Business Breakdowns
· 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.
· Ramesh Narayanaswamy, Matt Reustle
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. [00:00:00] S0: On the side of the customer, is there anything as it relates to changes with Boeing or just how aircraft are produced that you would point to in terms of risk? [00:00:00] S1: 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 has 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 breakeven. 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 ten years.
· Ramesh Narayanaswamy, Matt Reustle
[00:00:00] S1: 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 has 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 breakeven. 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 ten years. [00:00:00] S0: 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?
· Matt Reustle, Ramesh Narayanaswamy
[00:00:00] S0: 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? [00:00:00] S1: 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 in 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. [00:00:00] S0: 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 GE?
· Ramesh Narayanaswamy
[00:00:00] S1: On the PMA part, I think HEICO is probably the exemplar of a fantastically well-run aerospace business that 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 & 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 are several fold. The first is the technical complexity, the regulatory and the certification requirements. And the second reason is most of the market today. So more than half the market today 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 and other forms of protection that sort of make it very hard for a new PMA Part entrant to write the business case. Keep also in mind that in the early part of an engine’s lifecycle, 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. So the real addressable market for a PMA parts maker is only towards the latter half of an engine’s 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. 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.
· Matt Reustle
[00:00:00] S0: 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.