GE Aerospace：油门全开【Business Breakdowns 第235期】

This is Matt Russell and today we are breaking down GE Aerospace. Now if you go by tickers, we did break down GE several years ago, but that episode focused on how Larry Culp at the time was turning around that Titanic that was GE the conglomerate. Today, Ramesh Narayanaswamy, co-founder and portfolio manager of Tubian Partners, joins me to go deeper on what is now a pure-play aerospace business. So, we get into some of the unique dynamics of the supply chain in aerospace, the long-cycle nature that differentiates it from many other industries that you look at. And I marvel a bit on the complexity that is aircraft-engine manufacturing, but not for long because this is another beautiful example of selling services attached to equipment. And I first met Ramesh back in the summer of 2024 at a Business Breakdowns event. It did not take long for me to appreciate his approach around finding these businesses with unique scarcity or scale benefits, and I finally got him on Business Breakdowns. So, please enjoy our conversation on GE Aerospace. All right, Ramesh, I am pumped to have you here. We're covering GE Aerospace today, and some listeners may remember we covered GE just a couple of years ago. This was prior to the spin-offs and the creation of these pure-play entities. We thought it was a good opportunity to come back to this name, particularly with how the story has played out over the past few years and even prior to that initial episode.

I thought the best place to start was just a reintroduction to GE, but specifically GE Aerospace, and a simple explanation of what it is that they do. What do they sell, and where do they operate in the aerospace spectrum?

1. GE Aerospace Engine Empire

Well, thank you for having me, Matt. First of all, it's really exciting to discuss aerospace. In terms of what GE Aerospace does, at its core, they sell jet engines for both commercial as well as defense and military applications.

The total fleet of GE Aerospace engines is about 70,000, broken down roughly between commercial and military: 45,000 engines in the commercial application space and 25,000 engines in the military space. Taking it one by one, on the commercial side, if you look at the 45,000 engines that are in service and the aircraft that they touch, GE powers something like 3 out of 4 commercial takeoffs pretty much every day. This includes a mix of engines where they are the sole-source provider for an aircraft, as well as programs where they have a holistic kind of market position.

Within commercial aircraft, there are 3 subsegments. One is the narrow-body segment. Think short-haul flights, like New York to Chicago. Their older-generation engines are called CFM56, which is sort of an industry benchmark. It has a very long-standing reputation for quality, reliability, and performance. It powers all Boeing 737s, the entire family, and just over half of the Airbus A320 family. This is an engine that has been in production for a while and is now sunsetting.

Their newer engines, which are currently in production, are called LEAP, short for leading edge aerospace propulsion. These engines power the Boeing 737 MAX, again in a sole-source position, and the Chinese COMAC C919, also in a sole-source position. So, they have pretty much 100% market share there, and just over half, or 60%, of the Airbus A320neo family. Overall, in the narrow-body segment, GE has something like a 70% share of that space.

On the wide-body side, which is long-haul flights—think London to Tokyo—they have something like a 50% share of the wide-body fleet and backlog. Here, you're talking about aircraft like the Boeing 787, where GE's engine is called the GEnx, with something like an 80% share of the backlog. On the Boeing 777, the GE90 engine also has something like an 80% share. And on the Boeing 777X, when it does enter into service, the GE9X is going to be the sole-source engine for that program. They have fairly dominant positions in a duopolistic landscape within the wide-body space.

Finally, to round things out, they also sell engines for regional jets and business jets. This includes aircraft like Bombardier, with the Passport engine, and Embraer, which uses the CF34 series. Within the commercial side, they're fairly well balanced. Half of their exposure is through narrow-bodies, about 35% is through wide-bodies, and about 15% is through regional and business jets.

Of those 3 categories, the wide-body engines maybe have slightly less market share, but they're making up a big chunk of that revenue. Are wide-body engines any more or less profitable than narrow-body engines? Is there a distinction you would make between those 2 categories in terms of what might be a higher-quality business line?

Historically, the narrow-body side has been more scaled because of the sole-source position they have with Boeing, which is roughly half the market, and because they have significant shares—nearly half to 60%—on the Airbus family. So, the narrow-body segment has been the key driver for GE over the long term.

They go to market on the narrow-body side through a joint venture with Safran called CFM International, which has been one of the most successful aviation franchises in history. In terms of profitability, there is no meaningful difference. Both wide-bodies and narrow-bodies are profitable, with something like 20% margins.

I would guess that, given the way the cash flows work in terms of the old fleet retiring and the new fleet coming on at different points in time, the narrow-body fleet might be more profitable for them by a few percentage points, perhaps. But despite the difference in market position, GE has done a phenomenal job delivering roughly 20% overall margins across those programs.

And then the military exposure as well. How would you frame that in terms of exposure and share, to the extent that they disclose that?

On the military side, it's more useful to think about how many programs and platforms they are on. They have something like 25,000 engines in their fleet. This includes engines for programs like the F/A-18 Hornet and Super Hornet fighter aircraft. It also includes nearly two-thirds of all U.S. military aircraft, including helicopters. So, it's a fairly diversified portfolio.

One thing I would note is that GE has not been as scaled as somebody like Pratt & Whitney on the defense side. Historically, for example, they lost out on the F-35 fighter program in terms of being able to provide the engines. Pratt provides the engine there.

Program by program, there can be changes. Overall market share is probably not as good a metric, and it's much more useful to look at program participation in the key programs that they're on.

Is there anything else besides those 2 lines that GE still has?

They do have a Defense and Propulsion Technologies business. Outside of the defense programs, something like 12% to 15% of the business is in propulsion technologies, which includes aircraft equipment businesses that go into both commercial and military applications. But overall, in terms of the revenue mix, commercial is overwhelmingly dominant, at nearly 85% of revenues, and in terms of profitability, it's even more pronounced.

I would also add that they do report insurance revenues, which is sort of a legacy part of GE given its intense transformation over the last few years. About 10%—less than 10% now, or about a mid-single-digit percentage—of their overall revenues comes from insurance. Though that has now been run off, it's not really a portion of the business where they're committing new capital.

Just to give some scale around the revenue base today, how big are they from a top-line perspective?

This year, they'll report something like $40 billion in revenues, of which 75% is commercial engines and services and 25% is defense and propulsion technologies. Due to the difference in profitability, the commercial engine and services business has roughly 25% operating margins. The other businesses—defense and propulsion technologies—tend to have more like 11% to 12% margins.

So, in terms of earnings contribution, you're really looking at a commercial engine franchise here in GE.

I assume that the way these cycles work, particularly with either replacements or new fleets coming out, you have pretty good visibility in terms of backlog and deliveries, or that revenue number and where it goes over the next couple of years.

Absolutely. If you look at how the aftermarket works, 70% of GE's revenues overall come from services. That consists of spare-parts revenues and services revenues from the installed base. Typically, engines are mandated to come in for overhauls and shop visits, purely from a safety and regulatory perspective. This gives rise to an extremely predictable earnings stream in the aftermarket, which also tends to be the more profitable earnings stream.

And just on the backlog point, I understand it's a smaller percentage of revenue relative to services, but can you contextualize what backlog looks like now and maybe how that compares to history? Whatever framing you think would be most effective.

Absolutely.

2. The Backlog Visibility Advantage

The backlog is one of the more interesting underpinnings of GE’s 5- to 10-year outlook. Their current backlog is something like $175 billion. On a headline basis, that’s 4.5 years of revenue. But underneath that, there are a few nuances. If you strip out just the commercial backlog, which obviously is the majority of the business, that’s closer to 6 years. And within that, if you take out just the services element of revenue, which obviously is the key profit pool that GE Aerospace enjoys, that’s closer to 7 years.

So we have a very unusually long backlog and visibility for GE. To put it in context, this is not unusual in the supply chain. If you look at the airframers themselves, both Airbus and Boeing, with their current production rates, are running at close to a decade’s worth of backlog. So there’s very strong visibility throughout the OE as well as the engine ecosystem.

And relative to, let’s say, 5 years ago or 10 years ago, are those numbers—4.5 times current revenue, 10 years of backlog for the airframers—meaningfully higher, lower, or in line with where they’ve been historically?

I would say they’re moderately higher than historical averages, but not substantially. Aerospace generally has very long-term cycles, and that allows these companies to have significant backlogs and visibility in terms of how these engines are produced, because they need to tie in with the airframers in terms of their production. They’re very closely knit in the supply chain. Secondly, because of the increasing prevalence of long-term service agreements, that has also ticked up in terms of how much visibility the backlog gives you.

And for a business like GE, I’ll use the simple numbers: somewhere in the range of 4 to 5 times revenue in terms of backlog, or 4 years’ worth looking out. Is that lumpy in terms of seeing a major realization of backlog 2 years out, but maybe having a slow year next year? Does the lumpiness drive anything, or is it realized pretty evenly over the course of those 4 years?

That’s a good question. On the services side of things, which is something like 70% of the backlog, you should see a fairly predictable, steady evolution of the burn rate, so to speak, of the backlog converting into revenue. On the OE side, that is somewhat lumpier because that sort of ties into production rates at Boeing and Airbus. If there are any issues in terms of either the supply chain or their production run rates, you will see some lumpiness.

But given that Boeing has fixed the sorts of issues it has had in the last few years, and Airbus as well has been on a pretty good rhythm, I would say both the OE and the services backlog today seem well positioned to have a fairly steady cadence over the next 5 to 10 years. This is outside of things like pandemics and recessions, so to speak. On a normalized run-rate basis, we should be able to see fairly steady growth of that revenue and earnings.

Yeah, and calendar years and quarters shouldn’t matter as much as they sometimes do in the markets. Many times investors will see through, but it’s interesting to note and hear nonetheless. Maybe we could revisit the GE pure-play story. We captured it to some extent in the previous episode, but it’s played out even more. We don’t have to spend too much time on the origin stories of GE; we can hit on that. I want to talk a little bit about Larry Culp in particular and some of the moves that he’s made. Do your best to outline some of the key milestones and things that really were done that moved the Titanic around when it was struggling for so long. What would you point to? Because I think the track record from Danaher was there to point to, but he certainly followed through with some of the execution on the GE side.

3. Larry Culp Rebuilds GE

GE goes back more than 100 years. It's a company that dates back to none other than Thomas Edison. For most of the previous couple of decades, GE was probably the very definition of a conglomerate, with a very diverse portfolio of businesses operating in industrials, healthcare, and financial services. But if you look at business history, there are very few things as reliable as a cycle of conglomeration and then deconglomeration. Under the time of Jack Welch and Jeff Immelt, their eras were defined by a focus on growth, on market share through acquisitions, and what I would call earnings-per-share management. A big part was played by GE Capital, which exposed a lot of leverage in the system, and the various businesses housed under GE were competing for capital and there was no true business rationale holding them together. Now all of that changed with the arrival of Larry Culp, who was really the first outsider CEO at GE. Culp was on the board at GE during the brief tenure of John Flannery, and he took over as CEO in October 2018. Now Culp, for those who follow industrial businesses, is a very well-known and proven operator and capital allocator and had a fantastic performance, both operationally and stock-price-wise, at Danaher, where he was CEO from 2001 to circa 2014. So if GE needed to deconglomerate, then Larry Culp was the perfect choice. In simple terms, I would say Larry brought the Kaizen-like lean-manufacturing principles that he was so successful implementing at Danaher to GE. To use a sort of Japanese phrase, he walked the gemba, as they call it—i.e., went to the place where value is being added, the manufacturing floor, the shop floor—and really focused on very basic ideas of continuous improvement and problem-solving. More importantly, he addressed the “don’t shoot the messenger” culture, which was badly needed at GE, and also crucially focused on the customer. I think I’ve heard Larry describe his philosophy as “common sense vigorously applied,” which is probably a good phrasing of what he did at GE.

For GE in particular, that meant simplification, deconglomeration, and focus. So he spun off the healthcare assets as GE HealthCare, the power businesses as GE Vernova, focused on debt reduction, and what we’re left with is just the aerospace assets.

What do you think led him to sticking with the aerospace assets versus going with healthcare or Vernova? It’s just an interesting choice. It might have simply been market size, but do you think there’s anything there in terms of what led him to continue on with this specific business line?

If you go back in time to 2020, the board awarded Larry a one-time performance grant to incentivize him to stay. It was at the very high end of what you would normally see—something like $200 million in shares based on certain stock-price targets. It was a little bit controversial at the time, simply because the share price was depressed given the fact that we were reeling from the pandemic. But it also aligned outcomes between management and shareholders. Similarly, a very similar grant was made in 2024, again tied to operating metrics but on a smaller scale compared to the 2020 grant.

As to why Larry decided to become CEO of GE Aerospace rather than Vernova or HealthCare, a couple of things I would point to: one might have been the fact that he was historically well-versed in industrial businesses, so Danaher; and second, perhaps it was an implicit indicator of how strong aerospace was compared to their other segments, and he wanted to be the CEO of the crown-jewel asset, so to speak.

You referenced some of the market shares that they have in this jet-engine business. Can you just bring us back in time in terms of the origins of that industry, and that’ll lead us on to how GE has captured the share and foothold that they have? I have some sense that when jet engines came around, it was probably correlated to when airplanes came around, but maybe you can lay that out for us.

4. The Jet Engine Barrier

The jet-engine business is nearly 100 years old, so it’s a fairly long time. It was first invented in the 1930s here in the UK. Actually, the first jet engine built in the US, however, was a GE engine, which incidentally was a copy of the British engine developed by Frank Whittle. Historically, you would find that as technologies develop, they become cheaper to manufacture and scale. But what we have observed in jet engines is that this has not necessarily been the case. Even inflation-adjusted jet engines still cost at least several billion dollars to make. And if you look at the most recent Pratt & Whitney geared turbofan engine, it reportedly cost Pratt something like $10 billion.

Now, it’s a good question to ask why that is the case. I would suggest that because jet engines are constantly pushing at the leading edge of materials technology and engineering, and we’re tackling new problems at the frontier, that keeps costs high and entry barriers high as well. It’s the type of product that I don’t mind if it’s a little bit more expensive as well, given what it actually does and how I might be a user of it.

Let’s discuss GE’s evolution in that space, in terms of leading to this place where you always hear about the duopoly at the top in terms of the OEMs, with Boeing and Airbus, but not so much about the rest of the value chain. Who else is in the jet-engine market? I think you’ve referenced Pratt & Whitney a few times, but how has that evolved over time?

First, to maybe set the scene, it’s worthwhile putting the industry in context and explaining why it’s so hard to make a jet engine. In simplest terms, the barrier to entry into the industry is the requirement to have both extraordinary technical performance at extraordinarily low cost. Making a jet engine at scale is one of humanity’s toughest technical challenges, right up there with semiconductor fabrication, manufacturing biologics, or even things like reusable rockets.

So this is a very hard technical challenge to overcome. Just to give you a flavor of what engines have to deal with in commercial aerospace, which we take for granted every time we take a flight: within the hot section of the engine, inside the high-pressure turbine, temperatures can exceed the melting point of alloys. When you stop to think about it, it is quite mind-boggling.

Similarly, engines have to withstand and be tested extensively in a variety of harsh conditions, including extreme cold, extreme heat, dusty conditions, and bird strikes, against which they have to be resilient. Bird strikes happen more commonly than you think. Even at the manufacturing level, atomic-scale defects can be catastrophic. For example, in the most recent issue that Pratt & Whitney had with the geared turbofan, they found a microscopic contaminant in the manufacturing process, which led to a worldwide grounding of the entire fleet.

So even extremely small issues can cause significant aftereffects and significant catastrophic losses for the engine makers. Now, once you have solved these technical problems, you need to convince Airbus and Boeing that you can manufacture and supply this at scale, and then convince the airlines that it will be reliable to operate for decades on end, all at a cost of ownership that is competitive based on worldwide global aftermarket support. And, by the way, you also need to sell at a loss to Airbus and Boeing before you can see the first profit from spare parts in 5 or 10 years' time from the airlines.

This is an extraordinarily difficult industry with very significant technical barriers, in addition to regulatory barriers, where, rightly, regulators require extensive certification and safety testing of aircraft and every single part that goes into an aircraft, including the engines.

It's a marvel in terms of what they've been able to do. Who's on the other side of the spectrum beyond Boeing and Airbus? What goes into those partnerships and relationships that creates the ecosystem that now exists, where you do have certain parts of the value chain entirely relying on each other?

When you look at jet engine makers—the primes—you only have 3 or 4 companies that can do this at scale. GE is one of them, along with Safran. Rolls-Royce is one of them, and Pratt & Whitney and MTU.

Given the history of the industry, you can see that Rolls-Royce, for example, collapsed in the 1970s and had to be nationalized while trying to develop the RB211 engine, which was ironically a successful engine and the basis of their current Trent architecture, but they almost went bankrupt doing it. Similarly, if you think about state-owned companies, including China's COMAC, which has deep manufacturing muscle in China, it chose a GE or CFM engine to power its latest aircraft. While it's developing its own engine, it just shows you the barriers to entry that even extremely scaled players and serious new entrants face when tackling this industry.

Given these challenges in developing engines, it is not a surprise to see that most of the companies in the space enter into risk- and revenue-sharing agreements or joint ventures simply to mitigate and share the risk and revenue when they are trying to develop new engines. For GE, the most prominent of those is in its narrow-body segment, where it has a joint venture with Safran. It's a 50-50 joint venture with Safran called CFM International, which we spoke about before.

Through the CFM International program, you have a very strong presence that GE has on the Boeing platforms, which are sole-source, and the Airbus platforms, not to mention COMAC, which is also sole-source with GE.

For that joint venture, I just have to ask: What is Safran doing, and what is GE doing?

Historically, CFM International has been a 50-50 joint venture. GE historically has done more on the hot side of the engine, and Safran has done more on the cold side of the engine, but effectively everything is split 50-50 in the partnership, and it's a very long-standing partnership, almost 50 years old at this point. It's been one of the best models of joint ventures and risk- and revenue-sharing agreements in the industry.

Interesting. Yeah. It's interesting to have a joint venture that's been running that long and to be taking something as complex as this and splitting it between 2 businesses. So I can only imagine—

Technology also plays a role in terms of how these market shares evolve. It is not just the case that you only have a few players and therefore tend to have consolidated market positions. When it comes to choosing an engine, you have 2 choices that are really being made. One is at the Airbus-Boeing level. They can decide if they want to go sole-source, which is a strategic decision as well as a technical decision in terms of how much more efficient an engine is compared to the predecessor it is replacing.

For example, the Boeing 737 is sole-source with GE, but Airbus offers 2 engine options. Similarly, airlines can also choose engines based on their reliability. Most critically, they look at time on wing, which is a metric that airline operators care a lot about in terms of availability and reliability. Remember that these engines need to fly for 10 hours a day for years and years at a stretch before they can be brought in for servicing.

So the total cost of ownership over 20 or 25 years, which is the life of an engine, is extremely important for airlines. This combination of factors in the industry—both the barriers to entry we spoke about and the choices that Airbus and Boeing have made in terms of sole-source or dual-source—has made the industry extremely consolidated and GE a dominant player in the industry.

When I'm thinking about the revenue model itself, I'm sure there's a price that they're offering, but there's got to be some scaled pricing incentives. Can you talk a little bit more about the revenue model? Again, because these new fleets and whatnot get scheduled out for such long periods of time, I would imagine there's visibility, but some of the more interesting details and nuance to it would be interesting to hear about.

5. The Aftermarket Profit Flywheel

Before we get into the revenue model, it's important to think about who the buyer is. Within commercial aerospace, there are actually 2 distinct customer segments. The first customer segment is the aircraft airframers: Airbus, Boeing, and COMAC. They make the aircraft itself. Hence, the engine is sold to them as an original equipment product.

But because Airbus and Boeing are so dominant in manufacturing, they can exert enormous negotiating leverage against engine makers and the entire supply chain. So they have a huge influence in terms of engine choice and technology, and whether or not they want to offer engine options, as we spoke about just before. So there's not that much profit on the OE sale for an engine maker because of this. You typically sell the OE engine at a loss or break-even at best and make up for it in the aftermarket.

Now, the second customer group that ties into the aftermarket is the airlines. Once an aircraft starts flying, it's owned and operated for 20 or 30 years by the likes of Delta, American, Emirates, or Ryanair. That industry, i.e., the airlines, is a very fragmented industry. There are hundreds of airlines. So the engine makers are in a much better position in terms of negotiating leverage to make a profit, and they do, because typically in the aftermarket, airlines have to bring the engines in for servicing at some point. Typically, if they don't choose an OE spare part, they lose the warranty protection on the engine.

Therefore, the engine makers tend to get spare-parts revenues, which are very lucrative and very high margin. So this bifurcation of one buyer who is your engineering customer and another who is your usage-based customer also leads to significant barriers to entry for new entrants, and it informs the revenue model.

When it comes to the revenue model, we have 2 different customer groups. The first is the OE. If you look at the LEAP engine, which is the current in-production next-generation engine for GE, the list price of a LEAP engine might be something like $20–22 million. So, almost 20% of the list price of the aircraft itself. This is for delivering to Airbus, Boeing, or COMAC.

Typically, on the OE side, you sell at a very deep discount. It can be up to 70% or 80% until the program is mature or you're delivering spare engines. So you generally end up making losses on the OE side. You have negative margins until you get to maturity, which the LEAP is fast approaching. At that point, you start selling the OE on a break-even basis. So you still don't make any real profit margin on the OE sale.

If you look at GE, for example, revenue per engine typically is around $6 million. So that's very different from the headline price of $20–22 million. On the aftermarket side, the revenue that they get from airlines lasts 20, 25, or 30 years. This is extremely profitable, as spare-parts and service revenues are effectively exclusive to the engine makers, and regulations mandate that you need to bring in these engines for servicing after a certain number of flight cycles—typically every 6, 7, or 8 years. Airlines typically don't want to use alternatives to the original spare parts, as it voids the warranty protection on them. So this revenue stream is extremely profitable. You're looking at something like a 60% gross margin on the aftermarket.

Now, the mix within GE's commercial engine services segment is 3/4 service revenue and 25% OE. Given overall margins of 25%, you can see how profitable the service component is. Though none of the companies really report this, it would not be unthinkable if operating margins for the aftermarket were 40% or better. And that is overwhelmingly the most important economic driver for engine makers. More importantly, typical aircraft lives are 25 years plus.

So from an NPV perspective, this multidecade aftermarket profit is really what drives value for GE. Over the life of an engine, the aftermarket can be 3 to 4 to 5 times the OE sale. That really drives the value for the business.

Now, here, in terms of upfront sales versus service costs, sometimes 50/50 is the model, but this feels like it's a little bit different in terms of what's going on. It's a much steeper difference in terms of how much is made on the back end.

I'm just curious about your point on engine sales being done at very steep discounts upfront and then that discount slowly closing as the program matures. Is there anything to that? I'm a bit surprised it's not smoothed out over the entire life of the engine program or the particular aircraft program. Do you know what goes into that and what drives that huge discount upfront?

The discounts tend to be more on the commercial side of the business. This is not a feature that you'll see in business jets, regional jets, or even military applications, where there's a much more consistent margin profile between the OE and the aftermarket.

The steep discounts that you see on the OE side are simply a function of the fact that Airbus and Boeing are very powerful and very consolidated, and therefore they can drive significant volume leverage on the supply chain, including GE and the engine makers.

It's an interesting nuance that I can somewhat understand. There are certain aspects about it that I have a hard time wrapping my brain around, but I certainly understand the power they have on the aftermarket.

Can you detail a little bit more about the revenue model there? You went into exactly what's happening, but are there actual service contracts or warranties? Does it come at a certain price upfront? What are the dynamics going on there?

On the aftermarket side, there are 2 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 5, 6, or 7 years. That's the traditional model.

The second model is long-term service agreements, or, in the industry, 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. They can convert what is effectively CapEx into OpEx, and the cost can, but does not always, include the cost of overhaul and spare parts.

In a way, GE takes more risk. It's like selling insurance contracts to the customer. However, the mix of long-term contracts has more recently been reducing meaningfully, and 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.

The basic difference between the 2 models is who bears the risk of the engines being reliable. In the time-and-materials world, the airlines take the risk. Typically, you see this when an engine has proven reliability and 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 widebody 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-the-hour basis.

Talking a little bit about the growth model and how they grow, there are probably some obvious ways, just in terms of new aircraft entering the market. How would you lay that out strategically?

6. Air Travel Drives Growth

On the commercial side, overall commercial travel is the tailwind here. It is reported that something like 3 out of 4 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, or RPKs, they tend to grow in the mid-single digits, which historically has been 2 times GDP growth. That multiplier varies substantially between developed and emerging markets.

In developed markets, the multiplier clusters around 1. It could be anywhere from half of GDP growth to 1.5 times GDP growth. But on the emerging-market side, it is significantly higher, so it's 3 times 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 1.5 times GDP.

In addition to that, GE in particular has more levers for growth, in terms of its installed fleet growing faster than the rest of the market. For GE, the LEAP engine is over time expected to be twice as big as its 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.

Even in the older CFM56 fleet, something like 40% of the engines haven't really come in 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 visit.

In addition to this, aftermarket pricing continues to be quite strong. It's particularly strong today since the pandemic, but will remain at least in the mid-single digits toward the end of this decade. This tailwind from the growth of their installed fleet plus pricing means GE's commercial services revenues could grow at something like an 8% to 10% clip, very predictably, with high visibility over at least the next 5 years.

When did the LEAP engine first come into service?

The LEAP entered into service circa 2016, so it's still a very young program. The typical aircraft program, from inception to development to retirement, is 4 decades, and the useful life of an aircraft is 25 years. So it's still a very young program that will deliver earnings for decades to come.

And then on the defense side, I'm sure there's exposure to defense budgets. Is there anything else that goes into that growth equation?

On defense, it does tend to grow in line with defense budgets, with an additional uplift based on which programs are participating. 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 the 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.

Just in terms of the cyclicality of the revenue, there are the longer cycles of aircraft coming into service and 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. What would you point to in terms of, if you do see general economic weakness, how exposed would the business be to something like that?

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-cost, high-operating-leverage business model. Airlines are the key customer on the aftermarket side of the business.

Today, if you look at load factors across the industry, they're pretty much maxed out in the low 80s, maybe 83% to 84%, which is unprecedentedly high. So any decline in air traffic will affect airline profitability quite significantly.

Having said that, GE, Pratt, and MTU are much more insulated from this for a few reasons. The first is that 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 they have to happen.

Relative to other costs, like fuel, which tend to be a large portion of an airline's costs, this is a fairly small portion of airline OpEx. In addition, given the sole-source nature of aftermarket spare parts, GE has fairly significant pricing power, which they have demonstrated through multiple cycles over the last 10 to 20 years, including the pandemic, when 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, 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. 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.

On margins, you've laid out some of the differences 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?

For GE, the overall margin expansion that you've seen in the reported numbers has largely been driven by portfolio rationalization, much more than individual operating performance improvement at GE Aerospace.

For example, GE 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% before Larry Culp took over. You can also see that in Safran’s reported numbers over the last 10 years or so, at around 20% in terms of operating margins.

Rolls-Royce more recently has reported 25% and historically has been around 18%. MTU Aero Engines, within its equivalent commercial engines business, reports a 25% to 26% kind of margin. So, it’s a very, very profitable business. GE in particular, over the last few years, has improved from 20% to 23% to 25% margins—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.

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 all the way to free cash flow conversion?

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 suffer a lot of losses in the early phases. Then, as they mature and the aftermarket earnings come through, they throw off a lot of cash and have much, much higher margins toward 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 that is in runoff, a pension deficit, and significant goodwill on the balance sheet. There are also 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, 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% to 25% on a cash basis. That’s a fairly good indicator of what the return profile of the business is.

As a sense check, Safran is somewhere around 20% to 25% as well. MTU and Rolls-Royce are around 16% to 18%. So, this is a fairly good return-on-capital business. The return is very healthy, but it’s not spectacular.

What I would suggest, however, is that what you lose in ultrahigh returns on capital, you make up for in durability and visibility. All of the engine makers—GE, Safran, MTU, and Rolls-Royce—participate in programs with useful engine lives of 25-plus years. 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.

What does capital allocation look like, and pairing with that, what do they do with the cash flows that they have?

GE management has talked about all excess cash flow coming back to shareholders, something like 70%. Dividend payout runs at 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’s intent is to be very disciplined with shareholder capital, which is very consistent with Larry Culp’s tenure at Danaher.

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?

7. What Could Break The Thesis

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 have been key risk factors for most of the current generation of engines.

Pratt & Whitney’s GTF is suffering from that right now, with a potential fix on the way. Even the LEAP is still only maturing into the reliability that its predecessor, the CFM56, had. That’s an ongoing challenge, especially in the earlier parts 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 the ins and outs and the cut and thrust of the business.

The much 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 technology. GE has gone all-in on open-rotor architecture, or 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 roughly a 20% fuel-burn improvement in the next generation.

If you look at the bypass ratios for typical engines, they all hover around a 10-to-12-to-1 ratio, and an open rotor might be 4 to 5 times that—so, 40 to 50 times. It’s a 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 & Whitney, MTU, and Rolls-Royce 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. 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.

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?

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 an 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-up in terms of the difficulty and the learning curve. And if you look at how production is slated to continue for the LEAP, you can make a good case that the losses from the OE side for LEAP should reduce quite substantially over the next 5 years to make it break even.

That gives GE an additional lever for earnings growth as well, because they’re in a fortunate position that the CFM56, the previous-generation engine fleet, is retiring more slowly than expected. 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 5 to 10 years.

How about Boeing’s stance in the industry? GE is obviously a preferred partner there. Whether it’s Boeing changing itself or seeing Boeing lose share, how do you frame that risk, and whether it’s a real or less substantiated one?

Boeing historically has shown a preference for GE as an exclusive engine partner, but that is not necessarily cast in stone for its next-generation narrow-body aircraft. For example, Boeing can choose to dual-source, given that it’s a very large market. Airbus is already dual-sourced, for example, in the current generation, and airlines generally tend to prefer more options.

Having said that, multiple engine options are generally a logistical nightmare, 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 negotiates hard or if the economics are not particularly favorable.

And then, just in terms of competitive threats, we’ve had breakdowns on businesses like HEICO and TransDigm, where there are PMA parts that sit outside of the original manufacturers. How does that impact a business like GE?

On the PMA parts, I think HEICO is probably the exemplar of a fantastically well-run aerospace business that focuses on PMA parts.

The engine business has historically, and continues to be, relatively more protected from PMA parts. To back up very briefly, PMA parts refers to Parts Manufacturer Approval—PMA—which is effectively, in simple terms, the private-label or store-brand version of the original parts that the manufacturers produce. The earliest and most significant threat that the ecosystem faced from PMA parts was from Pratt & Whitney, who tried to do something like 20 LLPs—life-limited parts—on a PMA basis on the CFM56 engine, the GE engine. It reportedly cost several billion dollars, possibly, and failed spectacularly.

That tells you that even a very credible and industrial-scale player within the ecosystem finds it very hard to manufacture as well as credibly go to customers and steal share away from the OEMs. The reasons for this are severalfold. The first is the technical complexity and the regulatory and certification requirements. The second reason is that most of the market today—more than half—is with leasing companies that are effectively against the use of PMA parts. It voids the warranties, for example, that the OEMs provide, and even the OEMs, the original-equipment engine makers, provide material service agreements and other forms of protection that 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 life cycle, 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 toward the latter half of an engine program. When you peel all those layers back, the true addressable market for a PMA-parts maker 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, whereas in engine land, you see long-term service agreements and the spare parts that the OEMs effectively try to capture very effectively.

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.

I think valuation for these companies—the method that the market uses—tells you more about where we are in the cycle 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 predictable and visible earning streams that you're looking at.

In a way, the install 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 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 at 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 5 and 10 years, you're buying it on 10 times earnings in 10 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, 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 tend to be priced on earnings multiples based on expected growth and the certainty of that growth. Especially in an environment like today, where that combination of predictable, solid earnings growth is rare, today's valuations reflect that.

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?

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 learning from the engine business model is that the bifurcation of the buyer and the user is a recurring pattern in many enduring businesses.

For engines, you have Airbus and Boeing as OEM customers, but the long-term users are airlines. 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. 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 has provided the foundation for Larry Culp to come in, bring in focus, and crystallize that latent value embedded in the franchise.

Well, Ramesh, this has been a true pleasure. Thank you very much for joining us today.

Bless you, Matt.