Transitioning to Neo and Max. An Investor s Guide

Transcription

1 Transitioning to Neo and Max Dick Forsberg & Lucas Mollan February, 213

2 Dick Forsberg Head of Strategy, Avolon Lucas Mollan Chief Technical Officer Dick Forsberg has over 4 years aviation industry experience, working in a variety of roles with airlines, operating lessors, arrangers and capital providers in the disciplines of business strategy, industry analysis and forecasting, asset valuation, portfolio risk management and airline credit assessment. As a founding executive and Head of Strategy at Avolon, his responsibilities include defining the trading cycle of the business, primary interface with the aircraft appraisal and valuation community, industry analysis and forecasting, driving thought leadership initiatives, setting portfolio risk management criteria and determining capital allocation targets. Prior to Avolon, Dick was a founding executive at RBS (now SMBC) Aviation Capital and previously worked with IAMG, GECAS and GPA following a 2-year career in the UK airline industry. Dick has a Diploma in Business Studies and in Marketing from the UK Institute of Marketing is a member of the Royal Aeronautical Society and also a Board Director of ISTAT (The International Society of Transport Aircraft Trading). 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 6 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 2, 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. Acknowledgement The author would like to thank FlightGlobal Ascend, whose Online Fleets database is the source of all fleet data used 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.

3 Transitioning to Neo and Max 1 Contents 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 1 6. Avolon s single aisle fleet forecast 1 7. A32 and 737 backlogs Single aisle fleet evolution and replacement trends Asset value considerations Where will today s used aircraft go? 17 Conclusions 2

4 2 Transitioning to Neo and Max 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 A32ceo 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 A32ceos 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 A32 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.

5 Transitioning to Neo and Max 3 Key Findings Neo and Max represent the next evolutionary development of the A32 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. 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 A32s 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. 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

6 4 Transitioning to Neo and Max Transitioning to Neo and Max Detailed Analysis 1. Macro capacity trends Avolon has analysed aircraft deliveries made over the past 4 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 longterm slowing trend, from almost 8% in the early 197s 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 219/2. Exhibit 1: Narrowbody Seat Growth 12% 1% 8% 6% 4% 2% % % -4% -6% Source: Ascend Forecast Gross capacty growth Capacity growth net of storage Trend 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 8% over the past 2 years, with an average of 64%. The past four years has seen replacement averaging 4% with a peak close to 5%. 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 198s. 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. Exhibit 2: Replacement share of NB delivery capacity 1% 9% 8% 7% 6% 5% 4% 3% 2% 1% % Growth % Replacement % 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 1 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. Exhibit 3: Single Aisle Supply & Demand Growth Indices Z^1 Z11 K^1 K11 Y^1 Y11 ^1 Source: Avolon NB RPM Index NB Capacity index 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.

7 Transitioning to Neo and Max 5 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 $65 per barrel - a level that consensus oil price forecasts suggest will be comfortably exceeded on a long-term trend (see Exhibit 4) - will support the economics of new technology products at a price premium that reflects 5/5 value sharing on the part of the OEMs. Exhibit 4: Oil Price Forecast Consensus of 22 analysts (US$ per BBL) Brent WTI Std Dev (WTI) Source: Consensus Economics Inc. 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 A32ceo 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 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 (3,lbsplus thrust) and, having secured launch applications on the Mitsubishi MRJ and Bombardier C-Series, were able to demonstrate the effectiveness of their engine design and architecture during 28 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 21 and, given the existing dual engine offering on A32s, 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 29 having grown out of an existing CFM development program, LEAP56, which dates back to 25. 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 211, 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 211 Paris Air Show triggered the launch of the 737Max, restoring market equilibrium and the single aisle status quo between the two manufacturers.

8 6 Transitioning to Neo and Max 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 A32 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 GE9 and GEnx, and will be scaled down to the 2-3, lb thrust category. Since CFM agreed final design parameters with the airframe OEMs and launched the engines for A32 and 737 some two years after P&W, they will also be later to market - 9 to 12 months after the GTF on the A32 and as sole source on the 737Max in 217. 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 PW1G 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 the similarities in architecture and design features. In addition, the recently announced PW17G and 19G applications for the proposed re-engined E-Jets family will use basically the same cores as the 12G and 15G, 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 underestimated. Exhibit 5: Engine Family Applications PW1G Family Engine Aplication Thrust Class Fan Diam. PW12G MRJ 15-17, lbs. 56" PW15G CSeries 19-24, lbs. 73" PW11G A32neo 24-33, lbs. 81" PW14G Irkut MC , lbs. 81" PW17G E175G2 15, lbs. 56" PW19G* E19/195G , lbs. 73" *Subject to Embraer launch approval LEAP Family Engine Aplication Thrust Class Fan Diam. LEAP-1A A32neo 24-33, lbs. 78" LEAP-1B 737MAX 2-28, lbs. 68.4" LEAP-1C C , lbs. 75" Both aircraft programs come with not insignificant execution risk, although the OEMs position their products as evolutionary, not revolutionary. 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.

9 Transitioning to Neo and Max 7 3. Neo and Max production milestones Milestones for the 737Max include a firm configuration freeze in mid- 13, start of major assembly in early 215, first flight in the second half of 216 and EIS for the -8 in mid-217, 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 215. 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 A32 final assembly line ( FAL ) where completed major structures are joined. Exhibit 6 sets out the planned project development timelines for each of the products. Exhibit 6: Neo & Max Major Milestones A32neo PW11 LEAP-1A 737 Max LEAP-1B K1YK K1YZ K1Y Concept freeze Design freeze K1Y^ K1YT Commence Major Assembly First Flight K1Y[ FETT EIS K1Y_ K1YS 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 3 commitments and the 737-9Max 15+. 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 216 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 PW11G, where the first engine build has been completed and entered the test program, with test flights on schedule to commence in Spring 213. 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 GE9 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.

10 8 Transitioning to Neo and Max 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 A32neo has become the most successful product launch to date, outstripping even the 787. Exhibit 7: Cumula ve commitments since launch Cumula ve commitments Percent of in-service fleet % 12% 1% 8% 6% 4% 2% % Source:Ascend Years since launch 737 (CFMI) 737 (NG) 737 Max A32ceo A32neo Exhibit 8: Annual commitments as % of in service NB fleet Source:Ascend Years since launch 737 (CFMI) 737 (NG) 737 Max A32ceo A32neo By mid-february 213, Airbus had secured almost 19 commitments for the Neo family (Exhibit 9), whilst Boeing had passed 12 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 211 Paris Air Show, where they announced over 6 new Neo commitments 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. Exhibit 9: Neo Commitments Source: Ascend 1557 A319 A32 A321 With the Neo program firmly established from a demand perspective, Airbus primary objective in 212 was to ensure that additional A32ceo sales were booked to support production through the transition period. Their sales efforts have been rewarded with a very solid skyline which, when nearterm 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 5 units across Ceo and Neo).

11 Transitioning to Neo and Max 9 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 212. Limited information around detailed design and performance data may explain why 4% of the Boeing backlog of over 12 aircraft is currently not assigned to a specific model (Exhibit 1). 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, A32 and 737 backlog ). 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 5% 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. Exhibit 11: Neo Engine Commitments Exhibit 1: Max Commitments P&W CFM tba tba 558 Source: Ascend 643 Source: Ascend 154 The lion s share of commitments to date has been for the flagship A32neo 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 operators now taking incremental A32ceos and 737-8s 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. An important point to note is that, since the launch of Neo in November 21, Airbus has secured more than 85 further Ceo commitments (including 3 in 212), whilst over 6 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 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.

12 1 Transitioning to Neo and Max 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 A32neos entering service in late 215, with A321neos and A319neos following over the course of 216. The current process of transitioning Ceo production to the modified wing design required for sharklets would suggest that A32 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 217, 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 A32 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. 6. Avolon s single aisle fleet forecast Avolon regularly undertakes detailed market forecasts of commercial jet supply and demand looking out over a 2 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 1 individual aircraft types including inproduction, out of production and future planned production models. The WFF, which supports much of the forward-looking analysis in this paper, includes transitions from current to new generation A32s 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 macroeconomic 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. 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.

13 Transitioning to Neo and Max 11 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 A32s 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; Avolon, in its delivery forecasts, which are summarised for the A32 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 22, rates are expected to rise in tandem with underlying market demand. Exhibit 12: Avolon A32 & 737 Annual Delivery Forecast A32ceo 737NG A32neo 737 Max fourth, investors and lenders are increasingly taking potential last off the line value effects into their calculations and the proportion of lessor commitments in A32ceo and 737NG backlogs falls away from the middle of the decade, leaving a widening financing gap for others, including the OEMs, to bridge. Airbus anticipates the first A32neos entering service in late 215, with A321neos and A319neos following over the course of 216.

14 12 Transitioning to Neo and Max 7. A32 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, 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 ongoing 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 3 additional A32ceo family aircraft in 212 alone, whilst Boeing has received commitments for over 6 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. Exhibit 13: A32 Delivery Skyline Source:Ascend Headroom (@42pm) CEO NEO Over-booking Exhibit 14: 737 Delivery Skyline Source:Ascend Headroom (@42pm) NG Max Over-booking The lessor direct order component of the single aisle backlog also falls beyond 214/15, 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 2%-25% range by the end of the decade. Exhibit 15: Lessor Share of Current Backlog 35% 3% 25% 2% 15% 1% 5% % Source: Ascend, Avolon estimates Commitments as at mid-feb '13 Lessor share of A32s Lessor share of 737s

15 Transitioning to Neo and Max 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 the introduction of the 3rd generation (737NG, A32ceo), with 2nd generation (737 Classic, MD8) retirals only picking up velocity after 1 years or more. Exhibit 16: History of In Service Fleet Evolu on In service jet fleet st Gen: Trident, Caravelle, 727, 737-2, F28, DC9, nd Gen: 737 Classic, A32feo*, F1, MD8, 757, BAe146, Avro RJ 3rd Gen: 737NG, A32ceo, MD9, B717, E19/195 * A32feo denotes pre 1996 models rd Genera on 2nd Genera on 1st Genera on 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, /2s had been ordered, of which 1 had delivered. When the NG entered service 13 years later, 18 Classics had been delivered out of 2 orders, almost double the size of the fleet at the same point. By the time that the Max enters service, more than 6 NGs will have been delivered, almost all of which will still be active, and over 6 A32ceo family aircraft will be also in service out of a likely total order book of 67. These levels are three times larger than the installed base at the start of current generation fleet operations, as Exhibits 17 and 18 illustrate. Exhibit 17: In service 737 fleet evolution In service jet fleet orders 1 in service 737 Classic 2 orders 18 in service 737NG ~67 orders ~ 62 in service Classic 737NG 737 Max Source: Ascend E Exhibit 18: In service A32 fleet evolution In service jet fleet A32feo 5 orders 46 in service A32ceo ~67 orders ~6 in service * feo = first engine option A32feo* A32ceo A32neo Source: Ascend

16 14 Transitioning to Neo and Max 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 225, for the 737Max to account for 35% of the 737 operating fleet and also 8 years, until 223, for Neos to make up 35% of the installed A32 fleet (see Exhibit 19). Exhibit 19: Fleet Share Trends From Service Entry 8% 7% 6% 5% 4% 3% 2% 1% % Years since EIS Classic share of 737s NG Share of 737s Ceo share of A32s Max share of 737s Neo share of A32s Source: Ascend 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 198s. As shown in Exhibit 2, there are currently more than 3, single aisle aircraft that will be over 22 years old by 216 and thus at the forefront of the replacement process. This number, which will grow with the passage of time to more than 4 by the beginning of the next decade, includes 737 Classics, MD8s, 757s and some early A32s. At the same time, as the new Neo and Max models start to deliver in greater numbers, more than 6% of them on average will be required to meet market growth requirements. Exhibit 2: NB Retirement Candidates (>22 years) 6 Number of aircraft Others MD8/9 737 Classic 757 A32 737NG Source: Ascend, Avolon WFF Avolon forecasts that it will take 8 years, until 225, for the 737Max to account for 35% of the 737 operating fleet and also 8 years, until 223, for Neos to make up 35% of the installed A32 fleet.

17 Transitioning to Neo and Max 15 The pool of eligible retirement candidates will therefore remain deep enough to absorb the remaining 3-4% of new deliveries and, as greater quantities of A32s 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). Exhibit 21: A32 & 737 deliveries will not outrun replacement pool Candidate pool = 737s, A32s, 757s & MD8/9s Cum deliveries, retirements A32 & 737 For Replacement Retirement candidates 23+ years A32 & 737 For Growth Excess retiral candidates Source: Ascend, Avolon WFF 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. Exhibit 23: Market Value Indices Through 737 Classic Transition 7 year old aircraft CMV Index launch B737 Classic EIS 8 Source: Ascend 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. Exhibit 22: In Service Single Aisle Fleet Evolution In service jet fleet st Gen: Trident, Caravelle, 727, 737 2, F28, DC9, nd Gen: 737 Classic, A32feo*, F1, MD8, 757, BAe146, Avro RJ 3rd Gen: 737NG, A32ceo, MD9, B717, E19/195 4th Gen: A32neo, 737Max, CS3 * A32feo denotes pre 1996 models B DC9 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, plus a 2 year old 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 st Generation 2nd Generation 3rd Generation 4th Generation

18 16 Transitioning to Neo and Max Exhibit 24: Market Value Indices Through 737NG Transition CMV Index B737NG launch EIS 7 year old aircraft B737-3 B737-4 A32-2 DC9 (2 yrs) (2 yrs) MD83 Source: Ascend 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 737-3s 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. Percentage of original value retained Exhibit 25: Base Value Retention by Build Year (Ascend) Source: Ascend Years Since Delivery Percentage of original value retained Exhibit 26: Base Value Retention by Build Year (Avitas) Source: Avitas Years since delivery

19 Transitioning to Neo and Max 17 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 A32ceo and 737NG variants. Experienced investors will understand the need for prudence when assessing 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. The consensus of appraiser opinion is that a premium will be achieved for both Neo and Max relative to current specification aircraft. 1. Where will today s used aircraft go? Current market conditions, some seven years from the end of production of the A32ceo 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 A32ceo family has well over 2 operators and the 737NG family more than 15, 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 A32 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. Exhibit 27: Number of Operators Number of airline operators "x" = ~7 years from production end x x x Source: Ascend Classic 737NG A32 family A32 (Post '96) family