This story is perhaps apocryphal. But it is worth recounting as it captures succinctly not only the state of the India-Pakistan relationship but also the seeming pointlessness of some strategic actions of corporate managements.
The story goes that a delegation of the Pakistani civilian and military leadership was once briefing the former Chinese Premier Zhou En Lai about the strategic scenario in the event of a war between India and Pakistan. Zhou En Lai naturally wanted to know how the events would pan out in the event of outbreak of hostilities between the two nations. Pakistan expected the war to last up to 15 days as neither country has the logistics back-end to be at war beyond a fortnight, the latter responded.
They went on to add that there may be some territorial gains and losses for both the countries and that after a ‘ceasefire’ is declared under international pressure, the armies would retreat back to the positions previously held. “If that is going to be the only outcome, what was the point of going to war in the first place?” the Chinese premier is supposed to have commented.
Of course this was in the days before both countries acquired a nuclear arsenal of some destructive capability. The diplomatic interaction between the two nations hadn’t quite acquired the sophistication and polish of recent times, resembling as it does, all the characteristics of a ritual dance of some exotic African tribal community.
The two nations promise to engage in ‘uninterrupted’ and ‘uninterruptible’ talks. What is left unsaid is that these talks are also fated to remain ‘inconclusive’! But that is another story.
It does seem a pointless exercise to be engaging in a war, with attendant consequences of huge loss of lives and property, if status quo is a certain outcome. But the significance of Zhou’s comment extends to business as well. Enterprises must always try out new strategic initiatives to improve their business fundamentals. There is no guarantee the outcome will always be positive. But if a strategic initiative that has no prospect of changing the fortunes of the business it is best left unexplored.
Business sense
Then what sense can be made of a series of business decisions, when each consecutive one has the effect of cancelling out the previous one? Take the case of an enterprise that buys a piece of machinery that is vital to its business operations only to immediately sell it to a third party and compound the futility by leasing it back from the same entity. Why sell the machine if the idea is only to lease it back, is a question that one might be tempted to ask. Well, airlines do it all the time.
Far from the action appearing to be bereft of any strategic purpose, the market, or at least the investment-analyst community, endorses it with a robustness that leads to a rerating of the company’s stock in the market place. “It is an asset-light strategy that is so essential in an industry as prone to violent cyclical swings as airline business is,” they would say.
Up in the air
As if in confirmation, the other day, the CEO of SpiceJet announced that the airline is in talks with aircraft manufacturers to buy a fairly large number of aircraft from one of the two leading suppliers. In the same breath he also added that the company would be aiming to immediately sell them to an aircraft leasing company and lease it back from it soon thereafter.
Indigo Airlines too indicated in its public offer document that it would adopt the policy of sale and lease back of aircrafts. Jet Airways too, did it from time to time in the past. All this raises a more fundamental question. If the idea is to run the airline with a fleet of leased aircraft why go through the elaborate ritual of buying, selling and leasing it back? Social anthropologists may not have unravelled meaning of all the practices that tribal societies have adopted. But the airlines’ habit of owning a fleet of aircraft and promptly selling a part of it and leasing it back for their own use has an easy explanation.
Accounting standards
The accounting system tends to favour this approach. According to the Indian Accounting Standards (Ind AS 17), if an entity (seller-lessee) sells an asset and simultaneously enters into an ‘operating lease’ agreement with the lessor, the excess of the selling price over the value at which it is carried in the books of the former shall be recognised as profit.
Does the sale of old aircraft more often than not result in profits? As it happens, it does. For primarily three reasons. One, the depreciation rates charged for the use of an aircraft (most assets, for that matter) in the business tends to be somewhat conservative with the result that the value of the asset gets written off sooner than its useful economic life.
For a management that is under competitive pressure, as airline managements usually are, the opportunity to bring back as income what has been written off as expenses in earlier years (sale and lease backs ensure that) is too tempting to be ignored. The airlines can also front-end some extra profits by jacking up the selling price and giving it back to the leasing company in the form of higher lease rentals.
Secondly an airline’s preference for the type of aircraft once made tends to be a sticky one. If the airline’s fleet already consists of Boeing aircrafts then the chances are that fresh orders would favour Boeing. In the dynamic interplay of demand and supply the pricing thus tends to tilt in favour of the supplier.
In any case, the global market for commercial aircrafts is practically a duopoly (Airbus and Boeing). This increases the chances of collusive behaviour resulting in constantly rising prices. Consequently, in the secondary market (used aircrafts) the product gets valued at the current replacement cost rather than the old historical cost. This ensures that the airline entering into a sale and lease-back gets a premium over the book value.
High risk
But by far the most important reason is the excessively risky nature (from the perspective of income volatility) of the airline industry where boom and busts are all too frequent. One of the most common lament of the airline managements is this: “Everyone makes money in the aviation industry except the airlines.”
Neither the aircraft manufacturers are able to absorb the credit risk if the airlines go bust nor are airline investors willing to sink in more equity in a business where profits are highly volatile. But the underlying product (aircraft) is readily marketable from one consumer (airline) to the next.
In the event, aircraft leasing companies perform a vital economic function: That of aggregating the global demand for passenger aircraft and thus smoothening out fluctuations in capacity utilisation. In recent times, a loose monetary policy adopted by the central banks of the developed world has not only made access to credit easier but the cost of credit toohas come down. It is a win-win for both, the airlines and lenders. Is it any wonder that we are seeing a spike in sale and lease-back of commercial aircraft?