December 2010

Oliver Wyman

Airline operators face a difficult question: Should the airline take the opportunity to refresh our fleet by signing on for close-to-ready new aircraft, such as the Bombardier C-series? Should the carrier wait for Airbus and Boeing to potentially upgrade the engines of their venerable work-horse products, the 737NG and A320 families of aircraft, which may be launched late in 2010? Should the airline steer clear of reengining entirely and instead wait for Airbus and Boeing to develop a completely new narrowbody?

On the surface, making re-engining decisions may seem a lot like making any fleet strategy decision. But when it comes to re-engining, the decision process presents a few wrinkles. Of course, a cost benefit analysis occurs in either situation; however, operators (as well as owners, lessors, and financiers) must place a greater level of emphasis on the trade-off evaluation. These trade-offs include the potential benefits of re-engining including increased fuel efficiency and engine reliability against the possible costs such as more complex engine maintenance or if fuel prices increase or decrease significantly, and a decrease in valuation of their older fleet. Moreover, uncertainty surrounds the re-engining situation. The 2010 Farnborough Airshow, where many new programs are launched, came and went without any firm decision from the airframe OEMs on the topic.

A cost-benefit analysis of re-engining will yield different insights for different operators, depending on their unique business circumstances (such as current fleet configuration and business model). Using a  disciplined approach that outlines and quantifies the risks inherent in a re-engining effort, each company can properly manage the risks and uncertainties. In this white paper, we draw on our extensive stores of data, our analysis of past re-engining programs, and our considerable client experience to reveal the nuances behind the re-engining decision and offer recommendations for approaching it.

Let’s start by taking a closer look at the re-engining programs currently on the horizon.

Re-engining programs on the horizon
Airbus and Boeing are both examining CFM’s Leap-X and Pratt &
Whitney’s Geared Turbo Fan (GTF) engines, which are ready for near-term
adoption by airframe manufacturers. These engines promise approximately
12%-15% fuel-burn improvements over their predecessors in
addition to maintenance-cost reductions. The engines have already been
selected for in-development programs, which for the first time in decades
are starting to present Boeing and Airbus with significant competition in
the 100-plus seat narrowbody sector. Competitors include the Bombardier
C-Series (powered by the GTF) and the Commercial Aircraft Corporation
of China, (COMAC) C919 powered by the CFM Leap-X.

The re-engining programs that Airbus and Boeing are considering would
involve fitting a new engine to the existing aircraft with minimal other
changes. As previous re-engining programs show, this still involves significant
engineering work and cost. However, the goal is to improve aircraft
performance significantly while reducing development timeframes
and costs. Press reports suggest that Airbus will offer the GTF and Leap-X
as additional engine options, rather than as full replacements for the
CFM56-5 and V2500-A5 currently powering those aircraft, and Boeing will
offer the Leap-X for the 737NG.

Three considerations
As mentioned earlier, making re-engining decisions is more complex
than making ordinary fleet selection decisions. For traditional fleet selection
choices, most carriers use a Total Cost of Ownership approach that
takes into account not just the purchase price of an aircraft, but also the
cost of owning, operating, and disposing of it. However, this approach
usually pits two or more new aircraft against each other, rather than
comparing in-operation aircraft with proposed new aircraft. Moreover, it
does not consider the impact of a newly developed aircraft on the current
fleet’s value or the pros and cons of ordering the current versus the
enhanced version.

To make the wisest possible re-engining decision, operators must go
beyond the usual fleet selection process and weigh three crucial considerations:
(1) fuel-burn reduction and future fuel prices; (2) changes in engine
reliability and maintenance costs; and (3) impact on current fleet values.
Key to this analysis is quantifying these potential impacts—a frustratingly
difficult feat for most operators. With an eye toward attaching numbers to
the three considerations, we evaluate five re-engining programs launched
since the 1970s in the next section of this article and then show how our
findings can be applied to the current re-engining dilemma.

Five re-engining programs
As a normal course of business, engine OEMs create upgrade options
and new versions during each product’s lifecycle. Occasionally an engine
OEM, with an airframe OEM or another partner, will offer a new engine
for a current aircraft. These offerings generally fall into two categories:
retrofits for existing aircraft and new engines for new production aircraft.
Retrofits are more common in military programs, but are quite rare
in commercial applications with the CFM56-equipped DC-8 being the
notable exception. In this study, therefore, we concentrate on the second,
more common, category to draw lessons from past programs.

For the purpose of the analysis, we identified five aircraft re-engine/ upgrade examples that could provide insights for evaluating today’s
options. These examples span a range of time frames and narrowbody and widebody types. Exhibit 1 (click to enlarge) summarizes the programs, including technological changes that accompanied the efforts as well as the range benefits gained from the new models.

How did these new aircraft perform compared with their predecessors in terms of fuel burn, engine maintenance, and aircraft valuation? Let’s look.

Fuel Burn
If we assess fuel consumed per block hour for US operators of these aircraft, we find a median reduction in fuel burn of 9.5% in the new aircraft. (See Exhibit 2, click image to enlarge) This fuel burn decrease ranges from a  low of 5.6% for the 737-300 over the 737-200 to a high of 9.8% for the MD11 over the DC10-30. In this context, press reports of 15% fuel-burn reductions for the reengined 737 and A320 (before dilution from the extra weight of the new engines and modifications) appear consistent with previous programs.

This 9.5% median fuel-burn reduction isn’t surprising: The programs
would not have gone forward if the OEMs had been unsure of the benefit.
What is perhaps different for today’s scenario is the price of fuel consumed,
or not consumed. Since 1991, the average price paid by US airlines
fluctuated between $0.45 per gallon in Q1 1991 and $3.74 per gallon
in Q3 2008.

As Exhibit 3 shows, fuel prices and variability have changed more dramatically in recent years. While no one can foresee precisely what fuel prices will do in the medium and long term, carriers can (and should) use a fuel risk management strategy to arrive at educated estimates and include them in their decision-making process.

Engine Maintenance
US regulations require airlines to submit detailed financial data, including maintenance costs, to the Department of Transportation, which publishes the data in what is commonly called Form 41. Still, comparing aircraft engine maintenance costs across generations of aircraft presents
difficulties: The costs rise as an aircraft accumulates flight hours, but
they don’t do so in a smooth fashion that lends itself to a standard formula
(such as when costs are adjusted for stage-length).

To allow for a robust comparison, we plotted the annual engine maintenance
costs for the programs shown in Exhibit 1 on a per-flight-hour
basis against the average aircraft age for the time period 1991-2009.

Reporting for the A320 program blends data for the older and newer versions, so a comparison was not possible. For example, the 737-300 fleet had an average age of approximately 5 years in 1992 and a total engine maintenance cost of $99 per hour in 2005 dollars. The 737-700 fleet had an average age of about 5 years in 2007 and a total engine maintenance cost of $108 per hour in 2005 dollars. Exhibit 4 shows how these costs have changed as the fleets age over time.

Because of the staggered timeframes covered by the data set, it is not possible to create comparable full-lifecycle graphs for all generations of aircraft in our study. However, there is enough overlap and history to show that engine maintenance costs rose from the 737-200 to the 737-300 and decreased from the DC10-30 to the MD11. Cost changes wereinconclusive in the other two examples.

Despite this ambiguous picture, the increased interval of flight hours between scheduled shop visits is unequivocal, and impressive. (Engines usually follow a four visit overhaul program.) Exhibit 5 illustrates this progression for the engines powering the three generations of 737s in our study. This trend holds true for widebody aircraft as well.

Unlike fuel-burn improvements, a reduction in engine maintenance costs
is not necessarily a given with the re-engining programs on the horizon.
Maintenance costs will rise or fall depending on whether this next generation
of engines continues the progression of increased on-wing life and
how shop-visit costs change when they do come off-wing.

It is difficult for operators to forecast these parameters because, unlike
fuel prices, they vary across companies, depending on mission profile
and maintenance program. Operators can estimate the likeliest impact
of re-engining on maintenance costs by applying a risk analysis exercise
similar to the one we use to help clients model engine-services agreements.
(These agreements are sometimes referred to as Power-by-the-
Hour or PBH.) However, airlines have moved far beyond the PBH metric in
complexity and now seek to place risk with those best equipped to manage
it. For example, in engine services arrangements, the airline agrees
to a certain thrust range limitation on the engine while the engine OEM
agrees to the time-on-wing target.

For the purposes of this article, we’ve framed this as a simple twodimensional sensitivity analysis, which examines how much maintenance costs and fuel prices could move before putting fuel-savings benefits at risk. (See Exhibit 6.) To state it another way, when does the potential benefit become too small to warrant the risks outlined in this article?

As Exhibit 6 shows, the per-flight-hour benefit is uniformly positive. We found a 9.5% reduction in fuel consumption (737-700 improvement over the 737-300), a fuel price range reflecting the high and low points of the last 10 years, and engine maintenance costs flexing up or down 15%. At a 5.6% reduction in fuel consumption, the benefit is positive except for the worst scenario. Obviously, this exercise is sensitive to the starting values, which may be different for each carrier.

Aircraft Valuation
An often-voiced fear among owners, financiers, and operators is that a
re-engined 737 or A320 would make the current fleet (both with substantial
install bases) less attractive and, therefore, would reduce its value.
This is a serious concern, as loans, structured debt, and other financial
instruments that back the financing of aircraft are all built on assumptions
about the continuing value of the underlying aircraft. Additionally,
many of the business and financing plans of these constituents count on
future financing transaction being backed by the existing aircraft. Any
impairment of fleet value would reduce the owner’s financial flexibility.

Yet our study of the five re-engining programs suggests that the introduction of an improved aircraft variant does not have a significant
impact on aircraft values. Exhibit 7 shows how values varied in the 737- 200 to -300 changeover. We looked at the values of two vintages of the replaced variant – the oldest vintage and the vintage that would be 5 years old when the new variant was eventually introduced. We then compared these values with those of the earliest vintage of new aircraft. (All values provided by AVAC.)

Far from taking a hit, values of the 737-200 continued to appreciate after the announcement of the new model, even after the change in production occurred. Not until 1991 did values begin to fall, and this decrease was seen in the new -300 aircraft as well. The explanation: 1991 was the start of a downturn in the aviation industry (shown as shaded area in the charts).

The 737-200, by the standards of the 1970s, was a successful program,
with more than 600 aircraft in service at time of announcement; 900
were in service at the time NG production started. Even after -300 production
started, the -200 fleet remained almost fully utilized. Operators
began parking 737-200s during the downturn, but as the chart shows,
they also parked some -300s.

By way of contrast, consider the introduction of the Boeing 747-400.
At first glance, the data appear to show a rapid fall-off in values of
the replaced -200 at the time of introduction (To view this and additional
data and charts, please go to
Supplemental_Impact_of_Re_Engining_examples.pdf). However, the timing
of the new variant preceded the 1991 downturn by only a year. As a
result, parked -200s quickly appeared. In addition, the installed base of
747-200s of a single engine type was small. Although overall there were
692 747s of all variants in service in 1989, there were only about 150
PW-powered passenger configuration 747-200s. Because of significant
maintenance support challenges, similar aircraft with different power
plants were not readily interchangeable. Offering the 747-200 with three
different engines pleased different airline customers, but it reduced the
liquidity of each type. (This was a major factor in Boeing’s decision to
offer the most recent 777 variants with only the GE90 engine).

While the 747-400 provided significant benefits over the -200, re-engining
was only one factor among many driving the fall in -200 values after
1990. In downturns, airlines typically strive to reduce capacity, especially
of widebodies. The same forces affected the rest of our sample set,
including reductions in capacity of widebody versus narrowbody aircraft.

Extrapolating from this analysis, the valuation question becomes, “When
will the next economic downturn strike?” All aircraft suffer valuation
impairments in a downturn, and we model this in our work with owners,
financiers, and operators. However, older and out-of-production models
don’t experience the near-symmetrical bounce-back in valuations that
new models do. Some of the current 737NGs and A320s would have experienced
this impact in the next downturn by virtue of their age. But more
recent vintages could experience permanent impairment of their value
in a future downturn that they would not have otherwise seen. The size
of that population would likely depend on the timing of the downturn.
If it came well after introduction of the engine variant (which seems
likely, as we have barely emerged from the current recession), then the
valuation impact would probably be small to non-existent. We again find
ourselves with something that is “unknowable” but whose probability we
can assess.

Insights for Owners and Operators
Analyzing a re-engining program’s impact on fuel efficiency, engine
maintenance costs, and fleet valuation is no small feat. For this reason,
the decision to re-engine cannot be made by an airline’s fleet acquisition/
finance group alone. Instead, it must be extensively informed by input
from maintenance and engineering, fuel hedging and fuel risk management,
and strategic planning teams. Airlines must assemble a cross-functional
team representing all of these perspectives and arm it with potent
risk-measurement and management tools. They must then negotiate
agreements with their counterparties to place the risks with those best
able to minimize them. For example, if there is uncertainty about whether
the new engine will cost more to maintain, owners/operators should
ask the engine OEM to bear the risk (and reward) of such costs.

For investors, we believe that fears about the potential impact of reengining
on fleet values are overblown. In our view, the main driver of
current low values for in-service aircraft is the level of narrowbody supply
against industry demand that is only now emerging from the bottom
of the latest recession. The anemic level of financing available even for
5-year-old aircraft only aggravates the problem. Our analysis suggests
that the large installed base of 737NGs and A320 aircraft families and the
absence of significant maintenance issues as they have aged (to date)
will ensure continued demand for the aircraft, even if Airbus and Boeing
shift production entirely to re-engined models.

Clearly, airlines face a situation that’s more complex than normal regarding
their future fleet strategy. By asking the right questions, weighing the
right considerations, and quantifying the potential risks and rewards,
operators and other players in the industry can sweeten the odds of making
the best possible decision regarding re-engining.

About Oliver Wyman

Oliver Wyman has deep, international experience in all segments of aviation, including airports, airlines, service providers, MROs, OEMs, and investors. The Aviation, Aerospace & Defense Practice has consulted to nearly three-quarters of the Fortune 500 firms in these sectors, as well as to major airports around the world.


*The views and opinions expressed in the guest columns are those of the author
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