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Seneca Investment Managers commentary on A380 cessation of production

Seneca Investment Managers commentary on A380 cessation of production

Commentary about A380 cessation of production

Key points:

  • As investors in Doric Nimrod Air vehicles, the cessation of A380 production and its likely repercussions have been part of our thesis underpinning the risk reward of the investment.
  • For DNA2, at the prevailing share price of around 191p, there is around 100p of income due to be earned over the remaining life of the vehicle. Crucially at the end of the leases there is no residual debt sitting above equity holders.
  • Emirates needs the capacity the A380 provides for many of its routes. While that size has been a key problem for some airlines that would struggle to fill it, for other airlines serving routes and capacity constrained airports such as Heathrow, it is crucial.
  • Cessation of production does not mean cessation of operation. Indeed, the B747-400, the workhorse of British Airway’s long haul operations, has not been produced since 2007 and will continue to fly into the future. Emirates has confirmed “The A380 will remain a pillar of our fleet well into the 2030s…”.
  • With the supply of new aircraft no longer available, the existing global fleet will become an increasingly scarce asset over time either as a serviceable platform or as a source of spare parts.
  • While residual value risk cannot be ignored, we have long felt that the valuation of the shares sufficiently accommodates that downside risk.
  • Our main concern has always been counterparty risk i.e. the ability of Emirates to honour their lease obligations over the term of the lease, a profitable airline owned by the Investment Corporation of Dubai.

 

Airbus has today (14th Feb 2019) officially confirmed the expected news that it will cease production of the A380 in 2021. Orders from airlines have been well below expectations at the time of launch as many airlines have switched emphasis towards smaller “wide-body twins” such as the B777 and A350.  Emirates order for further A380s announced in 2018 had become doubtful due to widely reported performance issues on existing Rolls Royce powered A380s. It would appear Emirates lost confidence in Rolls’ ability to meet the performance requirements on the new A380 order. Consequently they have cancelled those further airframes and reduced the overall number of its previous delivery aircraft from 140 to 123. Future deliveries beyond 2021 are switching towards A330neo and A350 aircraft.

As investors in Doric Nimrod Air 2, such an outcome and its likely repercussions has been part of our thesis underpinning the risk reward of the investment. This vehicle owns 7 A380s all of which are operated under 12 year operating leases with Emirates. At the prevailing share price of around 191p (14th February), there is around 100p of income due to be earned over the remaining life of the vehicle. Crucially at the end of the leases there is no residual debt sitting above equity holders. The terms of the lease with Emirates is that they are returned to the lessor in “full life physical condition”. That essentially means each aircraft and its engines are required to undergo a substantial overhaul at the expense of Emirates. If it was to be found there were no further demand for the aircraft, either with Emirates or another operator, then such an overhaul would not be required and a negotiated cash settlement would be made instead.

The A380 forms the back bone of Emirates’ operation. It is a highly popular aircraft with travellers. The introduction in the future of the A350 and A330neo will not be able to entirely replace the A380 or the airline; rather they will complement operations. Emirates needs the capacity the A380 provides for many of its routes. While that size has been a key problem for some airlines who would struggle to fill it; for other airlines serving routes and capacity constrained airports such as Heathrow, it is crucial.

Cessation of production does not mean cessation of operation. Indeed, the B747-400 (the workhorse of British Airways’ long haul operations) has not been produced since 2007 and continues to fly into the future. Emirates has confirmed “The A380 will remain a pillar of our fleet well into the 2030s…”.

With the supply of new aircraft no longer available, the existing global fleet will become an increasingly scarce asset over time either as a serviceable platform or as a source of spare parts.

While residual value risk cannot be ignored, we have long felt that the valuation of the shares at around 200p sufficiently accommodates that downside risk. Our main concern has always been counterparty risk i.e. the ability of Emirates to honour their lease obligations over the term of the lease, a profitable airline owned by the Investment Corporation of Dubai. We continue to focus our primary attention towards that front, particularly at a time when many other airlines are financially struggling.

 

The views expressed are those of Richard Parfect at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca Investment Managers Limited and do not constitute investment advice or a recommendation to invest in any of the name securities. Whilst Seneca Investment Managers has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.  Seneca Investment Managers Limited (0151 906 2450) is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP19 050.

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