Hard landing

(This feature is taken from Private Equity Europe - the pan-European publication from the publishers of unquote")

Each week seems to bring news of an airline in trouble and headlines about an industry in dire straits. Recently we have seen the collapse of all-business class carriers Maxjet Airways, Eos Airlines and Silverjet, which saw a last-minute rescue package collapse resulting in the loss of 300 jobs. Maxjet and Eos were just two of eight firms to file for bankruptcy in the US in 2008. Business-class carriers have been the biggest victims of the problems afflicting the industry but across the board airlines have been suffering, from budget carriers to the established global brand-names. Oasis Hong Kong Airlines, which attempted to replicate the low-cost model for flights between Europe, North America and Hong Kong, wound up just 18 months after its inaugural flight reporting an accumulated loss of HK $1 billion (US $128 million).

Although passenger numbers continue to rise, record oil prices have been the main contributor to the glut of bankruptcies and profit warnings in the industry. One industry player who was a senior staffer at an airline start-up last year says, ‘No one could have predicted oil at $150 a barrel three years ago. To operate a low-cost airline in this environment is nigh-on impossible.’ Even British Airways, which reported record profits for the year to March, cautioned at the time that oil at $125 could wipe out all operating profit this year. Oil has since risen sharply since then.

Amid this doom and gloom one could be forgiven for thinking that the aviation industry is a no-go area for investors. Yet for all the pain being suffered by the commercial airliners, other sub-sectors within the industry are seeing healthy profit growth and continue to be targeted by private equity. ‘There are more planes flying than ever before, airspace is increasingly crowded and infrastructure which supports the industry, especially at secondary airports, is in need of upgrading,’ says Brian Scouler at UK mid-market buyout house Dunedin, which backed the £16m buyout of Fernau Avionics, a designer and manufacturer of navigational aids for the aviation market last summer.

Roberto Italia at Cinven, which owns Avio, an Italian producer and distributor of components and systems for aircraft engines, agrees. ‘The over-arching trend is people and goods traveling further distances and more regularly.’ Italia also points to recent discussions in the European parliament looking at ways to reduce noise and pollution in major urban centres as a reason for optimism. ‘Several public initiatives on a global scale point to reducing noise and pollution, such as for example the efforts to push airports outside of towns,’ which Italia says will create opportunities for firms focused on installing and updating airport infrastructure. For private equity firms, a fragmented industry is one full of opportunity, and it is this which is driving private equity appetite. ‘The supply base is a cottage industry and is in need of rationalization. There is a big consolidation play to be done,’ believes Scouler.

Bridgepoint’s reported interest in Aero Inventory, a component supplier to airlines, fits this rationale. The business controls only 3 to 4 per cent of the global component supplies market yet occupies a strong position due to the number of long-term sole-supplier contracts it holds and would provide any buyer a platform for a buy-and-build strategy. Bridgepoint already has a presence in the market through its ownership of Global Design Technologies (GDT), a manufacturer of tubes and pipes used in aircraft, and could bring its existing contacts through GDT with Boeing and Airbus to the table as a carrot to woo Aero Inventory management.

Another private equity-backed business focused on the components market includes MB Aerospace, which LDC bought last year from engineering firm Motherwell Bridge. The business designs, manufactures, tests and assembles defence and commercial aerospace systems and components. Its customers include multinationals such as Boeing, with which it has a $15m contract, and Rolls Royce, which placed a £25m order with the company in 2006. This is another business which looks well-placed to withstand the economic turmoil. With long-term contracts sown up with the largest aircraft manufacturers and a considerable revenue-stream from military customers it should be relatively immune from the battering being taken by the end-user airlines.

One business which may not possess the same ability to weather the storm is Dunlop Aircraft Tyres. Acquired last year by AAC Capital Partners for around €60m the company is heavily reliant on the commercial market, without the hedge of military contracts and does not possess the same scalability as a component manufacturer. ‘Dunlop is a smaller manufacturer competing with much larger players so the opportunities for bolt-on acquisitions are limited,’ says one person close to the original deal. The market for design, manufacture and testing of tyres, which Dunlop operates in, is dominated by Michelin and Bridgestone and any consolidation opportunities would likely be seized on by one of the big two. These two also snap up the majority of new business in the airline tyre industry. Boeing chose Bridgestone as supplier for its new Dreamliner and Michelin has the contract to supply Airbus’ A380 superjumbo. Dunlop is also a precise engineering business and as such, diversification opportunities, and the ability to generate new revenue streams, are restricted.

For all the opportunities on the supply-side, private equity has not been averse to investing in airlines and even in these troubled times retains an appetite. The US buyout house TPG tabled bids for Australian operator Qantas and troubled Italian carrier Alitalia early last year and when it failed in these attempts turned its attention to Spanish airline Iberia, leading a consortium of three Spanish private equity houses. Although as of yet unsuccessful in its pursuit of the airline, the firm bought a small stake in the company last year, alongside British Airways, which owns a 13.5% stake. Southern Europe has been at the forefront of private equity interest in airlines in the past year. Iberia’s budget airline Clickair is backed by Quercus Equity, which is looking to sell its 20% stake in the airline due to the poor performance of the company. In February it was reported that private equity houses Ibersuizas, Torreal and 3i were weighing up an offer for Spanish executive carrier Gestair and there have been suggestions that new Italian private equity firm GL Investimenti is considering a bid for the Italian airline Air One. Air One has been one of the airline industry’s success stories, announcing its expansion into the long-haul market last month with the signing of a $4.7bn deal with Airbus for 24 long-haul aircraft. The company has also been mooted as a potential buyer for Alitalia.

These are exceptions to the rule. Private equity firms looking for investments in the aviation sector will not be pursuing airline carriers. They require major investment in fuel costs, landing fees, insurance costs, and taxes as well as ground handling and customer service functions. Businesses supplying component parts have few of these burdens, yet can take advantage of the needs of the airlines while also tapping the military market when the civil aviation market is in trouble. As one GP on the board of a components manufacturer to the airline industry puts it; ‘The US war effort is helping push profits up.’

With airlines freezing orders for new aircraft and retiring older aircraft, Italia sees a possible source of upside in the medium-to-long-term emerging from the difficulties being suffered by the commercial airlines. ‘Airlines that choose to delay purchasing new aircraft will quite likely have to work their existing infrastructure and capacity harder to capture global revenue passenger trends. This could well result in even stronger demand for the services of companies supplying and maintaining technologies and systems aimed at such infrastructure and capacity.’ A number of airlines have recently announced cuts in the size of their fleet. Continental airlines said last month that it was retiring 73 old Boeing models servicing short-haul routes and United Airlines is planning to ground a fifth of its fleet.

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