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Optimizing ROI in a depreciating asset

 By Anthony Kioussis
President, Asset Insight

Each day, countless organizations collect and dissem­inate vast amounts of data points relating to business aviation. The challenge has always been translating such data into useful, actionable and timely information.

While computers can process immeasurable statistics at the speed of light, their analytical capability must be intelligently guided to generate useful conclusions, as op­posed to new data points that further complicate, rather than answer, the original questions.

And, perhaps even more important, computers are dispassionate workhorses that can objectively convert massive amounts of data into useful information.

Asset Quality Rating

When it comes to aircraft, one of the most basic objec­tive analytics able to act as a planning and decision-mak­ing tool is the Asset Quality Rating – a standardized scale by which one can measure the maintenance condition of any asset. Asset Quality Rating is comprised of 2 data points.

The first one is the aircraft’s Maintenance Rating, which grades an asset’s maintenance status on a standardized scale rel­ative to its Optimal Maintenance Condition (maintenance condition on the day it came off the production line). In very simplistic terms, the figure is computed as follows for a theoretical asset that has only 2 maintenance events:

The 2nd data point is the aircraft’s Financial Rating, which grades the asset’s financial condition on a stan­dardized scale relative to its Optimal Maintenance Condition, meaning the aircraft’s Maintenance Rating is weighted by the estimated cost to complete each maintenance event.

While the Maintenance Rating for this asset is 5.000 (see above), the asset’s Financial Rat­ing is 2.955 by virtue of its proximity to future sched­uled maintenance events (Remaining Useful Life) and the anticipated cost to complete each maintenance event (Maintenance Event Cost).

Averaging the Maintenance Rating and Financial Rating figures derives the aircraft’s Asset Quality Rating:

To simplify the Asset Quality Rating explanation we as­sumed the asset had only 2 maintenance events. In reali­ty, an aircraft may have hundreds of maintenance events.

Also, each aircraft must be continually compared against its own Optimal Maintenance Condition. Using this methodology, Asset Quality Rating permits us to establish a measurement standard that can be ap­plied to all aircraft and allows us to compare different make/model assets directly on the same measurement scale (see Pro Pilot, Aug 2018, p 14).

The Asset Quali­ty Rating scale ranges from a low of -2.500 to a high of 10.000, and the significance of the figures are detailed on Table A. The Maintenance Rating scale ranges from a -5.000 to a 10.000, while the Financial Rating scale ranges from 0.000 to 10.000.

There are 2 reasons for this: 1, an op­erator flying on Part 91 can overrun the OEM’s “recom­mended” maintenance time-period, at which point the Maintenance Rating for that event would post a negative value. And 2, the financial Rating can be no less than the cost for conducting the event, therefore its value cannot go below zero.

Maintenance Equity and Maintenance Exposure

There are 2 other objective analytics that can help an aircraft owner plan an aircraft replacement strategy that optimizes their investment in the asset: Maintenance Eq­uity and Maintenance Exposure. Maintenance Equity represents, in financial terms, the amount of maintenance value embedded in the asset.

It defines the difference between the aircraft’s maximum scheduled maintenance financial value (achieved the day the aircraft came off the production line), LESS the main­tenance financial value consumed through utilization.

Maintenance Exposure represents, in financial terms, the amount of maintenance value consumed through uti­lization, LESS maintenance completed on the aircraft. There is a widely-held misconception that aircraft main­tenance condition deteriorates dramatically over time.

While some maintenance event costs increase as the as­set ages, an aircraft’s Maintenance Equity is renewed as maintenance is conducted. Table B depicts the percent­age of Maintenance Equity retained by an aircraft during its first 5 years in operation, and the percent of Mainte­nance Equity available during operating years 15 through 20.

The initial Maintenance Equity is available due to the aircraft’s recent production date, while scheduled main­tenance completion will renew the asset’s Maintenance Equity in later years.

While the aircraft’s Maintenance Equity may be higher during year 20 than during year 5, that is not to suggest this asset will be worth more during its 20th year as op­posed to its 5th.

However, if you are an in-service aircraft buyer, you may wish to focus your search on aircraft that are between 18 and 20 years old.

If you’re a seller, your optimum value may be realized by operating your aircraft into year 18, and then listing it for sale – once the nec­essary scheduled maintenance has been completed.

The value received may not fully refund the recently-com­pleted maintenance, but your aircraft will have greater market appeal and the buyer will have no basis by which to deduct for the potential unknown major maintenance that may surface following purchase. From a macro perspective, whether the Asset Quality of inventory aircraft is improving or degrading can be determined by examining how Maintenance Exposure is trending.

Maintenance Exposure decreases when higher quality assets enter the inventory fleet and/or when lower quality assets are the ones primarily trading. Conversely, Maintenance Exposure increases when lower quality as­sets enter the inventory fleet and/or when higher quality assets are the ones primarily trading.

Justifying an ask or offer price

Knowing an aircraft’s Quality Rating and Maintenance Equity allows the seller or prospective buyer to justify their ask or offer price, respectively.

Table C compares the Quality Rating and Maintenance Equity of a specific aircraft to the average figures for the inventory fleet.

As the specific aircraft’s figures are above the for sale fleet’s average, the Aircraft Value is also esti­mated to be higher – all other things being equal.

Aircraft marketability

Aircraft marketability can be objectively measured through the Maintenance Exposure to Ask Price Ratio (ETP Ratio). The ETP Ratio calculates an aircraft’s Maintenance Ex­posure as it relates to the Ask Price. Achieved by dividing the former with the latter, the asset’s value increases (in relation to the aircraft’s price) as the ETP Ratio decreases.

Days on Market (DoM) analysis has proven that when the ETP Ratio is greater than 40%, a listed aircraft’s DoM in­crease – in many cases by more than 30%. It is important to understand that the ETP Ratio has more to do with buyer and seller dynamics than it does with either the asset’s accrued maintenance or its price.

For any aircraft, maintenance can accrue only so far before work must be completed. But as an aircraft’s value decreases, there will come a point when the accrued maintenance figure equates to more than 40% of the aircraft’s Ask Price.

When a prospective buyer adjusts their offer price to ad­dress this accrued maintenance, the figure is all too often considered unacceptable to the seller and a deal is not reached.

Hourly Cost Maintenance Programs

The potential improvement to an aircraft’s marketabil­ity through Hourly Cost Maintenance Program (HCMP) enrollment, especially when the majority of their model’s fleet is enrolled on HCMP, cannot be overstated.

Program coverage has now reached the point where some aircraft brokers refuse to represent sellers whose aircraft engines are not enrolled on HCMP.

Table D demonstrates how much of an aircraft’s value is contributed by HCMP engine coverage during the first 15 years in operation. The value percentages will vary based on the specific model and the engine’s scheduled main­tenance requirements.

However, in this example, engine HCMP coverage is anticipated to exceed 80% of the air­craft’s total value starting around year 14. Some sellers feel that HCMP enrollment at time of sale is expensive. This might be true, especially when consid­ering the loss of protection and value-add benefits not secured during the (unenrolled) ownership term (see Pro Pilot, Dec 2017, p 18).

However, the potential holding costs due to the aircraft’s decreased marketability might more than offset the program’s buy-in fee. Lastly, the value of HCMP coverage is neither theoreti­cal nor insignificant. When a prospective buyer accounts for the cost to conduct aircraft engine maintenance, HCMP coverage is likely to make the difference between a successful transaction and an unacceptable offer.

HCMP and the ETP Ratio

Earlier we discussed how an aircraft’s marketability is likely to be impacted when the ETP Ratio exceeds 40%. Since the ETP Ratio is calculated by dividing the aircraft’s Maintenance Exposure by its Ask Price, HCMP coverage can favorably impact the ETP Ratio by effectively de­creasing the asset’s Maintenance Exposure figure by the amount covered under HCMP.

Residual Value: Trend vs Actual

Traditional Residual Value (RV) forecasts have started by estimating the aircraft’s current value, then degrading it based on the aircraft model’s average historical annu­al depreciation percentage.

The result has been a graph showing a RV Trend Line that fails to account for the air­craft’s future maintenance condition, perhaps the most important value influencer. In reality an aircraft’s RV in­creases and decreases due to maintenance completion or maintenance accrual, respectively.

Additionally, it is important to place the aircraft’s RV into context using logical comparable air­craft – which may include make/model assets that differ from the subject aircraft (Table E). There are those who believe it is not possible to predict an aircraft’s RV more accurately than basing the aircraft’s fu­ture value trend on the model’s value degradation history.

Today, this is simply not the case, as high-speed computing allows for complex formulas to utilize dozens of historically-proven value in­fluencers to calculate RVs that account for maintenance with a high degree of confidence.

Putting it all together

Whether you are a buyer or a seller, objective analytics allow you to define your view of an aircraft in precise, fi­nancially comparative terms, and to make decisions based on historically-proven statistics.

While there are many ex­perienced brokers that can help you buy or sell an aircraft, understanding how market dynamics are likely to impact any aircraft can help your planning and decision-making, allowing you to buy at the right price, pay the least for main­tenance during your ownership term, and plan to replace the asset during one of its optimum remarketing periods.

Those seeking to purchase an aircraft may wish to read my article entitled “Optimizing value when acquiring an aircraft” (Pro Pilot, Nov 2018, p 10). Anyone considering selling their asset might find it useful to review “Optimizing value when selling an aircraft” (Pro Pilot, Feb 2019, p 10). Both these articles can help optimize your return on invest­ment – no matter what model you have elected to own.

Anthony Kioussis is President of Asset Insight, which offers aircraft valuation and aviation consulting services. His 40+ years of experience in aviation includes GE Capital Corporate Aircraft Finance, Jet Aviation, and JSSI.