On 1 October, Rolls-Royce disclosed a plan to raise £3 billion ($3.9 billion) of fresh capital through new shares and a bond offering to help weather the aviation crisis. It was a stark reminder of the predicament all engine manufacturers have faced since the pandemic began.
If the dearth in new aircraft orders wasn’t trouble enough for the entire aerospace sector, engine makers have additionally been hit hard by the decline in passenger flights, as maintenance of the existing fleet is a key revenue source for manufacturers.
Maintenance providers – both manufacturers and third-party MROs – have seen a sharp fall in demand as airlines reduce their activity amid the pandemic.
Engine overhauls rank among the most profitable services in the MRO sector and are vital for some service providers. But one insider tells Cirium that work volume at a major European engine overhaul facility has shrunk 75%. Another says a third-party overhaul shop lost virtually its entire orderbook within weeks.
For engine manufacturers, the decline in airline passenger flights has laid bare the Achilles heel of their business model.
As engines are typically sold with substantial discounts, as part of aircraft deals, aftermarket services are crucial for manufacturers to recover development and production costs.
Under the long-term, hour-based service agreements frequently arranged as part of aircraft sales, airlines pay flat-rate fees to manufacturers for engine support, irrespective of whether action is required or not.
In return, the manufacturers carry all financial risk associated with the engines’ operation. If a failure occurs, it is up to the OEM to provide a spare, get the aircraft back in the air, and repair the engine.
So when operators parked aircraft because of the pandemic, the engine makers’ aftermarket business dried up.
Cirium flight-tracking data shows that at 30 September, the seven-day average in daily flight-hours for air-transport-category aircraft was 56% below the level a year before.
Daily flight-hours were down 51% for narrowbodies and 71% for widebodies.
The seven-day average number of aircraft in operation had declined 38% overall – or 34% for narrowbodies and 59% for widebodies.
AIRLINES ADOPT TACTICAL APPROACH TO MRO
For those flights that are being operated, airlines tend to deploy their latest, most-fuel efficient aircraft in order to preserve cash.
The engines of many new aircraft and especially of new-generation types are covered by long-term service agreements with OEMs, so shop visits – if even necessary – might not be an immediate concern for operators.
Pratt & Whitney tells Cirium: “In many cases, our flight hour-based agreements make our engines the most practical option to fly since the cost is consistent, predictable, and aligned with the aircraft utilisation.”
For mature and long-established engines, airlines tend to find more bespoke MRO arrangements, as third-party overhaul capacity is widely available and lively spare-parts competition exists for many engine types.
For aircraft powered by such engines, airlines have made efforts to avoid shop visits as overhauls are among the mostly costly MRO items.
Shop-visit costs vary depending on workscope and sparepart choices. A typical narrowbody engine overhaul can cost anywhere from $3 million to $8 million, while shop visits for widebody engines can surpass $10 million.
In order to preserve cash, airlines tend to deploy aircraft with engines for which scheduled overhauls are not due for some time. If issues arise that require ad-hoc shop visits, airlines tend to exchange rather than repair engines as a lot of spare equipment is on the ground.
This dynamic has affected all MRO providers. But what has made the situation challenging for OEMs is their reliance on aftermarket activities to recoup heavy upfront investments in new engine programmes.
In addition to the costs of development and production, engine manufacturers bear the weight of the discounts they offer, the reliability and efficiency targets they guarantee, the spare engines they provide, and the MRO capacity they have built up. With new-generation equipment, they are often required to develop product updates and cover airline costs incurred while technical issues are being ironed out.
In July, GE Aviation posted a second-quarter loss of $680 million – after a $1.39 billion profit in the same period in 2019. Revenue was down 44% at $4.38 billion. Revenue from commercial engine services alone fell 67%.
The US engine maker attributes the overall loss primarily to Covid-19-related charges in the commercial services business, fewer spare-part and spare-engine shipments, and a decreased volume of shop visits.
GE Aviation’s partner in the CFM International joint venture, Safran Aircraft Engines, reported a two-thirds decline in its aftermarket business for the second quarter.
Pratt & Whitney’s commercial aftermarket revenue was down 51%, while overall adjusted sales declined 30% to $3.6 billion and the US engine maker slid to a $151 million adjusted operating loss, from a $452 million profit last year.
The result was “primarily driven by lower commercial aftermarket sales volume and unfavourable mix”, P&W said in July.
Rolls-Royce reported in August that flight hours for its large engines had nearly halved during the first six months this year, and that it expected the number would be down 45% for the full year.
Like its competitors, the UK engine maker saw the decline in flying hours as a main reason – alongside reduced deliveries and exceptional charges – for an underlying gross loss of more than £1.5 billion for the half-year.
Rolls-Royce is especially affected by the sharp decline in long-haul flights as its commercial engine business is entirely concentrated on Airbus and Boeing widebodies.
In August, Rolls-Royce forecast that flight hours could recover to around 70% of 2019 levels next year and 90% in 2022.
But a recovery in airline activity seen in July and August subsequently petered out, and operators have since reined in previous capacity growth plans.
AFTER THE MARKET CHANGES
Roland Gerhards, chief executive of German aviation research centre ZAL, believes the competitive MRO environment will “definitely change”, partly because low aircraft utilisation has put manufacturers and their hour-based service agreements in a “weak” position.
Engine OEMs may be keen on renegotiating service agreements that were signed in a previous age and currently work mainly in the airlines’ favour since they pay only for hours actually flown. However, airlines are themselves in a survival struggle too and in no position to accept potentially higher prices from OEMs.
“The engine manufacturers really stand with their back against the wall and are in a bad negotiating position,” Gerhards says.
CFM says it is in constant contact with operators. Asked whether contractual changes to its hour-based services are being considered because of the crisis, the engine manufacturer responds that it is “working with each customer individually to ensure their support is optimised” as airlines seek “solutions to preserve cash and maximise flexibility”.
Customer-support teams liaise with clients on a daily basis to assess maintenance needs and assist with aircraft preservation or reactivation efforts, CFM notes. Three call centres have been maintained throughout the pandemic to provide 24h customer support as “one of the CFM’s key areas of focus is responsiveness”.
However, the manufacturer does not foresee a fundamental review of its hour-based aftermarket services: “Based on today’s environment, there are no plans to make significant changes to CFM Services’ business model.”
Similarly, Rolls-Royce tells Cirium: “We continue to believe in the benefits our TotalCare agreements offer our customers and we have no plans to change the shape of our service contracts.
“Rolls-Royce has pioneered long-term service agreements under the power-by-the-hour model in civil aerospace since the late 1990s and it remains very popular today – around 90% of our customers have chosen TotalCare coverage on new to mid-life engine programmes.”
The vast majority of Trent-series operators have subscribed to the UK manufacturer’s support packages because there are no overhaul shops that are not at least part-owned by Rolls-Royce, and there is virtually no third-party competition for Trent spare parts and component repairs.
Still, Rolls-Royce pledges that it is “always listening to our customers on what they need and we will continue to offer them a range of flexible services”.
Pratt & Whitney suggests that terms in its hour-based aftermarket agreements can be changed if there are mutual benefits: “Where it makes sense for our customers and Pratt & Whitney, we will modify contract terms, or change the structure to help each other during this difficult period and create more value for the long term.”
The US manufacturer adds that customers may want to convert agreements nearing expiry to new contract structures while utilisation is low. However, it believes that the crisis will not fundamentally change the engine MRO market and that aftersales activities will remain central to the manufacturer’s business model.
“Overall, we like our products and we like the relationships that have created MRO capacity and flexibility… We intend to leverage our customer relationships, engine knowledge and expertise, and our extensive part-repair capabilities to create value for our customers and for Pratt & Whitney.”
Whether OEMs are in a position to sell their engines at higher prices and rebalance their revenue from aftersales toward equipment sales – especially in the current environment with limited order prospects – is a key question.
Lufthansa Technik senior director of product sales and engine lease Marc Wilken does not foresee a fundamental shift away from hour-based service agreements, especially for new engines. As manufacturers provide product warranty and performance guarantees for new engines’ initial “honeymoon” period anyway, as part of regular equipment sales, Wilken argues that the step to providing full-service support is a small one.
Furthermore, airlines have embraced hour-based service agreements for new equipment because they transfer operational risk to manufacturers and offer predictable MRO costs. But as equipment matures and a greater choice of spare parts and component repair options becomes available, there is a shift toward more customised MRO solutions based on time-and-materials contracts – or variants of that model, such as fixed-price or maximum-ceiling-price overhauls.
Wilken notes that the risk-transfer principle of hour-based support contracts becomes too costly and inflexible when ageing equipment requires more maintenance.
Support for most middle-aged and older engines is therefore based on time-and-materials contracts, say LHT and other MRO providers.
Wilken can imagine, however, that greater availability of spare engines – given the spike in aircraft storage – has the potential to change the MRO market.
He recalls that the retirement of Airbus A340-500/600s by several airlines prior to the crisis had a clear effect on Rolls-Royce’s support for Trent 500 engines, the sole powerplant for these aircraft. The manufacturer adapted its support programme as a large number of still relatively young engines became available for redeployment on in-service aircraft or as spare-part sources, he says.
LHT has seen increased demand for hospital shop visits to conduct limited, specific quick-turn engine repairs, for example, to replace individual modules.
As there is no shortage of idle equipment on the ground, Wilken says airlines are using modules from multiple engines to keep others in service in an effort to delay overhaul costs.
LHT disclosed in September the opening of a new hospital shop in Dublin – close to the leasing community – in addition to similar facilities in Frankfurt, Montreal, Tulsa and Shenzhen.
Swiss maintenance provider SR Technics meanwhile announced last month that it had established a dedicated quick-turn line in its Zurich overhaul shop.
Still, growth in quick-turn shop visits by no means compensate the decline in regular overhaul work amid the crisis, Wilken warns.
And, he notes, the practice of avoiding overhauls by stripping modules from some engines to keep others in service cannot be pursued forever. At some point – whether traffic demand recovers or not – airlines will have to bite the bullet and overhaul engines, he points out.
In the meantime, the crisis is likely to lead to further consolidation in the MRO sector. LHT chief executive Johannes Bussmann said in August that he foresaw “fairly fierce competition” and that some maintenance providers would exit the market.
This could play out during the northern winter season, a period in which maintenance providers’ activity typically peaks as airlines’ fleet utilisation drops and there is time for longer checks.
MANUFACTURERS FEEL THE REPURCUSSIONS
For the engine manufacturers, the decline in aftermarket activity comes at a crucial point in time – just as investments are required to develop new technology for future aircraft generations.
Already before the crisis, manufacturers were under pressure to recover development costs for their latest aircraft and engines, as product cycles had become shortened versus previous equipment generations, leaving fewer years to make money back.
But now, manufacturers are on the brink of a technological step change to entirely new propulsion systems that require huge investment – be it full- or hybrid-electric or hydrogen-fuelled power systems.
Noting that new engine technology is central to new aircraft developments – and accounted for most of the fuel savings delivered by latest-generation jets – Gerhards thinks the manufacturers’ situation is a “very exciting challenge [about] who will eventually have deep pockets to develop the new technologies”.
Rolls-Royce said on 1 October that it was “re-phasing” investment in its UltraFan future engine programme – which involves a geared-fan architecture and new materials – to cope with a probable shift in the timeframe. Previously, the UK manufacturer had been aiming the programme at applications beyond 2025.
“We are looking at new ways of working in order to deliver more compelling returns for shareholders,” said Rolls-Royce, adding that it was “actively exploring new forms of industrial partnership” on the UltraFan, with the intention of optimising investment return.
Ultimately, Gerhard predicts, “a lot of state aid” will be required to prop up engine manufacturers and facilitate development of new technology.
Citing the multibillion support packages provided by several European governments for their nations’ aerospace and airline sectors, he says he expects that aid will be conditional on companies having to meet increased environmental targets. “Politicians want to have more environmentally air transport, and this will demanded by [passengers].”
However, Gerhards foresees another reason why engine manufacturers need to review their business models and be less reliant on aftermarket revenues.
Electric propulsion systems will have “radically reduced” maintenance costs because they will have fewer moving parts and won’t operate at temperatures as high as in gas turbine engines.
Indeed, lower maintenance costs will enable the aircraft to be used for applications – such as air taxis or short-haul regional flights – where widespread deployment of gas turbine-powered equipment was previously not viable, Gerhard says.
He acknowledges that large gas turbine engines will unlikely be replaced by electric powerplants in the foreseeable future. But, given the possibility of using electric power to boost performance of gas turbine engines for selected flight phases, and thus reduce the size of fuel-burning engines, he is certain that electric power will revolutionise commercial air transport.
“This will turn the entire industry on its head in 20-30 years,” says Gerhards. “Maintenance costs will be a fraction [of current MRO costs] as soon as you fly electrically… because it so much simpler.”
This analysis was written by Michael Gubisch, part of Cirium’s London based reporting team