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With the airline industry being brought down by the pandemic, the future looks a whole lot less bright with high debt levels and a recovery trajectory spanning multiple years. For airlines, aircraft lessors and jet makers it means that order books are currently revised. Those revisions come in the form of order cancellations, deferrals and order conversions. One of the airlines that’s looking to convert part of its order is Emirates. In this analysis, we have a look at their plan to convert orders and why this hardly comes as a surprise.
Source: Boeing
Matching the fleet with ambitions
Emirates for a long time grew its fleet with the Airbus A380, embodying the spirit of Dubai offering a luxury standard that only few airlines can match. Dubai transformed, or better said diversified, itself from a pure business center of the Middle East to a tourist destination where at very affordable prices tourists can experience the luxury of Dubai. Next to that, Dubai has started to focus on the more cost-conscious tourists as well. That combination made the Airbus A380 key to their expansion strategy, offering a combination of capacity to carry tourists, while also providing the capacity to provide a luxury cabin. In some way, you could say the Dubai experience already starts when boarding an Emirates flight.
Matching fleet with airport development
Source: Dubai
Emirates plays a key role in developing Dubai as a hub and driving the tourism sectors. As Dubai was realizing its growth, it started working on building a new airport that would add capacity to keep Dubai as a competitive hub for years to come. However, due to the Dubai real estate bubble years ago, falling oil prices and regional turmoil between Qatar, Iran and Saudi Arabia and the UAE, the growth of Dubai International Airport slowed while continued airport innovations increased the capacity of Dubai International Airport.
The result was that while bigger jets seemed to be favored to efficiently fill the airport capacity, the headwinds started putting more emphasis on incremental capacity expansion as we noted in a series of reports in February 2019 (so a pre-COVID-19 note):
To realize growth all the way up until 2030, Dubai would need more aircraft, but according to our estimates, the year-over-year growth will not be as high as we seen in recent years, meaning that after the demand increase in 2020-2021 Emirates could opt for incremental growth and capacity additions. What we do see is that as growth slows, less aircraft the size of the Airbus A380 are required and incremental capacity steps provide a better solution. So, not only does slower economic growth in Dubai result in slower passenger growth and a delay in the opening of Dubai’s new mega airport, it also reduces the need for the biggest aircraft available on the market.
At a time where cost savings and incremental capacity expansions are key, aircraft such as the A330neo, Boeing 787 and Airbus A350 with their associated propulsive and aerodynamic efficiencies offer very good fleet solutions.
Initially, we saw chances for the Boeing 777X but throughout the course of 2019 on further delays and absence of a meaningful uptick in passenger growth that expectation faded and I started to see a future in which Emirates operated a hybrid hub model, which would give space for smaller and medium wide body aircraft at the expense of the Boeing 777X and Airbus A380.
Changes before the pandemic
Emirates already started preparing itself for a more hybrid approach where there would be more emphasis on incremental capacity expansion last year. The airline decided to convert orders for six Boeing 777-300ER to options for six Boeing 777X aircraft while converting 30 orders for the Boeing 777X to the Boeing 787 and converting another five orders for the Boeing 777X to options. So, the order book fell by a combined 11 units as options are not firm orders. So, Emirates started realigning its order book with Boeing late last year and it did something similar with Airbus (OTCPK:EADSF) in November 2019 when it reduced the Airbus A380 order book and opted for the Airbus A350-900 instead.
Changes during/after the pandemic
Source: Boeing
So, we can’t say that the pandemic has sparked a change in Emirates’ strategy as the Gulf carrier already was repositioning itself for the next phase in its growth story that would see growth rates slowing and a longer-term move to an airport with more capacity allowing for the deployment of smaller jets. The pandemic, however, will likely accelerate this move to smaller aircraft at the expense as we noted in January when the pandemic was nothing more than a virus affecting the Chinese mainland:
Financial difficulties among airlines are challenging for jet makers. The reason is simple; When airline profitability falls, airlines first look to reduce capital expenditures so deferring deliveries of wide bodies that cost over $150 million in case of the Boeing 777 becomes an easy way to preserve cash. On top of that, airlines will focus more on incremental capacity deployment to improve unit revenues. That can be achieved by a more modest growth profile or by simply adding smaller aircraft. What we have been seeing is that many airlines have started to add smaller aircraft and potentially that puts pressure on the Boeing 777X. The largest variant carries 414-426 passengers, that puts the aircraft in the higher end of the range that the Boeing 777-300ER currently serves. So, have we seen that shift to smaller jets? Yes, I think we did. Lufthansa hasn’t firmed its commitment for 14 jets (from its orders and commitments for 34 aircraft only 20 have been firmed) but converted those to orders and ordered more Airbus A350s and Boeing 787s instead, while Emirates converted 777X orders to orders for the Boeing 787 and in recent years we have seen aircraft such as the Boeing 747 being replaced by the Boeing 787 and Airbus A350. To me it seems that the Boeing 777X is not a bad aircraft, but its size might work against it… similar to the Airbus A380, though the prospects for the 777X likely aren’t as grim.
What we are seeing is that the changes Emirates already was planning to implement to operate a more diversified network model has been accelerated as the airline now has the opportunity to rebuild its network with better suited jets for point-to-point operations as the market requires incremental capacity deployment to restore the network and improve yield rather than the aggressive capacity expansion Emirates used for years to win market share. In that sense, the story for Emirates isn’t much different from that of Qatar Airways. In our coverage for Qatar Airways we noted that the Boeing 777X is no longer in pole position to serve the role of a Boeing 777-300ER replacement and similar remarks on the role of the Boeing 787 for airlines that ordered the Boeing 777X were made in discussions with leading companies in the commercial airplanes industry.
Emirates currently has 115 Boeing 777X aircraft on order with options for 11 more meaning around 40% of all orders for the Boeing 777X should be for Emirates. With a focus on smaller jets that order comes under pressure and so does the production plan and that likely has contributed to Boeing deciding to drop the rates on the Boeing 777 program. We expect that Emirates will be looking to convert orders for 15-20 Boeing 777X aircraft to orders for the Boeing 787 which would result in the order book value to decline by $400 million or even up to $1B. For Boeing’s entire book, a billion is not big but specifically for the Boeing 777X this would be yet another blow and I believe that a 15-20 reduction would be the best case. The worst case would be a reduction of 50 units, which would result in a value decline of around $2.5B. However, that would really be a tremendous blow to the program and one could ask how even a company as plagued as Boeing will be willing to work with Emirates on this as the Boeing 777X is designed with specifications from Emirates in mind.
Conclusion
The Boeing 777X has been suffering setbacks driven by problems in the design and test phase of the program which pushed out the first deliveries. Last year, we already were cautious on the robustness of the order book as we saw a strong move toward smaller jets from customers that were previously favoring the Boeing 777X. For Emirates, we can’t say that the pandemic has sparked a new mindset but it certainly did accelerate the company’s move towards a hybrid model where it focuses more on point-to-point. The smaller jets are better suited to improve network connectivity as part of the recovery phase for the airline industry offering more incremental capacity additions to improve yield and possibly focus less on premium heavy cabins as there are major concerns regarding the recovery of business travel market while smaller also plays a role in the next growth phase of Dubai as a hub and whereas Emirates couldn’t see the Airbus A380 and Boeing 777X arriving fast enough to help it support the increased passenger streams during EXPO 2020, we now see that the EXPO has been delayed and the “normal traffic flows” are heavily dented reducing the overall demand for new aircraft.
The current developments are a clear net negative to the Boeing 777X and at least for the coming years turn the Boeing 777X into a niche aircraft in favor of the Boeing 787 and Airbus A350. Emirates already was heading in that direction, the pandemic just gave it the final convincing push.
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Disclosure: I am/we are long BA, EADSF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.