Large Equipment Leasing Outlook
Fitch Ratings’ 2018 outlook for large equipment leasing companies is stable, reflecting manageable leverage across most sub-sectors, adequate liquidity profiles, and the generally muted impact of rising interest rates on earnings. Potential headwinds include weakening asset quality and residual values, rising competition, which is expected to pressure profitability metrics, and the sensitivity of the business model to economic conditions and exogenous shocks.
Fitch believes large equipment lessors would be net beneficiaries of a gradual rise in interest rates, as rising rates generally indicate that economic conditions are improving and asset inflation is present. From an earnings perspective, Fitch believes rising rates would positively impact lessors’ profitability, as lease rates generally rise with interest rates, albeit with a moderate lag.
Aircraft lessors are benefiting from strong growth of global air traffic, moderate fuel prices, and largely stable airline credit fundamentals. Fitch believes air traffic will remain strong in 2018, but current growth rates are unsustainable over the long-term. Higher wages and jet fuel prices, along with intense competition, led to weaker operating margins and deterioration in credit metrics for certain airlines in 2017, although Fitch expects some of the pressure to ease in 2018.
Aircraft lessors continue to add to their respective order books with purchase obligations that extend a number of years into the future. Growth expectations in China have been a meaningful driver of order book activity, with expected future passenger traffic in the country among the primary reasons for lessors’ confidence in placing large and/or long-dated orders. At the same time, however, new Chinese-backed aircraft lessors have also entered the space, often competing aggressively across the spectrum of future aircraft orders, new delivery sale leaseback transactions and the leasing of older aircraft.
While having a substantial order book of next-generation aircraft could provide competitive advantages to aircraft lessors, because it allows them to better meet expected client demand, order books must be properly managed relative to funding risks and market demand.
Aircraft lessors continue to consolidate and form new partnerships to improve scale and meet rising demand. Fitch generally views these deals positively because scale provides strategic benefits, such as increased purchasing/negotiating power and more channels to re-lease planes. Further industry consolidation among large industry players is not expected in 2018 given favorable industry dynamics and valuations, though market stress may drive consolidation amongst newer or less experienced market players.
Fitch expects leverage ratios to remain stable in 2018, as most aircraft lessors seek to adhere to target levels. Unsecured bond, commercial bank and insurance markets continue to be the primary sources of debt funding for aircraft lessors.
Railcar lessors face varied price dynamics rail by railcar type. Utilization rates have weakened slightly, but remain at fairly strong absolute levels. According to the Railway Supply Institute and Economic Planning Associates, Inc.’s (EPA) September 2017 report, the outlook for rail car prices improved due to strong gains in certain commodity groups in the first half of 2017, but freight car prices remain weak as underutilized cars remain in some fleets, notably coal cars. Weak prices are expected to continue to negatively impact railcar residual values and lessor profitability in 2018.
In the U.S., utilization levels and lease rates have generally come off of peak levels, particularly in tank and sand cars leased to the energy sector. European fleets are older than U.S. fleets, suggesting that obsolescence risk is more elevated. In Europe, Fitch expects railcar prices to continue to modestly recover in 2018, but there remains limited demand for new fleets as most lessors plan to shrink their legacy portfolios with higher loan to value ratios.
In 2015, the Federal Railroad Administration adopted safety requirements intended to reduce the frequency of accidents involving trains transporting large quantities of flammable liquids. The costs of compliance are borne by lessees but could be passed on in the form of higher costs to end customers. The regulations may reduce railcar efficiency and therefore lessee demand. However, moderate fuel prices have bolstered demand of tank cars serving the flammable liquids market.
Truck & Commercial Fleet Leasing
Truck and commercial fleet leasing is relatively less cyclical than other large equipment leasing businesses given the greater focus on essential services and the shorter order-to-delivery cycle. Interest rate sensitivity is relatively limited as longer-term debt is used to match-fund the business, while firms have the ability to pass on higher funding costs to customers in the case of shorter-term lease or rental contracts.
Fitch believes residual values will remain under pressure over the medium-term, due to higher new car sales and rising trade-in volume, but the impact on earnings will be moderated to the extent that end-of-contract disposal gains can be offset by recurring lease revenue.
Truck lessors have been impacted by lower commercial truck and tractor rental demand, particularly from transportation companies moving less freight tonnage. As a result, truck lessors have trimmed their rental tractor capacity in anticipation of slower commercial rental activity, and are temporarily disposing of units at lower prices in the wholesale channel to better manage inventories. Truck and tractor pricing declines are expected to moderate in 2018 as Fitch sees positive signs emerging for freight demand. Fitch expects the truck lessors to continue to adjust residual values and depreciation policies, so they are not generating meaningful realized losses at exit.