MRO ASIA 2009

MRO – Challenge of Change

Christopher Gibbs, Engineering Director of Cathay Pacific Airways Ltd

Good afternoon. As this is a keynote speech, I’m going to use a wide canvas and paint a bigger
picture. What are the prospects for the global MRO business and what are the key challenges? I
do this from a Hong Kong and Asian perspective but what better perspective. We have despite the
current and previous downturns, many of the world’s largest, most dynamic and, crucially, most
profitable airlines in the world in the region, Singapore Airlines, Air China, Qantas and Cathay
Pacific Airways to name just a few. We are also home to some of the most successful MROs in the
world ST Aero, SIAEC, Ameco and HAECO/TAECO for example.

Overall I believe that the prospects for the global MRO industry are bright. The key driver for this
is airlines increasing the proportion of maintenance work outsourced. There are two main reasons
why airlines will increase outsourcing. Firstly, many airlines, indeed the vast majority, do not have
the economies of scale to conduct most MRO activities internally. How many airlines are there in
the world ? – accordingly to an Airbus presentation in this conference venue during Asian
Aerospace, there are around seven hundred airlines worldwide. Seven hundred! Plainly if market
forces were allowed to work, there would be a massive consolidation and far fewer. I don’t know
how many, but indications can be provided from other industries. - How many top computer
companies are there ? maybe a handful? How many top worldwide banks are there? Whatever the
number is here, it’s smaller than a year ago. Maybe I should not mention banks. But as we well
know, market forces are not allowed to work in the airline business due to ownership and route right
restrictions.

But market forces can work to achieve true economies of scale in the MRO business. Hence we
have been building up massive MRO businesses such as Lufthansa Technik, ST Aero, SR Technics
etc. HAECO for instance has a market capitalisation of around US$2.2bn which places it within the
top fifteen airlines by market capitalisation – or, put another way, HAECO’s market capitalisation is
more than 50% that of British Airways. How much of Lufthansa’s market cap of $7.9bn then is
accounted for by Lufthansa Technik – maybe a large proportion of it. The major MROs then are
large businesses. It is clear that they provide a scale which many airline engineering departments
cannot. So small to medium or maybe all airlines are increasing their outsourcing in order to
capture the massive economies of scale achieved by the MROs.

Of course it could be argued that airlines can achieve the economies of scale needed by insourcing
and then bulking up with third-party work. But I cannot see any successful examples of this
business within a business, there are too many conflicts of interest between the airline and the third
parties – the MRO, as it has now become, needs to be separated off from the airline.

    
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Secondly airlines are outsourcing more to focus on their core business. Airline engineering
departments are outsourcing line maintenance outside main base, hangar maintenance, powerplant
and component overhauls in order to focus on providing the airline with safe and reliable aircraft,
ensuring clean reliable cabins, working with internal departments to provide innovative, world
leading passenger product and maximising utilisations by ensuring the best fit between the MRO and
the commercial side of the airline. The overall direction, but with exceptions, is for airline
engineering departments to move to become integrators, integrators across the other airline
departments, across the MROs and across the other service providers such as the OEMs.

So, on these two counts, a trend to outsourcing by airlines to achieve economies of scale and a trend
to outsourcing to enable increased focus , I am bullish on the MRO sector as a whole.

There is however one major challenge to the MROs, the powerful and massive OEMs, such as
Boeing, Airbus, Rolls-Royce, GE, Pratt and Whitney, Honeywell etc. They are already huge and
their power is growing with two underlying drivers. Firstly to a greater or lesser degree they are all
moving into the services businesses in order to capture more of the product value chain and to
provide lifetime product support. Of course the most advanced in this are the engine OEMs who not
only sell you the product but then maintain the product using only their parts and often in their own
overhaul shops.

Secondly, new technology enables increased control by the OEMs. There is a parallel in autocar
maintenance – many of us will, aged twenty or so, have self-maintained our first cars. How many of
us do so today? Even if we wanted to, we cannot since the modern electrics and mechanicals do not
allow it without the use of very expensive tooling and diagnostics. The same is happening for
airframes and engines – as the technology increases the barriers to entry increase for the independent
MROs in the form of tooling but also access to the intellectual property of manufacturers.

I’ve mentioned the power of the OEMs, particularly powerful because there are now only two
airframe manufacturers and because the airframes they build have an increasingly diminished choice
of engines, and, for example, avionics. We went down from four or more airframe manufacturers to
two with the demise of McDonnell Douglas and Lockheed amongst others. But change is afoot.
There is now however, at last, a real prospect of serious competition to Boeing and Airbus, at least in
the medium term and in the narrowbody market with a number of new competitors, Bombardier,
Mitsubishi and Comac of China. I believe that this increased competition is extremely welcome,
and even essential.

So those MROs who are likely to be successful are those who have large scale and those who have
secured access to the required intellectual property either themselves, or through joint ventures, or
via arrangements with airlines, who have some leverage at the time of acquisition.

Up till now I’ve covered the MRO business as a whole but of course it has very different segments –
Line Maintenance, Base Maintenance, Components Overhaul, Powerplant Overhaul and Inventory
    
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and Fleet Technical Management. I will briefly review each of these businesses.

Firstly Line Maintenance. Outside an airline’s main base there looks to be less and less value added
in Line Maintenance and hence less opportunity for the MROs. This trend will increase as the more
reliable new technology aircraft require less and less transit maintenance. There are maybe two
exceptions. Firstly the cabin whose reliability is not yet sufficient so that main base maintenance
alone is not enough. This is a specialised business requiring close co-ordination between the MROs
and the seat and ife vendors. And the technician soft skills also need to be different – they need to
be treating the crew as their valued customers. The second opportunity is in helping airlines to use
otherwise dead extended ground times outside main base though this is not a huge business. So
station by station I see a limited, maybe diminishing opportunity. The opportunity, if there is one,
has got to be in some MROs building a global or at least regional business so that they can provide an
airline with service at multiple stations.

In Base Maintenance many MROs will be dramatically affected by the retirement of large 747 and to
a lesser degree DC-10/MD-11 and B767 fleets, the mainstay of many hangars, particularly in Asia.
Already the most recent recession has accelerated dramatically the retirement of the Classic 747, a
real hangar manhour guzzler, and even many 747-400s, both passenger and freighter, are parked
though hopefully temporarily. The current high fuel price, combined with their age, will lead to
large numbers of permanent 747-400 retirements over the next five to ten years. The new
technology aircraft such as the 787 and A350 will require far few hangar days and far lower burn
rates than their predecessors. So the challenge for the MROs, at least for the widebodies, will be to
optimise more to the increasing proportion of work taken up by the cabin, with airlines’ cabin product
life cycles becoming shorter and shorter. And at the other end of the aircraft size spectrum, the
A320 and B737 narrowbody base maintenance business, the key will be to establish production lines
fully leaned to achieve maximum efficiency. I believe Europe and the US maybe ahead of Asia in
this regard, though handicapped by high labour costs.

It is in the independent powerplant MRO sector that the threat from the OEMs is the greatest.
Firstly the traditional cost reduction tools of the independents such as PMA parts and DER repairs are
a lot more difficult to apply on the new technology engines. Secondly and more importantly the
market for these services is increasingly lost to the independents at the time of airline engine
acquisition, at least receiving the business directly. Airlines are increasingly buying long term
power by the hour contracts in order to lock down long term costs and to manage the perennial OEM
bugbear of formula-driver escalation. So the OEM rather than the airline becomes the potential
customer of independent powerplant overhaul shops. But the OEM owns fully or at least partially a
number of shops so is inclined to direct business to these. In powerplant overhaul the only option
seems to be to team up with the OEMs – this may be satisfactory, at least in the short term, as the
numbers are so large that there may be sufficient returns for both the overhauler and the OEM.

Some of the same arguments apply to component overhaul as to powerplant overhaul except that the
market is much more fragmented so that some other factors come into play – for example, the
    
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opportunity for the MRO to provide a one stop shop, the opportunity to carefully manage workscope
etc.

The major MRO opportunity however must be in inventory technical management encompassing the
MROs owning the inventory instead of the airlines. The main barriers to this business developing
more rapidly than it has are as follows. Firstly a concern from the airlines that there are only a small
number of providers limiting competition, a particular issue at renewal time when you have sold your
inventory and lost sight of repair costs. Secondly there is a preference for the OEMs and for other
airlines to do business with airlines rather than MROs, especially independent MROs. Thirdly the
airlines have themselves invested heavily in this business, in new generation IT Systems for example,
and they may not be that inefficient. But there is still no doubt in my mind that inventory technical
management will be a massive growth business for the MROs over the next ten years.

The last business segment and least outsourced, particularly by full service airlines is fleet technical
management. I don’t see this as a major growth area in the short term for the following two reasons.
Firstly the market in providing these services to full service airlines is not yet well developed.
Secondly striking a contract between the airline and the MRO to align all interests is extremely
complex. But of course this business will develop, first for the low cost carriers, for cargo carriers,
and for the smaller full service airlines.

So what new skills will the MROs be required to develop over the next decade to manage some of the
changes, threats and opportunities that I have described? Firstly they will require more skills in
process improvement and lean, as pioneered in the auto-industry. These skills have been most
applied in the powerplant and component overhaul shops but are far more applicable in base and line
maintenance than current usage would indicate, particularly as these businesses move to more of a
production line.

Secondly the MROs will require more sophisticated business planning skills. I always believe that
the MRO business can be strategically more complex than that of the airlines: each business, base
maintenance and powerplant overhaul for example have different dynamics, different competitors,
different cost drivers. And as I have identified skill is needed in managing the relationship with the
OEMs, as with the airlines.

Thirdly the MROs will require stronger financial management skills. The inventory management
business is, for example, an order of magnitude more complicated as a result of having a balance
sheet to worry about as well as a profit and loss statement.

In conclusion, for the MROs which develop these skills and manage well their relationship with the
OEMs, as well as with the airlines and partner MROs, I believe that the prize is a big one. A big one
as airlines increasingly outsource to these sophisticated companies with the economies of scale to
lower costs and enabling the airlines to focus on their core business of providing innovative,
excellent service, providing good value for money for whatever customer segment they focus on.
    
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And finally this is the Asian MRO conference – I do believe the Asian MRO businesses are as well
placed, if not better, to capture this opportunity, as a result of already world leading airlines and
world leading MROs. Perhaps the only part missing in Asia is a strong airframe manufacturing
business. Today Air China has the largest market capitalisation of any airline in the world, well
ahead of that of SIA, something unimaginable ten years ago. I believe that in ten years time we will
see Chinese manufacturers encroaching on Boeing and EADS further enhancing the prospects of the
MRO business in the region. And on that note, one of opportunity, driven by the growth of China,
right on our doorstep here in Hong Kong I conclude.

Thank you, I’d be happy to take any questions if there is still time.

    
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