Business Breakdowns
· 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.
· Matt Reustle, Ramesh Narayanaswamy
[00:00:00] S0: And when did the LEAP engine come into service? [00:00:00] S1: First, 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. The useful life of an aircraft is 25 years. So still a very, very young program that will deliver earnings for decades to come. [00:00:00] S0: And then on the defense side, I'm sure it's exposure to defense budgets. Is there anything else that goes into that growth equation? [00:00:00] S1: On defense, it does tend to grow in line with defense budgets, with an additional uplift depending 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 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. [00:00:00] S0: Just in terms of the cyclicality of the revenue, there's the longer cycles of aircraft 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?
· Ramesh Narayanaswamy
[00:00:00] S1: 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 costs and high operating leverage business model. They are the key customer on the aftermarket side of the business. And today, if you look at load factors across the 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; it is literally mission-critical for airlines, and it's mandated by regulation. You can defer some of these expenditures, but eventually it has to happen. And relative 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 10–20 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.
· Matt Reustle, Ramesh Narayanaswamy
[00:00:00] S0: 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? [00:00:00] S1: For GE, the overall margin expansion that you've seen on 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. MTU Aero Engines, within their equivalent commercial engines business, reports around a 25–26% kind of margin. So it's a very, very profitable business. GE in particular, in the last few years — between 2020 to 2023 to 2025 — 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 about.