit shows the same value trends for seven year old examples of fleets in service when the 737NG was launched and introduced in late 1993 and 1997 respectively,

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1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990

CMV

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B737-200 727-200 DC9

Exhibit 23: Market Value Indices Through 737 Classic Transition

Source: Ascend

B737 Classic launch EIS

7 year old aircraft

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1985 1989 1993 1997 2001 2005 2009 2013 2017 2021 2025 2029

In se

rvice jet fleet

Exhibit 22: In Service Single Aisle Fleet Evolution

1st Generation 2nd Generation 3rd Generation 4th Generation

1st Gen: Trident, Caravelle, 727, 737‐200, F28, DC9, 1‐11

2nd Gen: 737 Classic, A320feo*, F100, MD80, 757, BAe146, Avro RJ

3rd Gen: 737NG, A320ceo, MD90, B717, E190/195

* A320feo denotes pre 1996 models

4th Gen: A320neo, 737Max, CS300

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A320 & 737 ‐ For Replacement A320 & 737 ‐ For GrowthExcess retiral candidatesRetirement candidates 23+ years

Candidate pool = 737s, A320s, 757s & MD80/90s

Exhibit 21: A320 & 737 deliveries will not outrun replacement pool

Source: Ascend, Avolon WFF


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plus a 20 year old 737‐200 and DC9. In this case, all of the younger incumbent fleets saw values moving in step through the cycle recovery and into the following downturn. However, whilst values of the immediate previous generation types subsequently rebounded strongly through the next cycle recovery, those of earlier generations did not, with the oldest unsurprisingly taking the hardest hit.

Whilst appraisers have started to develop their views of the Neo and Max products and their expected values, most are still not advanced in determining their opinions and take a conservative approach when applying a value premium. Early pricing points, especially for Neo transactions, may not be reliable indicators of the long term value relationship between new and current models as the engine manufacturers are likely to have participated to some extent in incentivising customers in order to establish market share, remembering that, whilst these aircraft do not represent launch products for the airframers, their power‐plants do for at least one of the engine producers. Nevertheless, the consensus of appraiser opinion is that a premium will be achieved for both Neo and Max relative to current specification aircraft, the size of which will ultimately be driven by the dollar value of the operating efficiencies achieved and the extent to which the OEMs are willing to share that with the operators.

The issue of last off the line value compression is also receiving industry and media attention, with a concern that long‐term values of aircraft delivered during the last five years of their production cycle will decline faster than earlier examples, as has been the case with previous generations. Exhibits 25 and 26 show base value indices for 737‐300s built between zero and five years from the end of production, as recorded by Ascend and Avitas. Although the two appraisers present slightly different historical value profiles, the message appears to be consistent – that values of aircraft delivering closer to the end of the production cycle have converged with those of earlier vintages ‐ although the post‐9/11 era lies in the middle of these charts, adding a further complication to the analysis.

Notwithstanding all of the factors discussed earlier that support a softer landing for the current generation of aircraft (substantially larger fleets and operator bases, limited changes to payload/range capabilities, cushion of earlier generation retirement candidates, etc), it would be naïve to dismiss the potential for some level of value compression on last off the line A320ceo and 737NG variants. Experienced investors will understand the need for prudence when assessing

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Exhibit 26: 737‐300 Base Value Retention by Build Year (Avitas)

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Exhibit 25: 737‐300 Base Value Retention by Build Year (Ascend)

Source: Ascend

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Exhibit 24: Market Value Indices Through 737NG Transition

Source: Ascend

B737NG launch EIS

7 year old aircraft


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appropriate current generation aircraft pricing points through the transition period. The level of pricing adjustment required should be determined by all of the elements included in the pricing of acquisitions, the terms of any associated leases and the wider business model of the investor, rather than by a simple pro‐rata lowering of the acquisition price. For each investor, the appropriate treatment of aircraft acquired within the last off the line timeframe will be informed by the specifics of the transaction, the expertise of the asset management team, their market intimacy and their experience of investment and trading through previous cycles and aircraft family transitions.

10. Where will today’s used aircraft go?

Current market conditions, some seven years from the end of production of the A320ceo and 737NG families, might suggest that placement prospects for these types during the transition period are diminishing. From a lessor’s perspective, sustained liquidity is perhaps the most significant factor influencing investment decisions and the continued ability to place current portfolios on economic leases with operators will be a critical test. Several liquidity measures can be benchmarked against the performance of earlier generations of aircraft (with the 737 Classic being the most relevant example) to give some perspective to more recent market trends.

The first of these key measures of liquidity, and a crucial one for lessors, is the size of the operator base. Today, as can be seen in Exhibit 27, the A320ceo family has well over 200 operators and the 737NG family more than 150, 1.5x to 2x higher than the 737 Classic fleet reached in 1992, at a similar point in its production cycle around seven years before the end of production. This operator base differential is significant even taking into account their relative installed fleet sizes, where again the A320 and 737 families have a clear advantage over previous aircraft types, with in‐service fleets already more than double that of 737 Classics at their peak.

The second point to note is that the average fleet size of current A320 and 737NG families is 2x ‐ 3x larger than that of 737 Classics at the same point in their production cycles (Exhibit 28), making the absorption of incremental aircraft into airline fleets easier to manage whilst the absolute requirement for additional growth aircraft is also greater. The fall‐off in average 737 Classic fleet size following the end of production in 1997 reflects the then emergent capability of lessors to place quantities of used aircraft into newer, smaller operators, which today represents a core leasing market. Additionally, lessors play a key role in supporting operators as they transition from one fleet type to another, by replacing leased aircraft with newer models as leases mature, through the take

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Exhibit 27: Number of Operators

737 Classic 737NGA320 family A320 (Post‐'96) family

"x" = ~7 years from production end

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Source: Ascend

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737 Classic 737NGA320 family A320 (Post‐'96) family

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Source: Ascend


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out of older owned aircraft as a quid pro quo for placing new deliveries or by providing bridging capacity for operators awaiting delivery of their own orders, which for customers of the new products may well extend into the next decade. This is expected to represent a significant proportion of fleet mobility around the end of the decade.

The changing patterns of regional traffic growth are also increasingly driving demand for additional single aisle capacity, both new and used, facilitated by the emergence of new low cost and hybrid airlines in many developing markets. These new business models, which already account for 40% of Airbus and Boeing single aisle orders, frequently operate across political borders thanks to a steady momentum in market liberalisation and new opportunities to develop alliances and joint venture partnerships.

With levels of traffic demand already materially shifting from mature western markets to the emerging economies of Asia, Latin America, Africa and the Middle East (Exhibit 29), the geographic balance of new single aisle aircraft orders has also migrated since the 1990s (Exhibit 30).

At the same time, the number of narrowbody aircraft ordered by airlines in each region, as a percentage of the installed fleet in those regions, remains substantially below the rate of regional traffic growth predicted over the next ten years, indicating a deep reservoir of still unsatisfied demand for additional narrowbody deliveries (Exhibit 31), many of which will come from the used equipment channel given the existing levels of backlog in OEM order books.

Demand growth in emerging markets is underpinned not only by liberalisation, economic activity and rising disposable income, but by the realities of population growth, demographics and, often, geography. Commercial airlines already provide essential infrastructure links in many of the world’s most populous emerging markets, such as India, China, Brazil and Indonesia. With commercial aviation a critical component of the global economy, long‐term sustained growth can confidently be expected, as the air travel propensity chart (Exhibit 32) clearly illustrates.

‐ 1,000 2,000 3,000 4,000 5,000 6,000

Africa

CIS

Middle East

Latin America

North America

Europe

Asia Pacific

RPKs (Trn)

Exhibit 29: 2011 to 2031 Passenger Traffic Growth by Region

2011 2031 +6.4%

Source: Boeing

+4.1%

+2.8%

+6.6%

+6.4%

+4.7%

+5.6%

2001

% of 2001 RPKs

% of 2011 RPKs

% of 2031 RPKs

22% 28% 37%

27% 24% 20%

36% 28% 18%

6% 7% 9%

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3% 4% 3%

2% 3% 3% 26%41%

53% 26%

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Exhibit 30: Regional Distribution of Single Aisle Backlog

Latin America

MEAEurope

North America

Asia‐Pacific

737 Classic A320ceo/737NG

Source: Ascend

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APAC North America

Latin America Europe MEA

NB Fleet Increase on Order 10 year traffic growth

Exhibit 31: 10 Year Narrowbody Fleet Growth vs Orders Placed

Source: Ascend, Boeing, Avolon analysis

Unsatisfied demand

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Passengers carried by airlines domiciled in the country; vertical axis plotted on log scaleSources: ICAO, IMF, Global Insight , Boeing

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JapanGermany

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Qatar

RussiaBrazil

China

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80% of world population ‐ 25% of trips

Exhibit 32: Air Travel Propensity

GDP per Capita (2011 USD)


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Conclusions

Single aisle capacity growth is currently running at between 4% and 6% per annum. Storage is effectively used to mitigate peak cyclical over‐supply.

The overall level of narrowbody deliveries currently planned for the coming decade can be absorbed by the global market’s combined requirements for growth and fleet replacement. However, continued discipline on the part of the OEMs with respect to production rates is a critical factor in maintaining the supply and demand balance.

A deep and renewable pool of ageing aircraft will be available to absorb the replacement element of new deliveries, expected to average 40% of the total over the next decade. As with previous transitions, prior generations of technology will be retired ahead of current production models.

Neo and Max represent the next evolutionary development of the A320 and 737 families and the transition process is therefore expected to be orderly and stable.

Max and Neo will deliver real economic benefits to operators at oil prices at or above $65 per barrel, however they must deliver the fuel efficiencies that are being claimed.

Many of the execution risks associated with the Neo and Max programs lie with the engine manufacturers, who are nevertheless well equipped and resourced to meet the considerable industrial and technology challenges remaining.

With little airframe‐related evolution involved, delays emanating from the airframers or their non‐powerplant supply chain are not expected to follow the recent trend for widebody products.

Whilst Neo and Max values are still finding their equilibrium in the market, a meaningful premium over current generation equivalents is achievable based on stated performance targets and operating economics.

The number of narrowbody aircraft ordered by airlines in each region, as a percentage of the installed fleet in those regions, remains substantially below the rate of traffic growth predicted over the next ten years, indicating a deep reservoir of unsatisfied demand for additional aircraft, both new and used

Current production types will continue to be in demand from operators and retain high levels of liquidity during and beyond the transition period, following the pattern of earlier generations. Demand will be underpinned by strong growth in emerging markets and the continued development of low cost business models backed by market liberalisation.

Other factors, including large installed fleet and operator bases, limited changes to payload/range capabilities and a deep cushion of earlier generation retirement candidates also mitigate the “last off the line” effect on values of aircraft delivering close to the end of their production cycle and support value retention for current A320s and 737NGs.

The appropriate treatment of aircraft acquired within the last off the line timeframe will be informed by the expertise of the investor’s asset management team, their market intimacy and their experience of investment and trading through previous cycles and aircraft family transitions.

It will take more than 8 years from service entry for Max and Neo to build a 35% share of their respective family fleets, reflecting the very large installed base of current generation aircraft that will be in service – three times that of the previous transitional fleets.

Consequently, Neo and Max are not expected to directly impact values of current generation types for a number of years, with evidence from previous transitions pointing to the main impact being felt by prior generation models.

2013-02 Avolon - Transitioning to Neo and Max

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