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- [00:00]
Matt Russell
This episode is brought to you by Portrait. It's the AI research system that I used to prepare for today's episode and for all business breakdowns episodes. Portrait was built by former buy side investors and they understand great investing isn't just about having more information from low quality sources. It's about having the right information organized the right way. And if you listen to the show, you appreciate Diligence consists of many things Diving into the history of a business, framing the nuanced competitive dynamics, tracking key signposts around your thesis. And historically that would take up material time that you do not have. But Portrait is basically like adding an army of analysts to your team. It's powered by an AI system specifically designed for investment research workflows so you get nuanced idea generation. Portrait assesses the same types of qualitative attributes that we discuss on this show and that can help identify businesses which fit your frameworks. Portrait also customizes research report generation and I used Portrait to generate a primer and lay out bold bear cases ahead of today's episode to help frame the conversation. And third, there's intelligent thesis monitoring and that's where Portrait assesses thousands of data points across value chains each day, extracting the insights driving the business again. All this work would typically take hours and hours and hours. It's at your fingertips now. Visit portraitresearch.com to start your free trial today.
- [01:46]
Podcast Host / Narrator
This is Business Breakdowns. Business Breakdowns is a series of conversations within business investors and operators diving deep into a single business. For each business, we explore its history, its business model, its competitive advantages, and what makes it tick. We believe every business has lessons and secrets that investors and operators can learn from and we are here to bring them to you. To find more episodes of breakdowns, check out joincolasis.com all opinions expressed by hosts and podcast guests are solely their own opinions. Hosts, podcast guests, their employers or affiliates may maintain positions in the securities discussed in this podcast. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions.
- [02:34]
Matt Russell
This is Matt Russell and today we are breaking down GE Aerospace. Now if you go by tickers, we did break down GE several years ago, but that episode focused on how Larry Culp at the time was turning around that Titanic. That was ge the conglomerate today. Ramesh Narayanaswamy, co Founder and Portfolio Manager of Tubian Partners, join me to go deeper on what is now a pure play aerospace business. So we get into some of the unique dynamics of the supply chain in aerospace, the long cycle nature that differentiates it from many other industries that you look at. And I marvel a bit on the complexity that is aircraft engine manufacturing. But not for long, because this is another beautiful example of selling services attached to equipment. And I first met Ramesh back in the summer of 2024 at a business breakdowns event. It did not take long for me to appreciate his approach around finding these businesses with unique scarcity or scale benefits. And I finally got them on business breakdowns. So please enjoy our conversation on GE Aerospace. All right Ramesh, I am pumped to have you here. We're covering GE Aerospace today and some listeners may remember we covered GE just a couple of years ago. This was prior to the spin offs and having these pure play entities. We thought it was a good opportunity to come back to this name, particularly I think with how the story has played out over the past few years and even prior to that episode we did. Initially I thought the best place to start was just a reintroduction to ge, but specifically GE Aerospace and just a small simple explanation of what it is that they do. Maybe what they sell, give some context about where they operate in the aerospace spectrum.
- [04:43]
Ramesh Narayanaswamy
Well, thank you for having me, Matt.
- [04:44]
First of all, it's really exciting to discuss aerospace in terms of what GE Aerospace does.
- [04:50]
@ its core, they sell jet engines for both commercial as well as defense and military applications. The total fleet of GE Aerospace engines is about 70,000, which is broken down roughly between commercial and military. 45,000 engines in the commercial application space and 25,000 engines in the military space. So taking it one by one on the commercial side, if you look at the 45,000 engines that are in service, if you look at the aircraft that they touch, GE power something like three out of four, all commercial takeoffs pretty much every day. And it includes a mix of engines where they are the sole source provider of an engine for an aircraft, as well as programs where they have a diapolistic kind of market position. Within commercial aircraft there are three sub segments. One is a narrow body segment. Think short haul like New York, Chicago kind of flights here. Their older generation engines are called CFM56, which is sort of an industry benchmark. It's got a very long standing reputation for quality and reliability and performance. It powers all Boeing 737s, the entire family, and just over half of the Airbus C20 family. And this is the engine that has been in production for a while and now is sunsetting their newer engines which is currently in production. It's called leap, short for Leading Edge Aerospace Propulsion and These are engines that power the Boeing 737 Max, again a sole source position. And the Chinese COMAC C919, also a sole source position. So pretty much 100% market shares there. And just over half or 60% of the Airbus 320 Neo family overall. In the narrow body segment, GE has something like a 70% share of that space. On the widebody side, which is long haul flights, think London to Tokyo, they have something like a 50% share of the widebody fleet and backlog. Here you're talking about aircraft like the Boeing 787, where GE's engine is called Gen X, which got something like an 80% share of the backlog. And also the Boeing 777 where GE90 is the engine, also something like 80% share. And the Boeing 777X, when it does enter into service, GE9X is going to be the sole source engine for that program. Fairly dominant positions in a geopolistic landscape within the widebody space. And finally, to round up, they also sell engines for regional jets and business jets. This is things like Bombardier aircraft, the Passport engine, and Embraer, which is a CF34 series. So within the commercial side, they're fairly well balanced. Half of their exposure is through narrow bodies, what 35% is through wide bodies, and about 15% is through regional and business jets.
- [07:37]
Matt Russell
Of those three categories, the widebody engines may be slightly less share, but it's making up a big chunk of that revenue. Widebody engines, are they any more or less profitable than narrow body? Is there a distinction that you would make between those two categories in terms of what is maybe a higher quality business line?
- [07:59]
Ramesh Narayanaswamy
Historically, the narrowbody side has been more scaled because of the sole source position that they have at Boeing, which is roughly half the market. And they have significant share, so nearly half to 60% share on the Airbus family. So the narrowbody has been the key driver for GE over the long term. They go to market on the narrow body side through a joint venture with Safran called CFM International, which has been one of the most successful aviation franchises in history. In terms of profitability, there is no meaningful difference. Both wide bodies and narrow bodies are profitable, something like a 20% share, though I would guess that just given the way the cash flows work in terms of the old fleet retiring and the new fleet coming on at different points in time, the narrow body fleet might be more profitable for them by a few percentage points perhaps. But despite the difference in sort of the market position, GE has done a phenomenal job in delivering sort of 20% kind of overall margins across those programs.
- [08:59]
Matt Russell
And then the military exposure as well. How would you frame that in terms of exposure and share? To the extent that they disclose that.
- [09:08]
Ramesh Narayanaswamy
On the military side, it's more useful to think about much more programs and platforms they're on. So on the military side, they have something like 25,000 engines in their fleet. This includes engines for Programs like the FA18 Hornet Super Hornet fighter aircraft. It also includes nearly two thirds of all US military aircraft, including helicopters. So it's a fairly diversified portfolio. One thing I would note is that GE has not been as scaled as somebody like a Pratt and Whitney. On the defense side historically, for example, they have lost out on F35 fighter program in terms of being able to provide the engines track provides engine there program by program. There can be changes. The overall market share is probably not as good a metric. And it's much more useful to look at program participation in key programs that they're on.
- [09:58]
Matt Russell
Is there anything else besides those two lines that GE still has?
- [10:03]
Ramesh Narayanaswamy
They do have defense and propulsion technologies business. So outside of their defense programs, something like 12 to 15% of the business is in propulsion technologies, which includes things like aircraft equipment businesses that go into both commercial and military applications. But overall, in terms of the revenue mix, commercial is overwhelmingly nearly 85% of revenues. And in terms of profitability, even more pronounced, I would also add that they do report insurance revenues, which is sort of a legacy part of Georgia given their intense transformation over the last few years. And about 10% less than 10% now, about mid single digit percent of that overall revenues comes from insurance, though that is now in runoff. So it is not really a portion of the business where they're committing new capital to.
- [10:50]
Matt Russell
Just to give some scale around the revenue base today. How big are they from a top line perspective?
- [10:58]
Ramesh Narayanaswamy
This year they'll report something like 40 billion in revenues, of which 75% is commercial engines and services and 25% is defense and propulsion technologies. Due to the difference in profitability, the commercial engine services business is 25% kind of operating margins. The other businesses, defense and propulsion technologies, tend to be more like 11 12% margins. So in terms of earnings contribution, you're really looking at a commercial engine franchise here in Germany.
- [11:28]
Matt Russell
I assume that the way that these cycles work, particularly with either replacements or new fleets coming out, you have pretty good visibility just in terms of backlog and deliveries for that revenue number and where it goes over the next couple of years.
- [11:45]
Ramesh Narayanaswamy
Absolutely. So if you look at how the aftermarket works. 70% of GE's revenues overall comes from services, which is very predictable. Spare parts revenues and services revenues from the install base. Typically engines are mandated to come in for overhauls and shop visits, just from a safety and regulatory perspective. So this gives rise to an extremely predictable earning stream in the aftermarket, which also tends to be the more profitable earnings stream.
- [12:13]
Matt Russell
And just on the backlog point, I understand it's a smaller percentage of revenue relative to services, but can you contextualize what backlog looks like now and maybe how that compares to history and whatever framing that you think would be most effective?
- [12:31]
Ramesh Narayanaswamy
Absolutely.
- [12:32]
And the backlog is one of the.
- [12:33]
More interesting underpinnings of GE's five to ten year outlook. Their current backlog is something like $175 billion on a headline basis. That's four and a half years ish of revenues. But underneath that there are a few nuances. So if you strip out just the commercial backlog, which obviously is the majority of the business, that's closer to six years. And within that, if you take out just a services element of revenues, which obviously is the key profit tool that GE Aerospace enjoys, that's closer to seven years. So we have a very unusually long backlog and visibility for ge.
- [13:14]
And to put it in context, this.
- [13:16]
Is not unusual in the supply chain. If you look at the airframers themselves, both Airbus and Boeing, with their current production rates, they are running at close to a decade's worth of backlog. So very strong visibility throughout the OE as well as the engine ecosystem.
- [13:33]
Matt Russell
And relative to, let's say five years ago, 10 years ago, do those numbers, terms of four times current revenue, 10 years of backlog for the airframers, are those meaningfully higher, lower in line with where they've been historically?
- [13:52]
Ramesh Narayanaswamy
I would say they're moderately higher than historical averages, but not substantially so. Aerospace generally has very long term cycles and that allows these companies to a have significant backlogs and visibility in terms of how these engines are produced because they need to tie in with the airframers in terms of their production. They're very closely knit in the supply chain. And secondly, because of the increasing prevalence of long term service agreements that is also ticked up in terms of how much the backlog gives you the visibility for.
- [14:24]
Matt Russell
And for a business like ge, I can hear the essentially again, I'll use the simple numbers of somewhere in four to five times revenue in terms of backlog. So four years worth looking out, is that lumpy in terms of seeing, you know, major realization of backlog two years out, but maybe you have a a slow year next year. Like, does the lumpiness drive anything or is it realized pretty evenly over the course of those four years?
- [14:59]
Ramesh Narayanaswamy
That's a good question.
- [15:00]
On the services side of things, which is something like 70% of the backlog, you should see a fairly predictable steady evolution of the burn rate, so to speak, of the backlog converting into revenues. On the OE side that is somewhat lumpier because that sort of ties into production rates at Boeing and Airbus. And if there are any issues in terms of either the supply chain or their production run rates, you will see some lumpiness. But given that both Boeing, since the sort of issues they've had in the last few years, it's been fixed, and Airbus as well has been on a pretty good rhythm, I would say both the OE and the services backlog today seem well positioned to have a fairly steady cadence over the next five to 10 years. This is outside of things like pandemics and recessions, so to speak. So on a run rate, normalized basis, we should be able to see a fairly steady growth of that, of that revenue and earnings.
- [15:57]
Matt Russell
Yeah, and calendar years quarters shouldn't matter as much as they do sometimes in the markets. Many times investors will see through. But it's interesting to note and to hear nonetheless. Maybe we could do a revisit to the GE Pure Play story. We captured it to some extent in the previous episode, but it's played out even more. We don't have to spend too much time on the origin stories of ge. We can hit on that. I want to talk a little bit about Larry Culp in particular and some of the moves that he's made. Do your best to just outline some of the key milestones and things that really were done that moved the Titanic around when it was struggling for so long.
- [16:39]
Ramesh Narayanaswamy
GE goes back more than a hundred years. It's a company that dates back to none other than sort of Thomas Edison. For most of the previous couple of decades, GE was probably the very definition of a conglomerate with a very diverse portfolio of businesses operating in industrials, in healthcare and in financial services. But if you look at business history, there are very few things as reliable as a cycle of conglomeration and then deconglomeration. And under the time of Jack Welch and Jeff Immelt, their eras were defined by a focus on growth, on market share through acquisitions and what I would call earnings per share management. And a big part was played by GE Capital, which exposed a lot of leverage in the system and that the various businesses were housed under ge, were competing for capital and there was no true business rationale holding them together. Now all of that changed with the arrival of Larry Culp, who was really the first outsider CEO at ge. Culp was on the board at GE during the brief tenure of John Flannery and he took over as CEO in October 2018. Now Carl, for those who follow industrials businesses, is a very well known and proven operator and capital allocator and had a fantastic performance both operationally and stock price wise at Danaher where he was CEO from 2000, 2001 to circa 2014. So if GE needed to deconglomerate then Larry cup was the perfect choice.
- [18:08]
Matt Russell
Maybe you can detail some of the steps that he took in that deconglomeration. It goes beyond that in terms of how the operational execution has played out. What would you point to? Because I think the track record from Danaher was there to point to, but he certainly followed through with some of the execution on the GE side.
- [18:29]
Ramesh Narayanaswamy
In simple terms I would say Larry brought the kaizen like lean manufacturing principles that he was so successful implementing at Danaher to ge. To use a sort of Japanese phrase, he walked the GEBA as they call it, I. E. Go to the place where the value is being added, the manufacturing floor, the shop floor, and really focus on very basic ideas of continuous improvement, problem solving and more importantly addressed the don't shoot the messenger culture which was badly needed at GE and also crucially focus on the customer. I think I've heard Larry describe his philosophy as common sense, vigorously applied, which is probably a good phrasing of what he did at ge and for GE in particular that meant simplification and deconglomeration and focus. So he spun off the Healthcare assets as GE Healthcare, the power businesses as ge. Vernova focused on debt reduction and what we are left with is just the aerospace assets.
- [19:29]
Matt Russell
What do you think led him to sticking with the aerospace assets versus going with Healthcare or Vernova? It's just an interesting choice. It might have just been market size but do you think there's anything there in terms of what led him to continue on with this specific business line?
- [19:48]
Ramesh Narayanaswamy
If you go back in time to 2020, the board awarded Larry a one time performance grant to incentivize him to say it was at the very high end of what you would normally see something like $200 million in shares based on certain stock price targets. It was a little bit controversial at the time simply because the share price was depressed given the fact that we were reeling from the pandemic, but it also aligned outcomes between management and shareholders. And similarly a very similar grant was made in 2024, again tied to operating metrics, but in smaller scale compared to the 2020 grant. As to why Larry decided to become CEO of GE Aerospace rather than Vernova or Healthcare, couple of things I would point to. One might have been the fact that he was historically well versed in industrials businesses, so Danaher. And second, perhaps it was an implicit indicator of how strong aerospace was compared to their other segments. And he wanted to be the CEO of the crown jewel asset, so to speak.
- [20:50]
Matt Russell
You referenced some of the market shares that they have in this jet engine business. Can you just bring us back in time in terms of the origins of that industry? And that'll lead us on to how GE has captured the share and foothold that they have. But maybe go back in time. I have some sense of when jet engines came around. It was probably correlated to when airplanes came around, but maybe you can lay that out for us.
- [21:14]
Ramesh Narayanaswamy
The jet engine business is nearly 100 years old, so it's fairly long time. It was first invented in the 1930s here in the UK actually the first jet engine built in the US however was a GE engine, which incidentally was a copy of the British engine developed by Frank Whittle. Historically you would find that as technologies develop, they become cheaper to manufacture and to scale. But what we have observed in jet engines is that that has not necessarily been the case. Even inflation adjusted jet engines still cost at least several billion dollars to make. And if you look at the most recent Pratt and Whitney geared turbofan engine, it reportedly cost Pratt Something like $10 billion. Now it's a good question to ask why that is the case. I would suggest that because jet engines are constantly pushing at the leading edge of materials, technology and engineering and we're tackling new problems at the frontier that keeps costs high and entry barriers high as well.
- [22:13]
Matt Russell
It's the type of product that I don't mind if it's a little bit more expensive as well, given what it actually does and how I might be a user of it. Let's discuss GE's evolution in that space in terms of leading to this place where you always hear about the duopoly atop in terms of the OEMs with Boeing and Airbus. Not so much about the rest of the value chain. Who else is in the jet engine market? I think you've referenced Pratt and Whitney a few times, but how has that evolved over time?
- [22:47]
Ramesh Narayanaswamy
So first to maybe set the scene. It's worthwhile putting the industry in context and why it's so hard to make a jet engine. In simplest terms, the barrier to entry into the industry is the requirement to have both extraordinary technical performance at extraordinary low cost. So making a jet engine at scale is one of humanity's toughest technical challenges. Right up there with some semiconductor fabrication, manufacturing biologics, or even things like reusable rockets. So this is a very, very hard technical challenge to overcome. Just to give you a flavor of what engines have to deal with in commercial aerospace, which we take for granted every time you take a flight. Within the hot section of the engine, inside the high pressure turbine, the temperatures can exceed the melting point of alloys, which when you stop to think about it, is quite mind boggling. Similarly, engines have to withstand and be tested extensively in a variety of harsh conditions, including extreme cold, extreme heat, dusty conditions, including things like bird strikes, which they have to be resilient against, which happens more commonly than you think. Even at the manufacturing level, atomic scale defects can be catastrophic. For example, the most recent issue that Pratt and Whitney had with the gear turbofan, they found a microscopic contaminant in the manufacturing process which led to a worldwide record of the entire fleet. So even extremely small issues can cause significant after effects and significant catastrophic losses for the engine makers. Now, once you have solved these technical problems, you now need to go to convince Airbus and Boeing that you can manufacture and supply this at scale and then convince the airlines that this will be reliable to operate for decades on end, all at a cost of ownership that is competitive based on sort of worldwide global aftermarket support. And oh, by the way, you also need to sell at a loss to Airbus and Boeing before you can see the first profit from spare parts in 5 or 10 years time from the airlines. This is an extraordinarily difficult industry with very significant technical barriers in addition to regulatory barriers, where rightly regulators require extensive certification and safety testing of aircraft and every single part that goes into an aircraft, including the engines, it's a marvel.
- [25:07]
Matt Russell
In terms of what they've been able to do. Who's on the other side of the spectrum beyond Boeing and Airbus, what goes into those partnerships and those relationships that creates the ecosystem that now exists where you do have certain parts of the value chain entirely relying on each other.
- [25:27]
Ramesh Narayanaswamy
When you look at jet engine makers, the primes, you only have three or four companies who can do this at scale. GE is one of them, along with Safran, Rolls Royce is one of them, and Pratt and Whitney MTU Given the history of the industry, you can see that Rolls Royce, for example, collapsed in the 70s and had to be nationalized trying to develop the RB211 engine, which was ironically a successful engine and the basis of their current trend architecture, but they almost went bankrupt doing it. And similarly, if you think about state owned companies, including China's comac, which is steeped in manufacturing muscle in China, chose a GE or CFM engine to power their last aircraft. And while it's sort of developing its own engine, it just shows you the barriers to entry that even extremely scaled players and serious new entrants face when tackling this industry. Given these challenges in developing engines, it is not a surprise to see that most of the companies in the space enter into sort of risk and revenue sharing agreements or joint ventures simply to mitigate the risk and to share the risk and revenue both when they are trying to develop new engines for ge. The most prominent of that is in their narrow body segment where they have a joint venture with safran. It's a 5050 joint venture with Safran called CFM International, which we spoke about before through the CFM International program. You have very strong presence that GE has in the Boeing platform, such as Solsource and the Airbus platforms, not to mention comac, which is also sole source.
- [27:03]
Matt Russell
With GE for that joint venture. I just have to ask, what is Saffron doing and what is GE doing?
- [27:10]
Ramesh Narayanaswamy
Historically? CFM International has been a 50:50 joint venture. GE historically has done more on the hot side of the engine and Safran has done more on the cold side of the engine. But Effectively everything is split 50, 50 in the partnership. And it's a very long standing partnership, almost 50 years old at this point is one of the best models of joint ventures and risk and revenue sharing agreements in the industry.
- [27:34]
Matt Russell
Interesting. Yeah. To have that long standing of a joint venture and to be taking something as complex as this and splitting it amongst two businesses. So I can only imagine technology also.
- [27:44]
Ramesh Narayanaswamy
Plays a role in terms of how these market shares evolve. It is not just the case that you only have a few players and therefore you tend to have consolidated market positions. When it comes to choosing an engine, you have two choices really that are being made. One is at the Airbus Boeing level. They can decide if they want to go sole source, which is a strategic decision as well as a technical decision in terms of how much more efficient an engine is compared to the predecessor it is replacing. For example, Boeing 737 is on a sole source with GE, but Airbus offers two engine options. And similarly, airlines can also choose engines based on their reliability, most critically, time on wing, which is a metric that airline operators care a lot about in terms of availability and reliability. Remember that these engines need to fly for 10 hours a day for years and years at a stretch before they can be brought in for a servicing. So the total cost of ownership over 20, 25 years, which is the life of an engine, is extremely important for airlines. So this combination of factors in the industry, so both the barriers to entry we spoke about and the choices that Airbus, Boeing have made in terms of sole source or dual source has made the industry extremely consolidated and GE a dominant player in the industry.
- [28:57]
Matt Russell
When I'm thinking about the revenue model itself, I'm sure there's this price that they're offering, but there's got to be some scaled pricing incentives. Can you talk a little bit more about the revenue model, which, again, because these new fleets and whatnot get scheduled out for such long periods of time, I would imagine there's visibility, but some of the more interesting details and nuance to it would be interesting to hear about.
- [29:21]
Ramesh Narayanaswamy
Before we get into the revenue model, it's important to think about who the buyer is. Within commercial aerospace, there are actually two distinct customer segments. The first customer segments is the aircraft airframers. So Airbus and Boeing and comac. So they make the aircraft itself, hence the engine is sold to them as an original equipment provider. But because Airbus and Boeing are so dominant in manufacturing, they can exert enormous negotiating leverage against engine makers and the entire supply chain. So they have a huge influence in terms of engine choice, in terms of technology, whether or not they want to offer engine options, as we spoke about just before. So there's not that much profit on the OE sale for an engine maker because of this. So you typically sell the OE engine at a loss or breakeven at best, and make up for it in sort of the aftermarket. Now, the second customer group this ties into the aftermarket are the airlines. So once an aircraft starts flying, it's owned and operated for 20, 30 years by the likes of Delta or American or Emirates or Ryanair. That industry, that is the airlines, is a very fragmented industry. There are hundreds of airlines. So the engine makers are in a much better position in terms of negotiating leverage to make a profit. And they do, because typically in the aftermarket, airlines have to bring the engines.
- [30:43]
In for servicing at some point.
- [30:45]
And typically, if they don't choose an OE spare part, they lose a warranty protection on the engine so therefore the engine makers tend to get spare parts revenues, which are very lucrative and very high margin. So this bifurcation of one buyer who is sort of your engineering customer, another who is your usage based customer, also leads to significant barriers to entry for new entrants. And it informs sort of the revenue model. When it comes to the revenue model, we have two different customer groups. The first is the oe. If you look at the LEAP engine, which is the current in production next generation engine for ge, the list price of a LEAP engine might be something like 20, 22 million, so almost 20% the list price of the aircraft itself. This is for delivering to Airbus or Boeing or comac. Typically on the OE side you sell at a very deep discount. It can be up to 70 or 80% until the program is mature or you're delivering spare engines. So you generally end up making losses on the OE side. So you have negative margins until you get to maturity, which the leap is fast. At that point you start selling at the OE on a break even basis. So you still don't make any real profit margin on the OE sale. If you look at GE for example, their revenue per engine typically is around $6 million. So very different from the headline price of 20 to 22 million on the aftermarket side, which is the revenue that they get from airlines and that lasts 20, 25, 30 years. This is extremely profitable as spare parts and service revenues are effectively exclusive to the engine makers. And regulations mandate that you need to bring in these engines for servicing after a certain number of flight cycles, so typically every six, seven, eight years. And airlines typically don't want to use sort of alternatives to the original spare parts as it voids the warranty protection on it. So this revenue stream is extremely profitable. You're looking at something like a 60% type gross margin on the aftermarket. Now the mix within GE's Commercial Engine Services segment is 3, 4 service revenue and 25% OE. And given overall margins of 25%, you can see how profitable the service component is. Though none of the companies really report this, it would not be unthinkable if operating margins for the aftermarket were 40% or better. And that is overwhelmingly the most important economic driver for engine makers. More importantly, typical aircraft lives are 25 years plus. So from an NPV perspective, this multi decade aftermarket profit is really what drives value for ge. And over the life of an engine, the aftermarket can be three to four to five times the OE sale. That really drives the value for the.
- [33:27]
Matt Russell
Business now here in terms of upfront sale versus services costs, sometimes 50, 50 being a model, but this feels like it's a little bit different in terms of what's going on. But it's a much steeper difference in terms of how much is made on the back end. I am just curious your point on the engine sales being done at very steep discounts upfront and then that being slowly closed in terms of what the discount is as the program matures, is there anything to that? I just am a bit surprised it's not smoothed out over the entire life of the engine program or the particular aircraft program. Do you know what goes into that and what drives that huge discount up front?
- [34:12]
Ramesh Narayanaswamy
So the discounts tend to be more in sort of the commercial side of the business. This is not a feature that you'll see in sort of business jets or regional jets or even military applications where it's a much more consistent margin profile between the OE and the aftermarket. The steep discounts that you see on the OE side is simply a function of the fact that Airbus and Boeing are very powerful and very consolidated and therefore they can drive significant volume leverage on the supply chain, including GE and engine makers.
- [34:40]
Matt Russell
It's an interesting nuance that I can somewhat understand. There's certain aspects about it that I have a hard time wrapping my brain around, but I certainly understand that power they have on the aftermarket. Can you just detail you went into exactly what's happening but a little bit more about the revenue model there, Whether there's actual service contracts, warranties, comes at a certain price upfront. Just the dynamics going on there.
- [35:07]
Ramesh Narayanaswamy
On the aftermarket side. There are two main types of revenue models for commercial aircraft and engines. One is called the time and materials model where airlines pay for the spare parts when they do the overhaul, when they do what is called a shop visit, which happens every five or six or seven years. So that's sort of the traditional model. The second model is long term service agreements or in the industry it's called revenue per flight hour or power by the hour, which is effectively a subscription type of revenue model. Here GE would offer a per flight or cost that the airlines can pay so they can convert sort of what is effectively capex into opex. And the cost can but not always includes the cost of overhaul and spare parts. So in a way GE takes more risk. It's like selling insurance contracts to the customer. However, long term contracts in the mix more recently has been reducing meaningfully. And in many cases when long term service Agreements are offered. The spare parts or the life limited parts as it's called, are often out of scope. So the basic difference between the two models is who bears the risk of the engines being reliable in time and materials contracts, or in the time and materials world, the airlines take the risk. So typically you see this when an engine has proven reliability is very mature, and in long term service agreements, the engine makers take the risk. So you effectively have underwritten a certain set of cost and reliability assumptions and how you price that contract for GE, to put some numbers around it, something like 60% of the Leap engines are under long term contracts, of which 30% is revenue per flight or so pay as you go. On the widebody side, the proportions are a bit higher. So 60, 70% are on long term contracts and 60 to 80% of that is on a pay by hour basis.
- [36:54]
Matt Russell
Talking a little bit about the growth model and how they grow, there's probably some obvious ways just in terms of new aircrafts entering the market. But how would you lay that out in terms of what that looks like strategically?
- [37:09]
Ramesh Narayanaswamy
On the commercial side, overall commercial travel is the tailwind. Here it is reported that something like three out of four people in the world haven't yet traveled on an airplane. However, that's probably an overstatement in terms of the growth potential. But every time somebody posts something on Instagram from a exotic location, that obviously boosts the need and demand for air travel. However, when you look at long term revenue passenger kilometers, as it's called, RPKs, it tends to grow in sort of the mid single digits, which historically has been 2x GDP growth. Now that multiplier varies substantially between developed and emerging markets. In developed markets, the multipliers are clusters around 1. It could be anywhere from half GDP growth to one and a half times GDP growth. But on the emerging market side is significantly higher. So it's 3x GDP growth for the next 10 years. Both Airbus and Boeing have given long term forecasts for the industry. For the next 10 years or so, it's reasonable to assume that air travel grows at 1 1/2 times GDP. In addition to that for GE in particular, they have more levers for growth in terms of their own fleets growing faster than the rest of the market. So for ge, the leap engine is over time expected to be twice as big as a predecessor engine, the CFM56, that it's sort of replacing. So the growth of the leap fleet will more than offset the retirements of the older CFM56 fleet. And even in the older CFM56 fleet, something like 40% of the engines haven't really come in even for their first shop visit. In fact, if you look at shop visits in 2025, they are roughly the same as they were in 2019. So there is a lot of latent growth still, which is extremely predictable because eventually the engines have to come in for a short visit. In addition to this, aftermarket pricing continues to be quite strong. It's particularly strong today since the pandemic, but will remain at least sort of mid single digits towards the end of this decade. So this tailwind from the growth of their installed fleet plus pricing means GE's commercial services revenues could grow at something like an 8 to 10% clip very predictably with high visibility over at least the next five years.
- [39:19]
Matt Russell
And when did the LEAP engine come into service first?
- [39:24]
Ramesh Narayanaswamy
The leap entered into service circa 2016. So it's still a very young program. And a typical aircraft program from inception to development to retirement is four decades. And the useful life of an aircraft is 25 years. So still a very, very young program that will deliver earnings for decades to come.
- [39:43]
Matt Russell
And then on the defense side, I'm sure it's exposure to defense budgets. Is there anything else that goes into.
- [39:50]
Ramesh Narayanaswamy
That growth equation on defense? It does tend to grow in line of the defense budgets with an additional uplift ahead when based on which programs they're participating in. More generally, as we touched on before, RTX and Pratt are much bigger and more dominant on the defense side. And GE has lost out on some of the key growth programs over the last sort of cycle. But if you look at more recent share of DoD spending, both Pratt and GE have gotten their fair share. So I expect this to be something like a 4% type of growth segment.
- [40:21]
Matt Russell
Just in terms of the cyclicality of the revenue, there's the longer cycles of aircrafts coming into service and when there's major fleet upgrades. But in terms of more macro cyclicality, Covid is probably not a great analog or scenario to use in terms of how aggressive of an environment that was. But what would you point to just in terms of if you do see general economic weakness, how exposed would the business be to something like that?
- [40:48]
Ramesh Narayanaswamy
There are several factors to consider here. Firstly, air travel, which is the end demand, is more or less discretionary to a large degree. And airlines are cyclical given their high fixed cost, high operating leverage, business model, who are the key customer in the aftermarket side of the business business. And today, if you look at load factors across industry, it's pretty much maxed out at low 80s, maybe 83%, 84%, which is unprecedentedly high. So any decline in air traffic will affect airline profitability quite significantly. Having said that, however, GE Pratt MTU are much more insulated from this due to a few reasons. The first is engine maintenance is not discretionary, is literally emission critical for airlines, and it's mandated by regulation. You can defer some of these expenditures, but eventually it has to happen. And related to other costs like fuel, which tends to be a large portion for an airline. This is a fairly small portion of airline opex. In addition, given the sole source nature of the aftermarket spare parts, GE has fairly significant pricing power which they have demonstrated through multiple cycles over the last 1020 years, including the pandemic where price increases went through. So there are multiple levels of protection and insulation for the engine makers in an economic downturn. It is also worth mentioning that the cyclicality of the engine makers has become much better since the financial crisis. You generally have better balance sheets overall. Today you have more disciplined management across all of the companies as well as more resilience through the pandemic. The closest comparable for GE operationally would be Safran, given their joint venture in CFM International. And if you look at Safran's results through the pandemic, they reported positive free cash flow even during 2020 when air traffic practically ground to a halt. So I would suggest that the businesses have become much more resilient and crisis ready overall compared to the previous cycle, including the pandemic.
- [42:49]
Matt Russell
On margins, you've laid out some of the difference in terms of revenues and the margin mix that you might see from a pickup in a certain revenue line. But can you lay out what that looks like for the business as a whole?
- [43:02]
Ramesh Narayanaswamy
For ge, the overall margin expansion that you've seen in the reported numbers has largely been driven by portfolio rationalization, much more than individual operating performance. Improvement. At GE Aerospace, for example, Vernova was loss making, which depressed overall reported margins for ge. If you take GE Aerospace specifically and within it, commercial engine services like for like margins have always been quite robust even outside the pandemic, for example hovering around 20% ish even before Larry Culp took over. You can also see that in Safran's reported numbers as well over the last 10 years or so, around 20% as well. In terms of operating margins, Rolls Royce more recently has reported 25% and historically has been 18% last year. And MTU Aerospace within their equivalent commercial engines business reports out of a 25, 26% kind of margin. So it's a very, very profitable business. GE in particular, in the last few years between 20 to 23 to 25 margins have improved, not to the same degree as the overall group margin suggests, but something like 500 basis points of margin improvement thanks to both pricing power and efficiencies that Larry Culp has brought.
- [44:15]
Matt Russell
About on the overall capital intensity of the business. It was interesting to hear that Saffron generated positive free cash flow in the midst of COVID What does the capex intensity look like? What are some of the aspects in terms of earnings and all the way to free cash flow conversion?
- [44:32]
Ramesh Narayanaswamy
There are a few nuances here. If you look at the headline capex numbers, headline capex for GE runs at a shade below 3% of revenues and about 10 or 15% of EBIT. So it's fairly low capital intensity. Earnings quality is also pretty high with pretty much 100% of conversion of earnings into free cash flow. However, it's worth bearing in mind that capex intensity at a point in time for this business can be quite misleading one way or the other. The correct framing is from a cash IRR perspective because engines cost a lot to develop and they suffer a lot of losses in the early phases and then they mature as the aftermarket earnings come through. They throw off a lot of cash and much, much higher margins towards a mature part of the cycle. So when you look at current CapEx.
- [45:19]
Intensity, you have to frame it within.
- [45:20]
The context of a fairly mature cycle where most of the engine makers, including ge, are entering sort of a harvest phase of cash flows. For instance, at GE, CapEx is now running slightly below DNA given the harvest phase. But obviously that is not going to be sustainable over the very long term. The better marker of capital intensity is probably return on capital. There are a couple of things to consider here for ge. GE has gone through a fairly intense transformation in the last few years, so the accounts still reflect the vestiges of that. It still has a legacy insurance business which is in runoff, it's got a pension deficit, it has significant goodwill on the balance sheet, and there are contract assets and liabilities based on the long term service agreements that they sign with airlines. So if you strip these out of their accounts and adjust for some of the intangible assets being operating in nature and try to get to a return on tangible operating capital employed, you get to something like 20 or 25% on a cash basis and that's a fairly good indicator of what the return profile of the business is as a sense check Safran is somewhere around 20, 25% as well. MTU and Rolls Royce is around 16 18%. So this is a fairly good return on capital business. It's very healthy, but they're not spectacular. What I would suggest, however, is that what you lose in ultra high returns on capital, you make up for in durability and visibility. All of the engine makers are ge, Safran, frat, mtu, Rolls Royce. They participate in programs with useful engine lives of 25 plus years. And much more importantly, it's a highly visible, highly certain earning stream, thanks to the regulations around safety and servicing and shop visits. So I would frame the return on capital within this context of unusually high visibility and durability, as well as unusually high barriers to entry. You're unlikely to wake up tomorrow and read that an AI startup has launched a new jet engine. So this is a very protected, highly visible, highly predictable earnings profile that you're looking at.
- [47:20]
Matt Russell
What does capital allocation look like in pairing with that? What do they do with the cash flows that they do have?
- [47:27]
Ramesh Narayanaswamy
So GE management have talked about all excess cash flows coming back to shareholders. Something like 70%, dividend payout runs at something like 30% and the rest is buybacks. Of course, whether the buybacks add value or not depends on the valuation the stock is trading at, but at least management intent is to be very disciplined with shareholder capital, which is very, very consistent with Larry's tenure at Danaha.
- [47:51]
Matt Russell
It's a fascinating snapshot of an industry and really the whole value chain. When you think about the actual risks here. What stands out the most to you beyond the headline things that can pop out?
- [48:03]
Ramesh Narayanaswamy
The complex supply chain and the reason the industry is so hard to get into, also gives rise to hundreds of technical challenges every day that you have to deal with. So that's a risk. More specifically and more topically, time on wing and reliability has been a key risk factor for most of the engines. The current generation of engines, Pratt's gtf, is suffering from it right now, with a potential fix on the way. Even the leap is still only maturing into the reliability that its Predecessor had, the CFM56. That's an ongoing challenge, especially in the earlier parts of the ramp up when the engines are still quite young. GE in particular has benefited from the troubles at Pratt and Whitney with the gtf, but it's something to watch whether or not some of the market share shifts that you've seen will revert against GE once Pratt fixes the issues and the GTF advantage enters into service. For example, but that's more or less ebbs and flows and the cut and thrust of the business. The much more longer term risk is measured in multiple decades. This is a long cycle business, so when you get it right, it endures. But the reverse is also true. If you study history, you know that Pratt and Whitney was maybe 60% of the commercial fleet in 1995 and now is less than 20%. So even the mighty fall GE is currently very well placed, but they need to stay relevant to keep that market leadership. The first threat I would point to on a structural basis is that of technology. GE has gone all in on open rotor architecture, the open fan architecture for the next generation aircraft, which may be at least a decade away, so it's not anything short term. Their argument has been that an open rotor with no casing reduces heat, which improves durability. And they believe that it's the only way to get to sort of a 20% fuel burn improvement in the next generation. If you look at sort of the bypass ratios for typical engines, they all hover around sort of the 10 to 12 times to 1 ratio. And open rotor might be 4 to 5x that so 40 to 50 times. So step change in the architecture of the engine. It could be a game changer for GE if they get it right. Having said that, Pratt and MTU and Rolls are pursuing a variant of the geared architecture, which is possibly lower risk but possibly lower upside as well, compared to ge, which is higher risk and higher upside. So it's a bit too early to tell. It really depends on how technology progresses, how and when Airbus and Boeing decide to go with these architectures and when they have to make that choice, as well as how the airlines receive it in terms of reliability and operational advantages.
- [50:42]
Matt Russell
On the side of the customer. Is there anything as it relates to changes with Boeing or just how, how aircrafts are produced that you would point to in terms of risk?
- [50:54]
Ramesh Narayanaswamy
In terms of manufacturing, it's always a challenge. The development of a new engine is pretty hard to begin with, but scaling it into production into tens of thousands of engines is order of magnitude even more difficult than designing the engine from a production perspective. GE is now gone through the worst of the leap ramp in terms of the difficulty and the learning curve. And if you look at how the production is slated to continue for the leap, you could make a good case that the losses from the OE side for leap should reduce quite substantially over the next five years to make it break even. That gives GE an additional level for earnings growth as well, because they are in a fortunate position that the CFM56, the previous generation engine fleet, is retiring more slowly than expected and therefore that gives them a cash cushion, so to speak, as the leap ramps into service. So overall that cash flow profile is going to be quite favorable over the next five to 10 years.
- [51:55]
Matt Russell
How about Boeing's stance in the industry? GE Obviously being a preferred partner there. Whether it's Boeing changing themselves or seeing Boeing lose share, how do you frame that risk and whether it's a real or less substantiated one.
- [52:11]
Ramesh Narayanaswamy
Boeing historically has shown a preference to GE as an exclusive engine partner, but that is not necessarily cast in stone for their next generation narrow body aircraft. For example, Boeing can choose to dual source given it's a very large market. Airbus is already dual source, for example, in the current generation and airlines generally tend to prefer more options. Having said that, multiple engine options is a logistical nightmare generally, which explains Boeing's logic and going for sole source positions, there is a possibility that the competition develops a credible engine program for Boeing to consider. If that happens, GE's 100% market share can only go down. Of course they can fight for exclusivity, but it might come at a cost if Boeing negotiate hard or that the economics are not particularly favorable.
- [53:00]
Matt Russell
And then just in terms of competitive threats, we've had breakdowns on businesses like Heico and Transdigm where there's PMA parts. They sit outside of the, you know, original manufacturers. How does that impact a business like.
- [53:18]
Ramesh Narayanaswamy
Ge on the PMA part?
- [53:21]
I think Heico is probably the exemplar of a fantastically well done aerospace business that focus on focuses on PMA parts. The engine business has been historically and continues to be relatively more protected from the PMA parts. Just to back up very briefly, PMA parts refers to parts manufacturer approval pma, which is effectively in simple terms the private label or the store brand version of the original parts that the manufacturers produce. The earliest and the most significant threat that the ecosystem faced from PMA parts was from Pratt and Whitney who tried to do something like 20 LLP Parts Life Limited parts on a PMA basis on the CFM56 engine. The GE engine reportedly cost several billion dollars, possibly and failed spectacularly. So that just tells you even a very credible entrant or industrial scale player, even within the ecosystem finds it very hard to manufacture as well as sort of credibly go to customers and steal share away from the oes. The reasons for this is several folders. The first is the technical complexity, the regulatory and the certification requirements and the second reason is most of the market today.
- [54:39]
So more than half the market today.
- [54:40]
Is with leasing companies who are effectively against the use of PMA parts. It voids the warranties, for example, that the OES provide. And even the OEs, the original equipment engine makers, provide material service agreements, other forms of protection that sort of make.
- [54:58]
It very hard for a new PMA.
- [54:59]
Part entrant to write the business case.
- [55:02]
Keep also in mind that in the.
- [55:04]
Early part of an engine's life cycle, you are not necessarily going to find good reliability data. The engine needs to be flying for a certain number of flight cycles before it becomes predictable in its behavior.
- [55:17]
So the real addressable market for a.
- [55:19]
PMA parts maker is only towards the latter half of an engines program. So when you sort of peel all those layers back, the true addressable market for a PMA part entrant is much smaller than it initially appears. On the aircraft side, for example, it is very different because Airbus and Boeing don't really offer a comparable sort of aftermarket solution. Whereas in the engine land you see long term service agreements and the spare parts that the OES effectively try and capture very effectively.
- [55:50]
Matt Russell
Just in terms of valuing these types of businesses, you could either talk about your approach or just how the market typically values these businesses and whatever types of frameworks or things that you would point to that stand out.
- [56:04]
Ramesh Narayanaswamy
I think valuation for these companies, the method that the market uses, tells you more about where we are in the cycle rather than anything about the value itself. So in a way, value is in the eye of the beholder. During periods of crisis, like in the pandemic for example, or previously in the financial crisis, you could do liquidation value analysis based on each engine in the fleet and the remaining useful cash flows you can extract from it to arrive at an NPV per engine in a fairly straightforward way. Given that there's very, very predictable and visible earning streams that you're looking at. In a way, the install base can be valued like a bond, an inflation protected bond. And there have been times when the market has priced in distress and these companies have been available for will proof of purchase below liquidation value. There is good logic to that approach, I would say, because theoretically each engine has a finite useful life, much like a toll road or a pharmaceutical drug pipeline. So I would suggest that conceptually this would be a good way of valuing it. Having said that, during normal periods like today, where we are sort of mid cycle, let's say, or when it's cruising altitude, the cash flow multiples or earnings Multiples tend to become the norm or become the shorthand. For example, today GE is price something like 40 times free cash flow. If you believe in low double digit growth in revenues and sort of low teens to mid teens growth in earnings per share and free cash flow per share over five and 10 years, you're buying it on 10 times earnings in 10 years time. So I would suggest that there's quite a bit of optimism about the future in the share price today. But again, value tends to be the eye of the beholder. My observation more broadly is that in this sector, value opportunities do arise either during a travel crisis like we saw in the pandemic, or a recession or a macro shock, or during periods where there might be a stock specific issue, like what happened with MTU around the GTF borrowed metal issues which caused a recall of the fleet and the stock dropped something like 10 or 11 times earnings. Outside of those environments, these stocks tend to be priced on earnings multiples based on expected growth and the certainty of that growth. And especially in an environment like today where that combination of predictable solid earnings growth is rare, today's valuations reflect that.
- [58:22]
Matt Russell
This has been a fascinating look and lens into a specific industry and then how GE fits in it. What would you say stands out as the lessons that you can take away from GE apply elsewhere?
- [58:35]
Ramesh Narayanaswamy
Given the technical complexity of making jet engines, it's hard to learn from GE in that regard. It's not like we can learn to make jet engines ourselves by observing ge. This is a case of do not try this at home type of thing. But jokes apart, the less obvious learnings from the engine business model is that the bifurcation of the buyer and the user is a recurring pattern in many engineering businesses. For engines, you have Airbus and Boeing as a OE customer, but the long term user being airlines. And whenever you have this kind of bifurcation, you set up conditions for a more complicated path for a new entrant, as you now have to solve sort of a 3D puzzle, so to speak. The other insight that I draw from GE is the importance of management culture and how some cultures emphasize growth and others emphasize durability. The most obvious one is sort of the importance of management culture in ge. So books like Lights out by Thomas, Greta and Ted Mann document some of the missteps that happened at GE in what became a culture that prioritized growth over durability amplified by balance sheet leverage. So even the mighty fall might be another lesson. And durability, rather than sort of a focus on growth, is another lesson, and the last one that comes to mind is how scarcity can drive value. There are not that many companies in the world that can do what GE does and that scarcity has what has provided the foundation for Larry Culp to come in, bring in focus, and crystallize that latent value embedded in the franchise.
- [60:10]
Matt Russell
Well, Ramesh, this has been a true pleasure. Thank you very much for joining us today.
- [60:15]
Ramesh Narayanaswamy
Pleasure, Matt.
- [60:17]
Podcast Host / Narrator
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- [60:24]
Matt Russell
Com.
- [60:25]
Podcast Host / Narrator
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