Interview Transcript

Disclaimer: This interview is for informational purposes only and should not be relied upon as a basis for investment decisions. In Practise is an independent publisher and all opinions expressed by guests are solely their own opinions and do not reflect the opinion of In Practise.

Just to give you a brief introduction to myself before we get into the interesting stuff with you, I'm basically a public equity investor trying to become more knowledgeable about Melrose Industries and GKN Aerospace. This conversation is part of a project to build a comprehensive understanding of various parts of the business, which will help me in valuing it sensibly.

It might be a good way to approach the business by stepping through it from the perspective of your career progression. But before we get into those questions, could you give me a two-minute overview of your career to make sure I'm not missing anything?

Absolutely. I started with GKN in late 2011 or early 2012 as a contractor and then went full-time. I began at their new composite manufacturing facility in Bristol as an entry-level data processor and spent some time as an operator. From there, I joined the continuous improvement team and became the continuous improvement manager for the organization. I also took over another site from a continuous improvement perspective and operations overview, which was Hilton, the largest site in the UK, previously an Airbus site in Bristol.

I was there for about four years before I got the opportunity to move to the US to help a struggling business in Cincinnati, Ohio. In 2014, GKN, when it was still publicly traded, acquired Volvo Aero. This acquisition brought several sites in the engine business, and GKN consolidated these under one business line, now known as GKN Engines. I moved to Cincinnati to work for GKN Engines as a program manager and temporarily took over as the site director. I also had responsibility for East Coast business development, including sales, customer management, contracts, and commercial management. I held this role for just over three years until 2018.

I then advanced into upper management of engines, helping to establish their MRO (Maintenance, Repair, and Overhaul) business. We had small operations in Sweden and the West Coast and decided to invest in building this business unit. As the director of business development and strategy, we developed a significant market strategy, recognizing it as the biggest growth opportunity for the business. Around this time, Melrose took over and supported our strategy financially. I moved to Malaysia to set up a repair business just over the bridge from Singapore, spending about 18 months to two years there. The business is now well-established. I returned to my role as the senior director of customer strategy, focusing on business development and commercial aspects, before leaving the business in 2022.

That aligns with the progression I planned to discuss. Let's revisit the continuous improvement work you did. Although it's been some time and things may have changed since Melrose's ownership, could you describe GKN's approach to continuous improvement? How did it compare to best-in-class practices? If you have experience with continuous improvement in other manufacturing companies, either personally or through third parties, please share your insights.

That's a great question. I co-led a lot of work around Europe, so I am familiar with the aerostructures business and many of their European facilities, including some of the Fokker acquisitions. Locations like Munich, Papendrecht, and the British businesses in Great Britain are involved. They are no Toyota, but within the aerospace industry, they have middle to upper capability.

The intention has always been there, but the operational teams have faced challenges in execution. When I was involved in continuous improvement, financial needs often took precedence over long-term initiatives, which was frustrating. However, the system, training, and manpower dedicated to continuous improvement were significant, with each site having two to four people working full-time on it. This is still the case, if not more so.

Under Melrose, the approach to Lean has become more operationally focused and less prescribed. They recognize that each industry site and region has different abilities to apply Lean principles. This pragmatic approach is a step forward. They tracked financial outcomes and benefits from Lean, and as a lean practitioner, it was clear that the expectation was to save the company at least 10 times your salary, focusing on cost-effectiveness.

When you moved to Cincinnati, you mentioned you were a program manager. What program was that?

It was the CFM56 and the LEAP programs. They were making parts for GE, located directly down the road. They were involved in one of the biggest legacy programs, CFM56, and the new LEAP program, making middle parts of the combustion chamber for GE.

And those parts weren't specified in RRSP arrangements, correct? They were just commercial OEM delivery?

Yes, they were just build to print.

How would you characterize the build-to-print engine component business? Some people view it as a commodity-type business, even though it's within the engine sector and involves customer parts. They own the IP, but there's manufacturing capability at the GKN facilities. I'm curious about the balance in terms of profitability and the durability of earnings, assuming similar relationships for future programs.

Great question. They're not as profitable as the RRSPs long-term. I can mainly speak about the engine sector, as I've spent the last seven to eight years there and wasn't closely involved with the aerostructures business. Engine is their cash cow among the three divisions. They're well-positioned on many engines, with legacy contracts from Volvo Aero and older GKN contracts. They've grown into newer aircraft engines and leverage RSP programs due to existing OEM relationships.

The build-to-print market is competitive, with companies like Hanwha and Asian customers entering. GKN is well-positioned, not only from RRSP and customer relationships but also with high technical capability in the engine world. Compared to other players like MTU, GKN is not as large in build-to-print but is technically capable. MTU is a bigger partner on DTF platforms. From a build-to-print perspective, GKN is relatively competitive. They may not always be cost-competitive but can drive decent margin improvements. Broadly, they are among the top three Tier 1 or Super Tier 1 suppliers to engine OEMs for build-to-print.

That's an interesting perspective. Let's move on to the initial conception of the business model around engine part repair and blade repair. I know there was some business in various parts of the group, and a strategy was formed around that. Could you dive into more detail? What was the original impetus behind that strategy? Was it a few people given the bandwidth to develop a business plan, or how did it form initially?

A couple of people had the industry knowledge, including my old boss and another gentleman. One of them is no longer with the business, but they both brought valuable industry knowledge. They saw the opportunity, and there are only really one or two entities in the world repairing fan blades at the volume that GKN Aerospace is. GKN Aerospace is still the highest volume producer, and there was an increasing need for extra capacity. The business was struggling with more demand than they could handle.

We faced this challenge just before Melrose Industries came into the picture. There were leadership changes at the PLC level, including a change in the CEO of Engines to the current CEO, Joakim Andersson. Joakim brought a different level of interest in the business. I wouldn't say he was more risk-taking, but he was open to new ideas and gave my boss the freedom to explore possibilities.

Myself, another gentleman who was the director of sales, and another who was the director of engineering and technology, sat down over about a three-month period. We did extensive work, interviewing senior executives and customers, and developed a strong strategy focused on acquisition and organic growth. This included building out operations in Malaysia and investing in technology development programs with the OEM to diversify the relationship beyond just fan blade repair.

We wanted to be seen as a partner, not just a fan blade repair shop. There were fan blades in El Cajon, San Diego, and case repair work in Sweden. We looked at the portfolio as a whole to ensure customers were aware of GKN's technical and historical capabilities in the repair world, differentiating it as engine parts repair. To this day, I'm proud to say the strategy has been very successful.

Absolutely. You mentioned that one component of the plan was acquisition. I don't think GKN Aerospace, correct me if I'm wrong, did anything seriously from an acquisition perspective on repair facilities, did they?

That is correct.

Who might they have been interested in at that time?

That is a great question. They were looking at a couple of small players, which would have been technology acquisitions. I can't remember the names off the top of my head, but there were a couple of US-based organizations with less than $100 million in revenue. They had a technology play that GKN thought could diversify into a different product stream or enhance future technology capability for LEAP and GTF.

We did some due diligence on bigger players. We considered buying Standard Aero, but that was a no-go. We also looked at some individual shops that Pratt and GE had, which we knew faced challenges. We tried to see if they were interested in a partnership or acquisition, but the OEMs were never interested.

We revisited these ideas every year, but they either didn't match the magnitude Melrose was looking to invest in, or they didn't fit the business model. Each year, we decided it would be more work than it was worth to drive profitability out of the business.

So the other major player in engine parts repairs is Standard Aero, right? There's no one else of significant scale to mention.

Absolutely. MTU leads that world, especially in new manufacturing due to their partnerships. You've got MTU, Standard Aero, and Chromalloy as major players. Then there are joint venture partnerships the OEMs have, like IHI, KHI, Mitsubishi Heavy Industries, and Kawasaki Air Industries. Some airline operators also have partnerships, like N3, a Rolls Royce joint venture in Europe, which has substantial parts repair capability. There are others too, but my mind's going blank now. The repair world is interesting because there are so many parts to repair. OEMs keep a lot in-house or within their partnership network. GE has more partnerships than Pratt, and Rolls Royce probably has even more. Rolls Royce partners directly with airline operators to build their own engine shops. Singapore Airlines is probably Rolls Royce's biggest partner.

I was specifically talking about fan blade repair. Back in the 2017, 2018 timeframe, GKN had the dominant market share. The significant majority of fan blade repairs worldwide were done by GKN. Who is the number two in fan blade repair, and what does that market share look like today, to the best of your knowledge?

The other major player, probably the second biggest, would be PTI, which is a GE joint venture. It's a GE-Safran joint venture in Florida. They are likely the second biggest player by a significant margin. Let's say GKN had about 60% of the market; PTI were probably handling 25% to 30% of the market. The remaining 10% to 15% was managed by the OEMs themselves. MTU does a little bit, but it's a really small amount. So, yes, PTI is the biggest after GKN, especially now that GKN is increasing their market share with the onboarding of the Malaysia facility.

Yes, I wanted to discuss Malaysia. I think it's a fascinating case study, from business plan to investment conception to execution. The capacity isn't fully utilized yet, but it's certainly doing a lot of business now. Could you walk me through what that investment looked like? What type of equipment were you installing? Was it different from what was in the El Cajon facility, for example? Or was it just replicating a site elsewhere in the network?

You hit the nail on the head with the latter. It was exactly replicating what we had in El Cajon and bringing that capability to Asia. The APAC region was handling about 50% of the volumes that El Cajon was managing. We saw it as an opportunity to invest in the region, gain capability, and prevent losing market share to someone else who might set up there. It was a chance for GKN to serve their customers better.

The support from Safran and GE, specifically CFM, was crucial for establishing more blade repair capability on the CFM56 platform in Asia Pacific. The belief was that replicating what was already done in El Cajon would make airworthiness authorities more agreeable, which they were. It potentially streamlined the approval process. It was replication, but also investment. We assumed we could win LEAP blade repair and gear turbofan work, among other products. We invested in equipment for future volumes and repair capabilities that we weren't handling at that time. It was a significant investment in automation and technical capability, including machinery and inspection capability. It was a substantial upgrade of what they were doing in El Cajon.

Is turnaround time an important factor in that business? Proximity to customers for the 50% of work El Cajon was doing for APAC is presumably important. How crucial is it?

If you asked the customers, they would probably say turnaround time is the most important factor. They would likely pay twice as much for a part that arrived in half the time.

The thing is, it's not unilateral across the repair business. Fan blades are the first things off and the last things on the engine. If your turn time is longer than the marshalling time, which is the engine marshalling time, it can affect the process. Stop me if I'm teaching you to suck eggs. The marshalling time of the engine is essentially the time off wing, from when they start the teardown to when it can be on the test rig for power tests. We used to say 60 days, for example. It's probably different now and varies per engine and shop.
If the fan blades are late and you miss your commit time to the customer, that aircraft could be AOG. Then the MRO shop or whoever it is starts paying penalties. Most MRO shops pay penalties on day two of having an engine on the ground or not having replacement parts. So, yes, fan blade TAT, especially fan blade TAT, is very important. That was a driving factor because you're saving like five days shipping time, potentially three days at best, to ship to APAC.

And the customer here, the work comes from the overhaul shops, right? Whether these are the engine OEMs, their partners, or independent shops, those are the people sending the fan blades to GKN. So, there's no direct price negotiations with the airlines, is there?

Yes, there are, but only if they have their own engine shops like Delta, Southwest, United, American, and others. They do their own engine overhauls to some extent. So, yes, the airlines send blades directly as well. They have various customers; they have the airlines, they have the OEMs. Those two make up the biggest. The OEMs and the MRO shops and the airlines, they make up probably 80% of the volume, the demand, if you will. Then you have brokers and people that are doing teardowns and resale and then you have the military.

Regarding pricing flexibility, given the investment being made and Safran and GE's support. Do they intervene on pricing? Obviously, they intervene in their own volumes, but do they intervene on behalf of customers to say, "We don't want your funded set repair to exceed X, Y, or Z"?

No, they will if they have an agreement with that operator to negotiate the price. Otherwise, no. They can't charge the OEM more than the least amount, and the OEM has the right to audit the books to ensure they get the best price, though I can't remember them ever exercising it. It's the same with the military.

That makes sense.

GKN has a tiered pricing system. Low-volume brokers, customers, etc., making higher profits on their engines, are probably paying three times the price that an American Airlines would pay.

One of the biggest factors in their ability to drive profitability is the annual price increases. It's a high-risk, high-reward situation because they can't control their demand. Unlike new manufacturing, where a customer might commit to sending 100 parts a year for the next five years, GKN Aerospace's performance dictates the number of parts they receive. This is similar to most engine repair shops.

That means that you can adjust your pricing as often and to whatever extent you want, as long as someone is willing to pay. This allows for a quicker cash generation from that business compared to new manufacturing or the RRSP.

Regarding the total investment, I don't know when it started or finished, but it was something like between US$30 million and US$40 million. Does that sound right?

Yes.

In terms of the conversations with executive management about justifying that investment, were people considering pure cash IRRs, EBIT margin, or a more strategic, non-financial basis? Help me understand those discussions.

That's a great question. I'll caveat it by saying that the GKN board, when it was a PLC, reviewed about 24 different iterations of the business case, which was 80 pages long. It involved a lot of financial tweaking. When Melrose Industries came in, they approved the Malaysia investment the same week they took over. They only wanted to see a one-page summary, which was approved the next day. This was the first investment they approved, sending a strong message to us as a leadership team that they were serious.

Melrose had a different risk tolerance and were less concerned with the upfront cash investment. They knew the profitability was there because the business model made sense. They weren't particularly bothered by specific numbers, whether it said 14% or 15%. I can't recall the exact percentage, but they focused more on the strategic aspects. They agreed with our market analysis and strategy for growing this business sector. They looked at it holistically, unlike the original GKN board, which focused on the financials. Melrose took a more holistic approach and focused on market potential for growth.

So today, if you could estimate, I know the El Cajon facility is still doing blade repair work, and Malaysia is also handling blade repair work. Are there any other facilities involved in blade repair?

Within the GKN network? No.

My understanding is that blade repair constitutes more than 75%, maybe 80%, of the total repair revenue for the business. Is that correct?

I would say yes. I think this will begin to change over the next few years because my team won a lot of work on the geared turbofan and LEAP repairs. However, those are probably at low volumes right now. So yes, blade repair is still the majority of their work.

Yes, and it's still primarily in El Cajon versus Malaysia, right?

Yes, correct.

What kind of capacity do you think Malaysia has compared to where it is today? Is there a need for more footprint there or elsewhere?

I think Malaysia is probably around 50%, maybe just over, if I were to guess.

It's at 20% today, in terms of capacity, correct?

Yes, and they have 50% left over.

The company has been discussing its work on repairs for the GTF and the LEAP. Do you think these repairs can be as profitable as the fan blade repair work? As you mentioned earlier, there's a different competency involved in these repairs. Are they likely to be as profitable over time?

That's a good question. Over time, yes. My hesitancy comes from the fact that the older the engine, the higher price you can ask for repairs. In the repair world, real profitability comes from heavy repairs.

What we call heavy repairs don't typically occur until eight to 10 years down the line. However, the margins for these repairs can potentially reach 50%. So, the simple answer is yes, over time. But you have to wait until those heavy repairs come in on the larger parts. GKN deals with large parts, and size often equates to higher prices. I believe it will take about five to six years before you start seeing some of those heavier repairs.

The challenge in the industry is being locked into pricing agreements with companies like Pratt or GE, typically for five-year terms. GKN is raising prices year over year on other items, so there's less flexibility on newer parts. However, in terms of volume, revenue, and overall profitability, I think it will be a very strong business for GKN. I expect them to invest again in the next five to six years. They are already investing in a new facility in San Diego, which indicates the necessity of increasing capacity.

Yes, they are talking about this business, including paid repairs and other work, being approximately a 100 million sterling business on a run rate basis today. It's not even a full 12-month trading period, but given recent growth, it's about 100 million annually. They aim to double that over the next three years. The San Diego facility is part of facilitating that growth. Some growth comes from LEAP and GTF repair work. If you exclude LEAP and GTF, would the rest of the repair work have been growing? What growth rates do you expect in the medium term?

The CFM56, particularly the 5B and 7B, are their main runners. Those volumes are growing about 10% year over year, especially for heavy repairs, as the engines are flying longer than anticipated. LEAP and GTF were delayed, and Covid set the industry back four years in flying rates. Consequently, older CFM engines are flying longer and require more repairs. GKN was well-positioned for year-over-year growth in basic fan blade products. While some products were sunsetting, about 75% were on a growth trajectory, with CFM56 and some military engines experiencing good 10% year-over-year growth.

And that's just from volume. So, you have pricing on top of that.

Exactly.

Is it fair to assume that the CFM price list increases can be used as a decent estimate for similar price increases, around 4% to 6%?

Yes, absolutely.

And then, just to clarify, after you returned from Malaysia, you went back to San Diego, correct?

Correct.

You had two roles there, one in business development and another in a strategic capacity. I'd be interested to hear your high-level view on the repair business from a strategic and valuation perspective. There's significant private equity interest in this area. These facilities are quite separable and not heavily linked with OEM deliveries. This is a theoretical question, and it's unlikely to happen since it's one of the more valuable assets GKN owns. However, were there discussions about making these investments because they're strategically more valuable and worth a higher multiple of operating profits, or was that never really considered?

It's an interesting question. Honestly, it was never really discussed at our level. We were managing a $100 million business, and it wasn't a topic of conversation. There was an awareness that it could increase in value, and we assumed that was why Melrose was significantly interested. Melrose stated their interest and intent early on, especially during the antitrust challenges in the UK. They mentioned plans to flip it, and we assumed their interest was due to the potential for a higher multiplier. However, I can't recall specific conversations about that. I was out of the business a couple of years ago when Melrose decided to run it as an aerospace company. Internally, they see it as an opportunity to drive a profitable business. They're trying to exit loss-making programs and focus on the RRSP and repair business to maintain profitability. That doesn't directly answer your question, but we made sensible assumptions without being aware of specific conversations.

If you were back in a leadership role today, or even higher up, focusing on strategy or business development at GKN, where would you allocate resources? Where do you see the biggest opportunities, aside from what we just discussed about engine components or blade repair work? Are there other significant opportunities where they might invest to yield fruitful returns?

I believe there is a significant opportunity with all the additive manufacturing initiatives they are pursuing. It's not just about repair; even in new manufacturing, it's a major change you'll see in the market over the next few years. GKN Aerospace is very well positioned in this area. They are considered experts in this type of technology. Personally, I would spend a considerable amount of time exploring and understanding this market, whether as a machine provider or integrating it into their portfolio.

Regarding additive manufacturing, I'm not an engineer, so please keep that in mind. When people say GKN is the go-to expert in additive manufacturing for aerospace, it sounds impressive. But how does it work on the factory floor? The recent £300 million investment they announced is essentially for buying equipment and machines, correct? They will either use their existing space or expand. But where does the capability come into play? Is it the operators who know how to work these machines, or is it about the workflow in the factory? If you were to compare another tier 1 or tier 2 supplier's additive manufacturing facility to what GKN is establishing or already has, what would be the noticeable difference between the expert and the follower?

It's about the ability to apply the technology to the part. The technology is highly complex, and the machines are extremely sophisticated. In Sweden, they've brought in many engineers and programmers, so there's a human capital element. However, the real difference lies in applying the technology to the parts they are currently making. This includes their relationships with OEMs. Through their RRSP programs, they have close ties with OEMs, engaging in technical discussions and developing future parts or cost-cutting strategies. GKN, especially in Sweden, has positioned itself well in using this technology to reduce costs. Instead of using a ring forging that weighs a ton and machining away 90% to get the final part, they can use something 25% of the size and apply additive technology to produce the same part. The challenge is the material properties. GKN's expertise in material knowledge and technology application on specific parts sets them apart significantly. I agree they are probably the best at it outside of the OEMs.

It's interesting because the size of this environmental investment, the 300 million they've announced, has created mixed reactions. Some people in the market are skeptical, while others think it's fantastic and makes sense. However, I don't believe the company has been able to convince the market or create a compelling story that justifies this decision. It's a significant amount of money, which will notably impact free cash flow generation over the next three to five years.

I think it's a very long-term play. If I were considering it with my own cash, I would view it as one of those things where, once you achieve one success, you're off to the races. Convincing one of the OEMs to use your part, like with the fan case mount, could quickly gain momentum. They're working with the US Military on several projects related to additive manufacturing, which also has great applicability in the repair world. I understand why people might be skeptical, as it's quite ambiguous right now. They have many irons in the fire, but not all will succeed. They need to focus their energy on those with direct investment and interest from the OEMs.

When did you leave the company?

2022. Two and a half years ago.

So the Melrose management was still very much present at that stage. I don't think there were any indications of them stepping down. However, the variable pay package, which has become controversial, may have impacted or shifted incentives within the organization. I'd love to hear your perspective on whether, in the 12 months before you left, you sensed any shift in the business towards pulling forward future expectations or pushing the envelope to generate short-term profits, potentially creating a vacuum to deal with later.

I think the honest answer is yes. Whenever we went in front of Peter, who was the CEO at that time, probably once a month, we would seek approval for a new business case or model. We knew that within the repair world, we were likely to get a yes. However, the immediate question would always be, "How much is it going to cost to do it twice as fast?"

That became the norm—being asked how to accelerate the process. I can't say if it was due to self-interest or a genuine drive to change the business. My instinct is that it was a bit of both, now that I understand what we're doing.

Yes, that makes sense. It would be irrational for anyone on the outside to conclude, without significant evidence to the contrary, that everything possible was being done internally to speed up or advance profits.

However, one area where that's not good, from my perspective, is where the management team had more flexibility in accounting and expectations. You may have had direct or indirect dealings with this. The business controls their estimations of future profits from the RRSP program. Early in the program, they imposed a big constraint on future profitability expectations due to the risks involved.

Some believe that between 2020 and 2023, the constraints on RRSP programs' expected profitability and accounting were somewhat relaxed. Do you have any insights or overarching philosophical thoughts on that, if you can't discuss it directly?

The honest answer is I don't have much firsthand knowledge. However, I do remember conversations during the monthly leadership team calls with Peter and the aerospace executive team. Within the engine's leadership team, there was always talk about the RRSPs. They were constantly looking at the numbers and reassessing the market.

I worked in the global business development team, using resources for modeling and market analysis. We used third-party tools for market assessments, supply, and demand. These resources were always tied up with the RRSP programs, which were prioritized by the executive team. They focused on the RRSPs and the cash flow forecast.

My observation of Melrose Industries was that they were aggressive compared to PLC. Not necessarily aggressive in the private equity market, but aggressive in generating cash and increasing profit. They approached it differently and more productively than PLC, seeking less conventional methods. PLC focused on reducing costs and increasing profit by selling more parts. That's all I can speak to, if that makes sense.

Yes, that's helpful. Based on our conversation, I think you have a good understanding of my direction of travel. Is there anything else you think I should have asked or any areas of concern or opportunity that I should explore further?

I lead my own business from the people element. In similar calls, people have asked about leadership behaviors. When I left GKN Aerospace, I was pleasantly surprised with the leadership team's direction. The executive leadership team in engines still faces challenges. They have challenges as a competitive employer, especially in the US, less so in Europe, but they have a long way to go.

Regarding pay scales, they haven't adjusted to what they need to in the US?

Pay scales, benefits, and becoming a more modern employer are crucial. To be honest, when looking at their competitors, there tends to be a mentality at GKN that they are better than they actually are as an employer.

When you benchmark what they're doing, they're about five years behind some of the bigger players. For example, in San Diego, which is the fourth largest tech hub in the US, to attract people from new tech companies into a more traditional engineering environment, you need to match not only the pay but also the benefits and opportunities available in those organizations. GKN isn't doing that, so they need to improve.

However, this is a huge opportunity for them as an employer, though it could also be a risk in terms of poaching technical talent. The only other thing I wanted to add is about Peter Dill. He was the sole survivor, if you will, and I worked closely with him on the bids we were working on. Out of all of them, I always respected Peter. I didn't respect any of the others, to be fair.

Of the Melrose leadership team, Peter was very pragmatic and more reasonable. I found him to be more ethical than the others, which is hard to say for a multimillionaire, but within the confines of what ethics look like, his approach was more balanced. He would listen to the experts and value their input rather than assuming he knew everything better than anyone else.