KEVIN O'TOOLE Conventional wisdom has held back outsourcing of heavy maintenance, but as it starts to be challenged, only as few as a dozen airlines may emerge able to justify keeping work captive, argues IPG Consulting.

On paper the equation looks perfect. On one side, airline boardrooms are keen to bring some hard business disciplines to their maintenance operations. On the other side sits a growing group of third-party providers hungry to take on outsource contracts. In theory, aviation should be in the midst of a frenzy of outsourcing. So why, then, is it not?

IPG Consulting, a London-based group of management consultants, believes that the answer probably lies in some lingering pieces of conventional wisdom that have so far held back the flow. But if IPG is right, then there are signs that they should not hold it back much longer. And once the market moves there may be room for no more than a dozen airlines to retain a full captive maintenance capability.

Traditional cautions against outsourcing have tended to centre on doubts over quality and reliability. IPG founder partner Kevin Lynch concedes that such concerns were real a few years back when third party maintenance was still a relatively small time business or an afterthought added on by airline engineering departments or the equipment manufacturers. Today it is turning into big business, as demonstrated by a tentative ranking of the Top 50 maintenance providers compiled by IPG. Not all the figures are easy to put on the same basis, but the trend is clear.

A new sense of scale

General Electric is in a commanding lead with revenues of $5 billion or more, but another 10 companies have already stepped beyond the $1 billion mark or are planning soon to cross it. The likes of GE and Boeing openly trade on the added security that their name can lend to an outsourced contract.

Operational factors too have been thrown up as barriers to outsourcing, but Lynch argues that if such concerns were real then it would rarely make sense for an airline to let go of any captive maintenance. In reality, most have whole sections of work which go outside the company. "Once you start to outsource part of your operation, that's the thin end of the wedge, you're giving up the logic of the argument," he says.

The presence of these emerging maintenance giants also start to expose the old certainties about what constitutes an appropriate scale for a repair and overhaul operation. "The whole thing is driven by utilisation and economies of scale," says Lynch.

The broad rule of thumb used to be that a carrier with a fleet of more than 40 aircraft could justify taking heavy maintenance up in-house. That number, he argues was just plain wrong. "There was a fundamental under-estimation of what was required to make a line run effectively," he says.

Assuming that a C Check takes a week to perform and is an annual visit, then to keep a single line running steadily throughout the year would take a minimum of 50 aircraft. The same calculation on a less-frequent D Check would perhaps require 60 aircraft.

That assumes, not only an impressive degree of scheduling, but also that the aircraft all the aircraft are within a single range. Given that most airlines, low-cost carriers excepted, have a fleet based on at least three different types, that adds at least a multiple of three to the equation.

In fact, IPG calculates a minimum of 200 aircraft and 400 engines to justify a full heavy maintenance facility. Even that ignores the slack likely to be present in inventory holdings or utilisation of equipment such as an engine test cell - generally down in the 10-20% area. Taking those factors into account probably pushes the minimum economic scale for a fully capable heavy airframe maintenance operation, or the equivalent engine hot section repair centre, closer to the region of a 300-strong fleet.

That would effectively mean that only around a dozen airlines in the world could justify a fully captive maintenance capability. The Top 50 data appears to support the trend, with only the US majors sitting in the ranking as predominantly captive. Others carriers such as Lufthansa Technik (LHT) and Swissair's sister company SR Technics are busy building scale as independent providers, through a mix of contracts, partnerships and acquisitions. LHT is close to taking its outside sales to more than half of the group, having hit 47% last year.

And as these independent groups begin to pull ahead, so they stand to expose the inherent diseconomies of scale in smaller captive maintenance departments. "We don't think that if they understand their costs properly that there's a single captive maintenance department that is as cost effective as an equivalent third party," says Lynch.

Many simply do not know their costs. Tim Longstaff, an associate at IPG who worked to compile the Top 50, points out that a number of carriers struggled to separate out revenue figures for their maintenance operations, let alone justify them in terms of harder investment measures such as return on capital employed. These are likely to be painful sums, especially given the valuable airport property locked up by many an engineering department.

Lynch points to other less visible costs, ranging from inventory holdings through to the sheer management time tied up in dealing with a labour intensive department. Those carriers that have ventured into third party sales can soon find themselves with 20-30% of their workforce in the non-core business of maintenance.

Investment in a particular overhaul capability and the accompanying pressure from labour unions to maintain it, may also act as a dead weight in fleet planning, reducing the flexibility to switch types and even weakening a carrier's hand in deal-making with the aircraft manufacturers.

"Once you've dismissed all the other arguments against outsourcing, the only reason left to keep maintenance in-house is because you've already got it, you're stuck with it and the question then is how you get rid of it?" says Lynch, conceding that existing investments, pressures from unions and lack of expertise in management of outsourcing contracts play their part in inertia.

Yet none of these represent absolute barriers and may be soon be deftly swept away as consolidation in the third-party business begins to gather momentum.

Impending consolidation

There are already early signs of a dash for scale, which, if it follows the pattern laid down elsewhere within the aerospace sector, could yet turn into a frenzy of consolidation.

In microcosm, that already started a few years ago among the three big engine manufactures. GE led the way three years ago with a string of increasingly ambitious acquisitions designed to give it greater control of its own aftermarket. Pratt & Whitney and Rolls-Royce, previously content to settle for a steady stream of spares sales, have since joined the chase, creating $1 billion engine services businesses. Snecma and MTU too appear as contenders among the Top 50.

The engine builders naturally have powerful vested interests in protecting their lucrative aftermarket and preventing parts repair from falling into other hands. The advent of "power-by-the-hour" contracts has only increased the pressure on manufacturers to focus on maintenance and so potentially shifted the burden away from the carrier.

"Only a few years ago it was in the airline's interest to understand as much as possible about their engines to make sure that they weren't paying too much. Now suddenly it the manufacturers who have the incentive to minimise maintenance costs and keep their engine on the wing," says Lynch.

Spares inventory providers have generally been excluded from the Top 50, which focuses on repair and overhaul, but groups like AAR are also emerging as giants in a sector in which economies of scale are everything.

"There are different niches in the market and they're all being filled," says Lynch, adding that this drive is being fuelled by the realisation that there is money to be made. Third party airframe operations have yet to achieve their goal of sustainable double digit operating margins, but that is perhaps a function of their rapid growth. IPG believes that some at least are capable of getting there.

The market is not to be ignored. IPG estimates that the total market for heavy engine and airframe maintenance for all types of civil aircraft is in the order of $35 billion a year, including captive. Figuring in-line maintenance, parts repair and spare parts supply, takes the overall cost base for commercial aircraft maintenance up to $70 billion. On top of that is another $40-50 billion of largely captive military maintenance, now being dangled temptingly in front of the third party providers.

The combination of a sizeable market and the prospect of profits has already started to pave the way towards outright acquisitions, providing a convenient exit strategy for airline groups keen to gear down their engineering activity.

One of GE's first big overhaul acquisitions was in taking over the British Airways engine facility. Despite the scepticism that surrounded that deal, which came just as BA selected GE90 engines, it appears to have worked well for both parties. GE privately admits to surprise at just how profitable the repair shop actually proved and it is doubtful that BA could be achieving the same cost levels if it had stayed owned.

A dash for growth

More recently FLS took over TEAM Aer Lingus, admittedly only after a prolonged standoff with the labour unions which eventually involved intervention from the Irish Government. But Lynch believes that such deals could become more plentiful and easier to secure as the outsourcing industry moves up a gear.

History suggests that he could be right. Consolidation elsewhere in the aerospace and defence sector ran at a breathtaking pace once the initial deals had been struck. In part, that was driven by a fear of falling behind which gripped even the largest companies as they saw competitors achieve previously unprecedented scale. It was also backed by pressure from defence customers keen to share the economies of consolidation.

In maintenance the conditions could soon be right for a similar upward spiral. As the third party groups grow, so they should be able to achieve better costs and bigger deals, potentially taking over whole captive maintenance operations and providing the expertise to manage the outsource contract effectively. If and when such deals do start to be put in place, that will only serve to highlight the inefficiencies of the sub-scale.

If IPG is even close in its analysis of the fleet levels needed to achieve scale, then there may only be room in the world for 30-40 major heavy maintenance operations. And if the consolidation continues at the top, then the prospect is that only a handful of multi-billion dollar groups come to dominate. The rankings should be interesting to watch.

Source: Airline Business