Business Breakdowns
· 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.
· Ramesh Narayanaswamy, Matt Reustle
[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. [00:00:00] S0: It's an interesting nuance that I can somewhat understand. There are 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 are actual service contracts, whether warranty comes at a certain price up front—just the dynamics going on there?
· Ramesh Narayanaswamy
[00:00:00] S1: 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, six, or seven years. That's 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 revenue model. Here GE would offer a per-flight-hour cost that the airlines can pay so they can convert what is effectively capex into opex. The cost can—but not always—include 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 have been reducing meaningfully. In many cases, when long-term service agreements are offered, the spare parts—or the life-limited parts, as they're 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, the airlines take the risk. You typically see this when an engine with proven reliability is very mature. In long-term service agreements, the engine makers take the risk, so you effectively have underwritten a certain set of cost and reliability assumptions in 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 hour—so pay-as-you-go. On the wide-body side, the proportions are a bit higher: 60 to 70% are on long-term contracts, and 60 to 80% of that is on a pay-by-hour basis.
· Matt Reustle
[00:00:00] S0: 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?
· Ramesh Narayanaswamy
[00:00:00] S1: 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 an 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 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 multiplier 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, it's 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 1.5x 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 the predecessor engine — the CFM56 — that it's 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's a lot of latent growth still, which is extremely predictable because eventually the engines have to come in for a shop or sale. In addition to this, aftermarket pricing continues to be quite strong. It's particularly strong today since the pandemic, but will remain at least 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 provide something like an 8 to 10% clip, very predictably, with high visibility over at least the next five years.