Views on the Global Aviation Industry

Henry Hubschman
President and CEO

GE Commercial Aviation Services (GECAS)

Remarks to the Aero Club of Washington

Friday, April 28, 2006

Thank you for the introduction, Debbie.

For those of you who do not know GECAS, we are the commercial aviation leasing and financing unit of General Electric. We are a solutions provider to the commercial airline industry, offering aircraft financing and productivity solutions. We have more than $40B in assets – including a fleet of 1,400+ owned and 300 managed aircraft. Increasingly, these airplanes are flown by carriers outside the U.S., but I’ll talk more about that in a minute. Last year, we made profits (net income) of roughly $750 million. We have longstanding customer relationships with more than 225 airline customers in 60 countries.

Like other parts of GE and most good businesses I know, we’re in the business of helping our customers. But we are also in the business for GE’s shareholders. Helping customers and making money – it is what we do. We have a local presence with 20 offices worldwide. Over the last three years, we’ve opened offices in Dubai, Moscow, Sao Paulo, and Delhi to be closer to where the growth is. We have a broad array of products – we’re a lessor and a financier. For example, we lease engines and offer an innovative component management service.

Your luncheon speakers are usually more U.S.-focused in their remarks. Today I want to talk more about the aviation industry outside the U.S. First, let’s take a look at where things stand today.

Despite the U.S. restructurings, world demand is strong and the outlook is good. Traffic has grown steadily for the past 2 years and is settling into its historically normal 4.5 percent annual growth rate. The last couple of years have seen higher growth rates, but the trend is settling on an average growth rate of 4.5 percent -- given the “Perfect Storm” of the last five or six years that’s not bad at all. Let’s recall:

q The dot-com bubble burst

q The 9/11 terrorist attacks

q The build-up to the Iraq war

q SARs

q The Iraq war

q Higher fuel prices

Everyone knows the airline industry is very cyclical, corresponding to external events and economic cycles as well as the typical behavior of the industry. As a lessor and financier, these cycles are very important to us – something we watch very closely as we invest in the industry.

As traffic and passenger demand goes up, airlines start to make money, they order more planes… but they don’t deliver for 2-5 years! Then, historically, one of two things has happened: 1) some external event or shock that sends traffic down, like a global recession; and/or 2) overproduction as the other airlines order planes, too. What happens? There are too many seats. The best way to say this among polite company is “stuff happens” in a long-cycle industry.

On the demand side of the equation, demand for aircraft is very strong with record orders/record backlogs. Now let’s look at the supply side. When we look at the supply/demand situation for aircraft, we look at more than manufacturer production. We also look at aircraft retirements. We also look at the roughly 2000 aircraft parked in the desert. We think of these planes like “unemployment.” Those older, mostly stage II aircraft that are not “actively seeking employment” and will never return to service. We feel very strongly that 1200 are in this category -- they are essentially scrapped or retired. There are some 450 aircraft that are candidates for possible return to service, although this is seemingly less and less likely the longer they are in the desert and the higher that fuel prices rise. In our judgment, given fuel prices and production of new aircraft, we feel that at best 350 aircraft may find new homes if demand remains strong.

The bottom line figures look like this: If you look at seats, you will see that active seat growth is averaging 5.5 percent annually for the next five years. Hmmm… 4.5 percent average annual traffic growth and 5.5 average annual seat growth. Are we headed for another cyclical turn of overcapacity?

In addition to the oversupply risk, there are other risks for the industry, including sustained high fuel prices and event risks like terrorism or human-to-human transmission of Avian Flu. Despite these risks, I don’t want to sound like a pessimist, although it is my nature to forecast rain when the sun is shining without a cloud in the sky. We at GECAS are optimistic due to the huge upside for the industry.

Demand for air travel in developing geographies – like India, China, and Eastern Europe – is enormous. Here is one way to gauge the upside.

There are about 296 million people in the U.S. and about 6,500 aircraft in the U.S. servicing those passengers. That translates into a ratio of aircraft per one million people of 22.3 (one of the highest in the world). Compare that to Eastern Europe – the 10 countries that are the newest entrants to the EU. They have a combined population of some 74 million people and approximately 300 aircraft. This translates into a ratio of 2.9 aircraft per million people.

Let’s assume EU membership is a benefit like it has been for Ireland. Ireland has a population of 4 million, yet has something like 175 aircraft - an astounding 43.8 aircraft per million population. The new 10 new EU countries would need about 3,000 aircraft to match this ratio.

Let’s discount that and say Eastern Europe’s population of 74 million requires only 10% of that -- another 300 aircraft, or a doubling of their current fleet! (The current fleet in Eastern Europe is about 300 aircraft) I should also add that the aircraft count for these 10 Eastern European countries includes about 75 non-Western aircraft that will likely be replaced.

Let’s be more conservative, and look at the aircraft to million population ratio of the U.S. as a gauge. If you do the math for the populations of China, India, Russia, Brazil and Eastern Europe – these countries will need thousands of aircraft to have similar aircraft/population ratios to the U.S. If you take only 10 percent – again, only 10 percent – we are looking at more than 6,000 aircraft or a 37 percent increase in the world fleet.

Lets talk about Russia for a moment. Currently, there is a steep 40% import duty on Western-built aircraft. Despite this, some Russian carriers have been better off paying this to replace some of the 30+ year old aircraft in their fleet to meet rising demand for air travel in Russia.

The Russian Institute of Aviation Economics study forecasts passenger growth of about 7 percent per year – which is in line with GDP forecasts. But consider this snapshot of the Russian fleet:

q The Russian fleet consists of approximately 650 aircraft (more than 50 seats) in service today

q Approximately 300 face certain retirement within 2-5 years as they have an average age of 32 years

q Another 300 have an average age of 20 years and will be gradually replaced

Our data suggest that there is an urgent need for the Russian airline industry to begin a fleet renewal program – or risk having their passengers served by European and Middle Eastern airlines.

A moratorium on this onerous import duty would give the Russian industry a chance to remain competitive in this global marketplace and rebuild its domestic manufacturing industry.

When you look at the demand for aircraft in places like Eastern Europe, India, China, Brazil and Russia -- in short, there is huge upside for the aviation industry outside the U.S.

Another area of growth around the world will come from the replacement of older, inefficient freighters and the growth in air freight, which comes from global sourcing and just-in-time inventory management. The world’s aging freighter fleet numbers approximately 1700 freighters -- about 400 are 35 years old or more including DC8s, 727s and even 707s!

We have been very active in this area and have an active freighter conversion program in place. To date, we have turned more than 55 older Boeing 737, 767 and 747 passenger planes into small, medium and large-sized freighters. Replacement to more modern and efficient models will accelerate if fuel prices remain at current high levels, as newer models offer crew savings, fuel savings, and maintenance savings. For example, today the trip cost for a 737F vs. 727F would be cut nearly in half -- from approximately US$8,200 to US$4,900.

In short, there is huge upside for the global aviation industry in freighter replacement

Finally, another factor to consider is the expansion of the low-cost carrier phenomenon. What Southwest has done in the U.S. and Ryanair and Easyjet are doing in Europe is happening in other parts of the world. If you don’t know the likes of GOL, AirAsia, SkyEurope and JetAirways, you’ll hear lots more about them in the future.

In some places, LCCs have a 25% cost advantage over competition driven by utilization and productivity. LCCs are growing at 3- to 4-times the rate of other carriers -- the pie is growing and the LCC share is growing, too. Today, there are about 55 operators we classify as LCCs flying more than 1600 aircraft. By 2008, we estimate the number of operators will increase and the number of aircraft will increase to more than 2800.

It is unrealistic to think that every new start-up airline around the world with a low-cost business plan is going to survive over the long-term. But I am certain that the low-cost model will survive… and the demand for aircraft needed to fly growing numbers of passengers with disposable income will be real.

What does this mean for us here in the room today? I think there are three things:

1. With the perfect storm behind us, traffic up and record aircraft orders, there is lots of money in aviation industry. Where is this money coming from? There are the traditional aircraft lessors like ILFC; there re the banks, like DVB, HVB, Citibank and others; there are the export credit agencies; and there is private equity and the hedge funds. That means lots of new sources of funding for airlines – look at the new equity at Air Canada, US Airways, and the entrance of the new financing arm of Dubai as examples.

That means lots of competition for companies like GECAS. We love the competition because it makes us better. But air financing fundamentals/expertise in remarketing and risk underwriting discipline are still key.

2. The demand potential outside the U.S. indicates aircraft supply will increase. Even if you assume some of the new aircraft ordered by start-up carriers and LCCs are ultimately not delivered and come become available again, and you add maybe 300 aircraft at most come back into service from the desert, recent trends suggest production rates will continue to climb. Depending on how the manufacturers increase production, we could find the industry awash in seats, which could further hurt yields. As the old saying goes, if you ignore history, you’re doomed to repeat it.

3. More aircraft will be leaving the U.S. to fuel the growing demand for air travel in Asia, China, India, Eastern Europe and South America. Despite the rumors you may be hearing, demand for 50-seat RJs is growing in regions outside the US. At US Airways, we are taking back 65 aircraft from the combined airline as part of their restructuring. Most of those are headed outside the U.S. The same is true at ATA. As part of that reorganization, we took back all 20 Boeing narrowbodies and redeployed them all outside the U.S.

To conclude, we look at the aviation industry through global glasses. Demand for aircraft in emerging regions is strong. We’re financing valuable assets with long lives that can be redeployed from India to Vietnam to Russia. We like to think our experience in the industry and our expertise will continue to serve us – and our airline customers – well in the future.

Thank you.