Business Breakdowns
· 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.
· Ramesh Narayanaswamy
[00:00:00] S1: I think valuation for these companies—the method that the market uses—tells you more about where we are in the cycle rather than anything about the value itself. So, in a way, value is in the eye of the beholder. During periods of crisis, like in the pandemic, for example, or previously in the financial crisis, you could do liquidation-value analysis based on each engine in the fleet and the remaining useful cash flows you can extract from it to arrive at an NPV per engine in a fairly straightforward way. Given that there are very, very predictable and visible earning streams that you’re looking at, in a way, the installed base can be valued like a bond—an inflation-protected bond. And there have been times when the market has priced in distress, and these companies have been available for, well, proof-of-purchase below liquidation value. There is good logic to that approach, I would say, because theoretically each engine has a finite useful life, much like a toll road or a pharmaceutical drug pipeline. So I would suggest that conceptually this would be a good way of valuing it. Having said that, during normal periods like today, where we are sort of mid-cycle, let’s say, or when it’s cruising altitude, the cash-flow multiples or earnings multiples tend to become the norm or become the shorthand. For example, today GE is priced at something like 40 times free cash flow. If you believe in low double-digit growth in revenues and sort of low-teens to mid-teens growth in earnings per share and free cash flow per share over five and ten years, you’re buying it on 10 times earnings in ten years’ time. So I would suggest that there’s quite a bit of optimism about the future in the share price today. But again, value tends to be in the eye of the beholder. My observation, more broadly, is that in this sector, value opportunities do arise either during a travel crisis, like we saw in the pandemic, or a recession or a macro shock, or during periods where there might be a stock-specific issue—like what happened with MTU around the GTF powder metal issues, which caused a recall of the fleet and the stock dropped to something like 10 or 11 times earnings. Outside of those environments, these stocks can be priced on earnings multiples based on expected growth and the certainty of that growth.