Business Breakdowns
· 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.
· Ramesh Narayanaswamy, Matt Reustle
And especially in an environment like today, where that combination of predictable, solid earnings growth is rare, today’s valuations reflect that. [00:00:00] S0: This has been a fascinating look and lens into a specific industry and then how GE fits in it. What would you say stands out as the lessons that you can take away from GE and apply elsewhere?
· Ramesh Narayanaswamy
[00:00:00] S1: Given the technical complexity of making jet engines. It’s hard to learn from GE in that regard. It’s not like we can learn to make jet engines ourselves by observing GE. This is a case of “do not try this at home” type of thing. But jokes apart, the less obvious learnings from the engine business model are that the bifurcation of the buyer and the user is a recurring pattern in many engineering businesses. For engines, you have Airbus and Boeing as the OE customer, but the long-term user being airlines. And whenever you have this kind of bifurcation, you set up conditions for a more complicated path for a new entrant, as you now have to solve sort of a 3D puzzle, so to speak. The other insight that I draw from GE is the importance of management culture and how some cultures emphasize growth and others emphasize durability. The most obvious one is the importance of management culture in GE. Books like Lights Out by Thomas Gryta and Ted Mann document some of the missteps that happened at GE in what became a culture that prioritized growth over durability, amplified by balance-sheet leverage. So “even the mighty fall” might be another lesson. And durability, rather than a focus on growth, is another lesson. And the last one that comes to mind is how scarcity can drive value. There are not that many companies in the world that can do what GE does, and that scarcity is what has provided the foundation for Larry Culp to come in, bring in focus, and crystallize that latent value embedded in the franchise.
· Matt Reustle, Ramesh Narayanaswamy
[00:00:00] S0: Well, Ramesh, this has been a true pleasure. Thank you very much for joining us today. [00:00:00] S1: Pleasure, Matt.