As with the engine manufacturers, consolidation among major airframe producers is likely to be followed closely by bold moves to secure dominance in the after sales market. Report by T Wakelee Smith and Jonathan Culley.It may be hard to believe. But with the recent absorption of McDonnell Douglas into Boeing, along with last year's demise of Fokker, the oligopoly which dominates the original equipment manufacturer (OEM) sector in commercial jets may be set to be reproduced downstream.

Boeing's takeover leaves just two western airframe makers and three jet engine manufacturers. In contrast, the after sales service support sector has until recently been highly atomized, with dozens of major airlines providing the bulk of the support, alongside a robust and diverse independent third party maintenance sector.

However, recent events in the maintenance, repair, and overhaul (MRO) sector for both engines and airframes presage a consolidation. After sales support may soon look increasingly like the OEM sector, dominated by a limited number of global players offering a broad array of services. Moreover, the emerging oligopolists in the downstream segment of the product life cycle will in many cases be the same companies which have solidified their dominance upstream: the OEMs.

In many ways, the stage for this consolidation has been set by the increasing tendency of airlines to outsource their MRO function. That has resulted in a third party maintenance sector that is a much larger proportion of the total MRO field than 10 or 20 years ago. The third party sector is now large enough to accommodate the economies of scale that encourage consolidation and to attract the attention of the industry's primary sources of investment capital.

The growth in outsourcing has also changed the nature of the standard customer profile for third party maintenance vendors. The typical third party customer used to be an airline either too small or marginal to afford its own maintenance operations. Now that customer is at least as likely to be a major airline that has made a strategic decision to limit investment in MRO capacity, or a well financed aircraft lessor.

Such customers are both more attractive to investors and more discerning in choosing vendors. These high-end customers are often more sensitive to quality issues than to price shaving, and look for long-term relationships with maintenance providers rather than ad hoc 'one plane stands'.

The more vigilant regulatory oversight and flight to quality of recent years have only served to further this trend. The result is that large, well capitalised, multi-location MRO vendors with diverse capabilities have a sustainable competitive advantage in marketing to the largest and most desirable customers.

A parallel trend driving further maintenance outsourcing has been product bundling, where maintenance services are increasingly packaged with an equipment lease or sale in a more seamless product. Examples include power-by-the-hour engine leases and wet aircraft leases, as well as extended warranties on new equipment sales.

Add to this the simple fact that after years of anaemic profits, the MRO business is being lifted by the same rising tide and absorption of excess capacity as the rest of the industry. As a result conditions are ripe for a sector which had previously been populated by overgrown 'mom & pop' repair shops to be rationalised and consolidated under the control of a more limited number of multinational behemoths.

In the engine sector, this story has largely been played out, and with dizzying speed. In the last five years, General Electric has initiated a stampede of acquisition and joint venture projects that have transformed both GE's Engine Services operation and the industry at large.

Including its partially owned CFM subsidiary, GE's share of the non-airline owned engine overhaul market has gone from under 20 to more than 50 per cent, spurring similar manoeuvres by its two main competitors.

GE and affiliate CFM have long had repair facilities to service their own products as an adjunct to the engine sales activity. GE's effort to expand beyond this base and commence servicing competitive engine types began in 1992 when it acquired the engine overhaul operation of British Airways.

Last year, GE acquired a majority interest in Celma of Brazil. By the end of this year, GE will have initiated three new joint ventures, two with component manufacturers and one with Malaysian Airline System to create GE's first major engine overhaul operation in Southeast Asia. Other developments include a planned 24-hour on-wing support centre in Kentucky, and a joint venture with EVA Airways to perform engine maintenance in Taiwan.

Not to be outdone, one of GE's largest US competitors, Greenwich, went on an acquisition binge of its own, buying the Gas Turbine division of Chromalloy in 1994; the commercial jet engine services unit of Aviall in 1996; and UNC in spring 1997. Within a month of the announced Greenwich-UNC combination, the mating frenzy was completed by GE's purchase of Greenwich.

In the blink of an eye, four major independent commercial jet facilities combined with each other, only to be swallowed whole by one of the OEMs. This leaves just one surviving independent overhaul facility in the US - namely Aerothrust, a unit of the Celsius group - a stunning reversal of the state of play just two years ago.

Two reasons for this aggressive tack in engine services are that it provides vastly more near-term growth potential and much greater profit margins than engine manufacturing. According to an official at GE, engine services provided just 40 per cent of the combined revenues of the Aircraft Engine division in 1996, but yielded approximately 75 per cent of the net profits.

The current number two in the engine services market is Rolls-Royce, which will reportedly gross in excess of $1.5 billion this year, in contrast to a base of approximately $4.5 billion in annualised revenue which GE is expected to have after completing the Greenwich deal. Rolls' most significant step in the expansion of its service business has been the Hong Kong Aero Engine Services joint venture with Haeco to support Rolls engines. The operation, initiated in early 1997, is likely to become the largest maintenance and overhaul facility in the region based on volume. It does not immediately provide capabilities in GE and Pratt engines, something that Rolls badly needs to become a formidable foe to GE.

Rolls-Royce is not alone in playing catch-up. Pratt & Whitney was the last of the OEMs to make a major foray into after sales, having formed its Eagle Services Division some 18 months ago. With roughly $600 million in 1996 revenues, Pratt has been well behind its two major rivals, but recently took some important steps to bolster its position.

In July, Pratt became a partner in the Singapore Airlines engine overhaul facility. The operation will initially focus on the PW4000, JT9D, and CFM56 engines, and represents Pratt's initial foray into competitor engine capability. In 1996, Pratt acquired several engine component repair facilities and opened a new dedicated JT8 overhaul facility in Columbus, Georgia. Eagle is understood to be considering opening other new overhaul facilities in pursuit of its 1998 revenue goal of $1 billion.

These aggressive initiatives by the manufacturers have left the rest of the industry scrambling to rethink their positions in the marketplace. For the handful of remaining independent competitors, the essential dilemma is whether to attempt to compete with these emergent Goliaths, or to join one of them via acquisition or joint venture.The most recent acquisitions are unlikely to be the last.

Airlines which see themselves primarily as customers of the third party repair business face a similarly stark choice of either expanding their internal capacity to keep pace with their own needs, or accepting the more limited set of options which will be available as they outsource such work. Airlines which have construed themselves more as competitors to the third party repair vendors than as customers are in the most delicate position. Epitomised by Lufthansa, they will find themselves balancing a customer/vendor relationship with the OEMs with competition with those companies in after sales. How each party juggles these conflicting roles is one of the fundamental issues raised by OEMs competing with some of their best customers.

Spurred on by the dramatic success of GE in outpacing its rivals, Boeing has announced plans for a major foray into the airframe maintenance market. Boeing's chosen vehicle is the newly created Boeing Enterprises unit, steered by industry veteran Larry Clarkson, whose larger mission is to help transform the number one aircraft manufacturer into more of a service provider.

Unlike the engine manufacturers, Clarkson does not intend to acquire independent repair facilities, expecting instead to become a partner in the existing maintenance operations of major airlines via outright acquisition, management contracts, or joint ventures. Boeing is to take a 9 per cent stake in the Taeco maintenance base in Xiamen and is rumoured to be in discussions with several major airlines. BA should be among the leading candidates given that its divestment of its engine shop five years ago, in a similar arrangement, has yielded very satisfactory results. In response, Airbus senior vice president John Leahy has been credited with the dismissive quote: 'We try whenever possible not to compete with our customers'.

Some of those customers have had similar reactions. With an eye towards the airline's Technik subsidiary, Lufthansa chairman Jürgen Weber characterised Boeing's maintenance campaign as bad business behaviour and indicated this might well influence the carrier's future aircraft orders. Other airlines with large third party maintenance enterprises, such as Cathay Pacific, Singapore Airlines and Aer Lingus, may have similar concerns.

If Boeing does succeed in establishing the sort of after sales dominance in the airframe market that GE has in the engine sector, Airbus may be forced into the same game. The Airbus partners are already intensifying their activities in airframe maintenance and engineering, especially freighter conversions.

In the meantime GE, which is reportedly contemplating a push into the airframe maintenance business, may prove a more immediate rival. Not only would this increase GE's one-stop shopping sales capability, but in recognition of Gecas' position as the world's largest owner of aircraft, it would also presumably satisfy internal needs.

It seems clear that the third party share of the engine overhaul sector is likely to shrink further if not disappear altogether. The OEMs have the means and the will to continue buying out the independents as well as significant strategic advantages which, anti-trust laws notwithstanding, they are likely to use to their full advantage.These include superior delivery - and perhaps pricing - on spare parts; unparalleled engineering support and geographic and product scope (at least in the case of GE); unquestioned quality standards; and the ability to bundle maintenance products with equipment sales or leases.

Against such a formidable array of competitive weapons, only the most efficient competitors will survive as independents. Nor is new entry very likely. Not only are the capital costs involved in building green field facilities daunting, but the OEMs possess a stranglehold on the engineering authorities necessary to repair their own engines, and have in recent years declined to grant these to prospective new entrants who were non-operators.

The surviving competitors will mainly be airlines, some of which will swim against the outsourcing tide and elect to be aggressive insourcers of work. It remains to be seen whether their dual relationship with the OEMs will enable them to contend better with the strategic advantages enjoyed by the latter.

In contrast, the future consolidation of airframe maintenance is likely to be less pronounced and should leave room for independents. The airframe maintenance business is characterised by less formidable barriers to entry. The capital costs are lower as the business is more labour than equipment intensive, and the airframe OEMs have not shown the same reluctance to provide technical support to new entrants as their engine counterparts.

Airframe maintenance is also far less dependent on a supply of spare parts from the OEMs, and therefore less prone to control by them. While certainly technical in nature, it is far simpler to replicate than the engine business. The greater cost and logistical problems of moving aircraft versus engines make geographical dispersion and proximity to customers key factors. And the greater size of the airframe maintenance business makes it harder to dominate.

Even if the airframe OEMs do assume a prominent role in the aftermarket - by no means a foregone conclusion - each has thus far eschewed a strategy of acquiring independents. Consequently, consolidation in this sector is being achieved by mergers between the independents, a trend which seems likely to continue. The result is likely to be an industry consisting of an independent third party sector dominated by a limited number of large multi-location operators, but with continuing room for smaller niche vendors. The insourcing airlines are likely to continue to play a significant role, in some cases in partnership with the OEMs.

This more orderly future MRO market promises more consistent and higher quality services provided by fewer, generally larger vendors with a broader scope and scale than at present. These vendors will tend to be more closely tied to the OEMs and therefore able to offer an array of increasingly seamless bundled maintenance products. This in turn will necessitate less maintenance infrastructure on the part of their customers. However, competitive options will be fewer, and prices are likely to be higher. The question of whether the prospect of improved service will fully counteract the dangers of an impending oligopoly remains unanswered.

Source: Airline Business