Business Breakdowns
· Matt Reustle, Ramesh Narayanaswamy
[00:00:00] S0: For that joint venture, I just have to ask: what is Safran doing and what is GE doing? [00:00:00] S1: 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 longstanding partnership, almost 50 years old at this point. It is one of the best models of joint ventures and risk- and revenue-sharing agreements in the industry. [00:00:00] S0: Interesting. Yeah, to have that longstanding of a joint venture and to be taking something as complex as this and splitting it amongst two businesses. So I can only imagine.
· Matt Reustle, Ramesh Narayanaswamy
[00:00:00] S0: Interesting. Yeah, to have that longstanding of a joint venture and to be taking something as complex as this and splitting it amongst two businesses. So I can only imagine. [00:00:00] S1: Technology also 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 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 and 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.
· Matt Reustle
[00:00:00] S0: 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?
· Ramesh Narayanaswamy
[00:00:00] S1: 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 segment is the aircraft airframers, so Airbus, Boeing, and COMAC. 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. They have a huge influence in terms of engine choice and 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. You typically sell the OE engine at a loss or breakeven at best and make up for it in the aftermarket. Now, the second customer group that ties into the aftermarket is the airlines. Once an aircraft starts flying, it's owned and operated for 20 or 30 years by the likes of Delta or American or Emirates or Ryanair. That industry—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 in for servicing at some point, and if they don't choose an OE spare part, they lose the warranty protection on the engine. 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 your engineering customer and another who is your usage-based customer also leads to significant barriers to entry for new entrants, and it informs 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 to 22 million, so almost 20% of the list price of the aircraft itself. This is for delivery 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.
· Ramesh Narayanaswamy
You have negative margins until you get to maturity, which the LEAP is fast approaching. At that point you start selling to the OE on a breakeven 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, very different from the headline price of 20 or 22 million. On the aftermarket side—which is the revenue they get from airlines and lasts 20, 25, 30 years—this is extremely profitable, as spare parts and service revenues are effectively exclusive to the engine makers. Regulations mandate that you need to bring in these engines for servicing after a certain number of flight cycles, typically every six, seven, or eight years. And airlines typically don't want to use alternatives to the original spare parts, as it voids the warranty protection. 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 three-quarters service revenue and 25% OE. 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 business.
· Matt Reustle, Ramesh Narayanaswamy
[00:00:00] S0: 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. It's a much smaller, steeper difference in terms of how much is made on the back end. I'm just curious about your point on the engine sales being done at very steep discounts up front and then that being slowly closed in terms of what the discount is as the program matures. Is there anything to that? I’m 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? [00:00:00] S1: The discounts tend to be more in the commercial side of the business. This is not a feature that you'll see in business jets or regional jets or even military applications, where there's a much more consistent margin profile between the OE and the aftermarket. The steep discounts that you see on the OE side are 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.