Q&A With AeroStrategy Principal KEVIN MICHAELS

AM: Kevin you indicated that the transport category aircraft fleet will grow from 17,500 aircraft in 2005 to more than 22,000 by 2010. What’s driving this growth and where will most of it occur?
MICHAELS: The need for air transport aircraft closely follows GDP growth and the demand ultimately for business and leisure travel. The growth that we’ll see over the next five years will come principally from Asia Pacific where we’re going to add on the order of 1,800 aircraft in Asia Pacific including China and India. North America and Europe will account for the vast majority of the rest of the 5,000 aircraft that’ll be added to the fleet; about 1,300 additional aircraft in North American and 1,200 in Europe.

Given that the industry in North America and Europe is fairly mature are these new aircraft replacing retired aircraft or are they additions to the fleet?
It’s a little bit of each and it depends. The answer varies by region. When we say the fleet will increase from 17,000 to 22,000 or by 5,000 aircraft, we’re suggesting that we will need on the order of nearly 5,000 more aircraft to meet the air travel and cargo demands of aircraft in the region. We will have on the order of 200 or 300 retirements a year over that time frame, but the vast majority of these aircraft will be for new growth. We’ll see annual fleet growth on the order of two to three percent per annum over this period.

What are the implications for this growth and for this projection on the MRO industry?
I think the fleet growth translates clearly into MRO growth and it underpins the growth for MRO, which tends to be a lot steadier than the delivery of aircraft. MRO is a function of the install base and the demographics of the install base. It also implies that there is going to be some churn coming up as new generation aircraft come in the fleet [and] older generation aircraft exit, in particular with the high fuel prices right now. And it also implies a lot of investment. The 1,800 aircraft going into Asia Pacific are going to need the requisite infrastructure to support them. And while there have been many headlines regarding MRO investment in places like China, in places like India we’re going to need to develop brand new infrastructure and we’ll be seeing more headlines about that in the years ahead.

Engines are getting more reliable and yet you project $13.8 billion in engine overhaul work which is about two and a half times the amount projected for air frame heavy maintenance. Why?
There’s no hard and fast rule that says that engine maintenance is supposed to be the same as airframe. The engines are maintenance intensive elements of the aircraft. They have grown to be more reliable, but there is a lot of value added engineering that has gone into these engines that has driven the increased fuel efficiency, environmental friendliness and longer intervals on wing. And all of that engineering, all of that investment is going to be paid for in part by the customer, and shop visit costs have gone up over this time. So engine overhaul is a big piece of the market. It’s over 30 percent. I guess the other element that I would add is in the air transport market, where you fly equipment on the average of 2,700 to 3,000 hours a year, you generate a lot of maintenance hours on engines. Whereas, airframe maintenance costs tend to be more a function of the time that an aircraft has been in service rather than how many hours a year it flies. So engines are very tightly coupled with utilization whereas, air frame maintenance is not so much. An old corroding air frame could be a function of the fact that it’s 35 years old and not that it flew a particular number of hours in a given year.

You indicated that the engine overhaul market is presently about a billion dollars larger than the prior year forecast and the air frame market is about 600 million higher than forecast. What’s driving these anticipated increases and why are they larger than forecast?
Well I think a lot of this has to do with demographics. We’ve delivered about 5,000 aircraft over the prior five years and it takes engines on average four years or so until they reach their first shop visit. So in essence what we were seeing — and we have been projecting this for quite some time — is that we are seeing a surge in engine shop visits as a result of all these aircraft we’ve delivered in recent years. In contrast, the airframe maintenance heavy checks, D-checks and so forth take on average eight to 10 years to unfold. So we’re not seeing the full affects of these just yet. So this has to do with a wave of engines hitting their first, second shop visits after a delivery boom in the late ‘90s and early part of this decade.

You indicated that Asia is the growth market, but you also believe that the Middle East and Africa will be the fastest growing regions of the global aviation market. Can you explain why?
The simple explanation of this is just they start from a lower base. The Middle East and Africa, we have both of those regions growing. We have Africa growing at 6.3 percent annual growth rate and the Middle East at 6.6 percent. They’re starting from very small bases and I think also when we look at the Middle East we need to think in terms of the significant number of orders that we have seen accrued in recent years especially with the carriers like Etihad and Emirates and the like. In contrast we have Asia Pacific growing at a five percent rate but coming from a much, much larger base than what we have seen. So in terms of absolute growth we’ll see more absolute growth in Asia. In terms of the annual growth rate, higher in the Middle East and Africa due to a lower base.

Even so, in absolute terms, North America, Europe and Asia remain dominant as you indicate, garnering about 48 billion of the anticipate 55 billion MRO spending. Can you offer some thoughts as to again why this is here in the projection?
Well I think you really have to just follow where the fleet is and what the utilization is. Between North America, Europe and Asia you have on the order of 85 to 90 percent of the aircraft utilization. So the MRO spending tends to track with that, so 48 billion out of 55 billion sounds about right.

You estimated that PMA, or parts manufacturing approval, sales in the industry will be on the order of $800 million to a billion by 2010 which is up quite a bit from the $330 million in 2005. What does this phenomenal amount of growth imply for the MRO’s and for their customers?
PMA projections are very hard in practice. So we have put our thoughts out there and what’s happening in the PMA and the major catalyst that we’ve seen at least in the recent year has been by Pratt & Whitney entering the PMA parts business — one of the first instances of an OEM actively getting in the service parts of another OEM. This will, in our view, serve to be a catalyst with some customers for them to accept PMA and it also opens up new categories of parts to the PMA market — categories such as life limit of parts on engines. Now in terms of what this means for operators and MROs and OEMs I think for operators it means that they’re going to have to make a choice as to how much they embrace PMA parts in light of their own maintenance philosophies and commercial commitments. There is no single right answer for this and operators have come out across the spectrum in terms of what their belief is. So whether they embrace PMA or not, they will certainly be using the existence of PMA to enhance their bargaining leverage against OEM’s on service parts. For the MRO’s I guess it depends on if you’re talking about independents or OEMs. For independent MROs they really need to decide how much they want to embrace PMA as a means of differentiating themselves in the market. Some may embrace it, some may not. And finally, for OEM’s there are huge implications whereas this can challenge or fundamentally alter the business model for engines and certain types of components on the aircraft. As we know at many of these businesses the money is made on service parts. So PMA introduces the alternative, which could really change the economics by impacting what OEM’s can charge for replacement parts going forward.

Why is the amount of inventory held by the MRO’s going up? In 2004 the MRO’s in comparison to the operators held some 40 percent of spares and yet you expect that share will increase. Why do you think that and what does the trend mean?
I think if we look at the traditional support packages for aircraft and historically airlines bought the provisions to what the OEM’s required or suggested. They bought LRUs and rotables which they own themselves and stocked at their running stations. What has really evolved in the last 10 years has been a couple things. One is operators are a lot more focused on capital investment productivity and they recognize that an investment of rotables does not earn them revenue in and of itself. So they’re asking themselves why are we making capital investments in inventory that can be viewed as non-productive aircraft earned revenue, not spares. At the same time, on the supply side of the market, a new array of alternatives has developed, where MRO suppliers provide bundled asset management and maintenance and in a lot of respects this makes sense, because a supplier that owns safety stock of inventory can be inherently more efficient in supporting larger fleets of aircraft than any individual airline. The short answer here is both the demand side of the market due to capital productivity and the supply side of the market due to new value propositions.

In terms of capital productivity, you indicated that the MRO supply chain is 40 percent more efficient. How do you measure it and what does it signify?
The way we measured the efficiency of the supply chain, it was our estimate of the total amount of value of inventory in the chain all the way from the OEM warehouse through MROs and distributors right on through to the operator. We divided that by the number of aircraft this chain was supporting. So our simplistic approach here was to conclude that the amount of inventory per aircraft had decreased from over three million, to just over two million per aircraft over the last seven, eight years. So a significant increase in productivity. What does it mean? Well I think it means that operators have done a good job at improving the productivity of their inventory for the reasons that I cited previously, and it should bode well. It leads to more savings throughout the supply chain.

You alluded earlier to bundled asset management. What does this mean for the operator and could you briefly recount again what bundled asset management means?
Bundled asset management is a service proposition whereby an MRO — it could be an independent MRO or an OEM, or an airline affiliated MRO — provides a bundle of asset management and maintenance services whereby the MRO supplier might preclude the need for investing in rotable inventory. More and more we’ve seen value propositions that focus on availability rather than more transactional value propositions where you’re just plain paying for an MRO service and then buying inventory on your own. So again I think this is driving the increased productivity in the chain. It also presents a new sense of challenges for MRO providers that traditionally just focused on transactional MRO services. Now more and more customers are looking for bundled programs and it means that MRO’s are going to have to make decisions regarding the amount of inventory investment they make and how they provide inventory management services and logistics.

More carriers are outsourcing their maintenance, but American Airlines is keeping its maintenance in-house and it’s doing work for other carriers. Is this a niche application or part of a larger trend?
It’s a niche application. I think American Airlines did what it had to do to maintain labor, to maintain labor harmony. They asked for significant sacrifices of their employees and their community stakeholders, including places like Tulsa, which kicked in significant incentives for American Airlines to maintain its maintenance presence there. American has worked very hard on productivity and changing the rules and the like. Does this mean that we’re seeing a trend where large carriers are now going to bring maintenance in-house? We think just the opposite. We think the American situation is a point solution to a particular circumstance that the world’s largest carrier (now the second largest) at the time faced. What we’re headed for in our view, is more outsourcing and more outsourcing to OEM’s, independents, and quasi-independent MRO organizations that can be affiliated with airlines. Lufthansa Technic is still partially owned by Lufthansa, but it maintains the best of both worlds where it’s still independent and has its own balance sheet, income statements, and it behaves as an independent, but yet it has some affiliation. So at American Airlines it’s still a cost center and in our view, I think in the long run, these cost centers are going to be either spun out into independent businesses or will slowly shrink over time.

One of the things we’re looking at here of course is more work to be done by the MRO industry. But what is your view about the supply of people to actually do this work and where are they coming from and whether that supply of people is adequate for the kind of growth that you anticipate?
We have not done a detailed human resources assessment to support the maintenance projections. The challenges in each part of the world are somewhat different. In Asia, with all the growth going on, there’s just a tremendous challenge to bring new people into the industry, to train them up to the anticipated demand and the investment plans already in place. In North America we have a situation where we have an aging work force. We have not done detailed retirement projections, but clearly there is anecdotal evidence to suggest that at certain airlines we may see a wave of retirements in the future. But at the same time North America also has a very substantial pool of trained technicians in the U.S. military, well over 100,000 aviation technicians. That makes it unique compared to other parts of the world. So there may well be challenges with certain carriers and certain points, but it’s a very different challenge from Asia. Europe is similar to North America in terms of demographics and the age of the technicians. But it differs in that it doesn’t have the large pool of military trained technicians that the U.S. has. So each region has its own set of challenges and I can’t give you a number as to how many technicians will need to be trained to support this growth.

It seems that the U.S. military may be tapped out as a source of experienced maintainers. But again your data may contradict that, but I see that perhaps the supply into the civilian work force from the military may not be what we need. At the same time there’s only a fraction of the number of people going to the school house at the entry level.
I wouldn’t disagree with either of those points. I guess in one sense it means that hopefully the supply and demand situation for maintenance technicians from the employee perspective could be good I think. From the employer’s perspective it could be a real challenge and it suggests that we’re going to have a real gap down the road. We looked at this three years ago and did not find a huge looming shortage of technicians in the U.S. in an aggregate sense. We found that there were regional shortages and shortages in certain pockets, but not an overall massive shortage as has been written up in some newspapers. What we found was that there was a training gap where up to one third of the technicians were non-certificated in the U.S. and that this was a real issue. But nonetheless it looks like training is going to be a growth industry. There are going to be challenges to meet this anticipated growth. And it is a global industry, which means that if the talent can’t be developed in the home region, operators can increasingly look elsewhere to get the best support for their aircraft.