Business Breakdowns
· 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.
· Ramesh Narayanaswamy, Matt Reustle
[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. [00:00:00] S0: On the overall capital intensity of the business. It was interesting to hear that Safran 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?
· Ramesh Narayanaswamy
[00:00:00] S1: 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% to 15% of EBIT. So it's fairly low capital intensity. Earnings quality is also pretty high, with pretty much 100% 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 the mature part of the cycle. So when you look at current CapEx intensity, you have to frame it within the context of a fairly mature cycle where most of the engine makers, including GE, are entering a sort of harvest phase of cash flows. For instance, at GE, CapEx is now running slightly below D&A 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 are 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, Pratt, MTU, Rolls-Royce.
· Ramesh Narayanaswamy, Matt Reustle
They participate in programs with useful engine lives of 25-plus years. And much more importantly, it's a highly visible, highly certain earnings 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. [00:00:00] S0: What does capital allocation look like in pairing with that? What do they do with the cash flows that they do have? [00:00:00] S1: So GE management have talked about all excess cash flows coming back to shareholders. Something like 70% dividend payout run rate, 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 Danaher. [00:00:00] S0: 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.
· Ramesh Narayanaswamy
[00:00:00] S1: 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 part of the ramp-up when the engines are still quite young. GE in particular has benefited from the troubles at Pratt & 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 & 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 5× 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.