By Scott Hamilton
Nov. 22, 2021, © Leeham News: GE Aviation’s (GEA) spin-off takes the corporate burden off its back and opens that way to move forward just as commercial aviation should be over the COVID-19 pandemic.
The engine unit will no longer be dragged down by, and cash diverted to, GE Corp.’s problems. It can raise money for research and development of new engines and for eco-aviation, without it being siphoned off for corporate or sister company uses.
GEA has challenges ahead, to be sure.
The business model for engine companies has been upended, requiring an entirely new approach to selling engines and services. Historically, engine makers often deeply discount engines—up to 80% or more in some cases—and contract maintenance, repair, and overhaul services to make their profits.
As the COVID-19 pandemic prematurely prompted airlines to retire older aircraft, maintenance, repair, and overhaul revenues and profits shrank, sometimes dramatically. And, with a new emphasis on eco-aviation, new planes have engines with warranties and extended on-wing time that pressure MRO revenues.
Breaking up GE Corp. into three major units will take a few years. When it’s over, chairman Larry Culp remains chairman of GE Aviation. John Slattery remains CEO.
Divesting from the corporate umbrella and siblings is a huge, positive step. Following the Great Recession of 2008, GE Corp’s fortune began a steady, downward slide as several business segments were hit hard. Although the aviation sectors recovered, the damage was done. The corporation never returned to its halcyon days. The COVID-19 pandemic hit all business sectors even worse.
The giant leasing company, GECAS, once a star portfolio, was sold off this year. GECAS was one of aviation’s leading players, with a portfolio of more than 1,000 aircraft. It placed orders with Airbus and Boeing, selecting GE or CFM engines in preference to others. GE Aviation Services performed MRO work. Now, part of AerCap, the preference for engines and services may be subject to competitive bidding instead.
As sister companies floundered, GE Corp. needed money from its healthy business, GE Aviation included. Funds up-streamed from GEA to the parent. This will no longer be the case once the spin-off is complete.
CFM joint venture
GE Aviation is 50% owner of CFM International, which provides engines on the Airbus A320 and Boeing 737 families. France’s Safran owns the other 50%.
The pandemic and the 21-month grounding of the 737 MAX hit CFM hard. GEA had to share 50% of the pain. The MAX was recertified in November 2020 by the Federal Aviation Administration. China has yet to follow but may by year-end. China historically represented 25% of the 737 deliveries.
Full delivery of the MAX inventory may not be accomplished until well into 2023 or, by a few outlier estimates, into 2024.
Chairman Culp, on an analyst call announcing the restructuring of GE, noted that “We have more than 37,000 commercial engines and over 60% haven’t seen their second shop visit, a tremendous opportunity as the market recovers. In fact, we power two-thirds of commercial flights, illustrating how impactful this business is today and to the future of flight.” Most of the engines are on 737s.
“Although Safran is more exposed on the 737MAX, it benefits from the ramp-up on the A320neo too, as it commands a slight market share advantage. LEAP engines are selling at a loss and management had targeted breakeven by 2022, a target now pushed out,” Bernstein wrote in a Nov. 12 research note about Safran. “Shop visits for CFM56 were not expected to peak until 2025, by which point LEAP aftermarket was expected to pick up. An important longer-term question was around the profitability of LEAP aftermarket. Although most long-term service agreements in the industry have not run into major issues, this would be an unresolved concern until LEAP engines come due for overhaul later this decade, a case that remains true today.”
As for GEA, without the corporate umbrella, “A standalone GE Aviation has enough resources to invest and be competitive,” Bernstein wrote Nov. 12.
On the spin-off analyst call, Andrew Obin of Bank of America asked, “Historically, GE funded Aviation from the rest of the company through the cycle. Now you’re funding it as a stand-alone entity. The question will be, how should we think about the stability of funding going forward?”
Carolina Dybeck Happe, SVP and CFO of GE Corp., said, “The key principle that the businesses, we believe, are best positioned for success as stand-alone companies. But to set them up for success, it also comes with an investment-grade balance sheet, and the companies will all be public and have access to capital markets in a focused way. So, by doing that, we set them up to both operate and invest in their businesses.
“And I mean R&D, sales or M&A and to be able to do so successfully through, I would say, the whole cycle, including downturns, and that’s why it’s important with these appropriate capitalization structures. Again, for very long cycle businesses, we talk about long-term.”
GE Aviation historically provided some customer financing. Culp and Happe didn’t address this on the analyst call. But one analyst later told LNA that GEA will likely continue financing in some form.
There’s been speculation for a long time that Boeing and GE Aviation might merge. The anti-trust issues would probably be insurmountable, however.
GEA funded the development of the GE9X for Boeing’s 777X on the forecast the 20-year market was 1,200 airplanes. The 777X program was launched in 2013. Since then, the market has changed. Orders for the X peaked at 344. Over the years, cancellations followed, and some customers encountered financial difficulties, putting orders at risk under an accounting rule called ASC 606. The low point, adjusting for cancellations and 606 reclassifications resulted in only 191 orders considered firm under the accounting rule.
Boeing now lists 320 orders on its website, but perhaps half of these are iffy, according to market intelligence.
Airbus now offers the A350-900/1000 Ultra-Long Range option and last summer launched the A350F. Each eats into an already small market demand for the X.
Finally, the Airbus A321LR/XLR and the 737-8 MAX can operate between 8-12 hours on thin-demand routes, bypassing hub collecting points needed to fill the 425-seat 777-9.
All these eat into the demand for the X program—and GEA’s big engine investment and future return. One Wall Street analyst suggests Boeing now sees a market potential of just 500 Xs.
The big opportunity for GEA rests with the Next Boeing Airplane (NBA), whatever form it takes. GE, CFM, and Safran are focusing on an engine called Revolutionary Innovation for Sustainable Aviation (RISE). This is what used to be called an Open Rotor engine but which the companies call Open Fan. Intended to have fuel consumption that is at least 20% less than today’s CFM LEAP and Pratt & Whitney’s Geared Turbofan, the engine will also have commensurate lower emissions.
“Product and technology investments that need to be sustained over time to keep leadership. And that is also why we’re setting the companies up the way we do,” Culp said on the analyst call.
Looking forward, “If you take Aviation business, we are seeing the commercial market starting to recover. We do expect to get to ’19 levels by narrowbodies in 2023, widebodies by 2024,” Happe said. “Larry talked about our young fleet. I would say more than half of that fleet hasn’t seen the second shop visit yet. So, we’re going to expect healthy shop visits as well, stronger utilization, military growing again, and then also the cost actions that we have talked about in Aviation. And together, that will expand the margins to the high-teens. And we also talked about high free cash flow conversion. So that’s the big Aviation to $6 billion.”
In an interview with a Wall Street analyst, he expects that the margin of Earnings Before Interest and Taxes (EBIT) will remain in the 22% range.
Although the Services business margin may decline due to a changing business model, the same model should offset with an increase of selling engines with smaller discounts, he said.
GE will get “a lot more money upfront,” he said.
Although the demand for the 777X appears to be much less than the forecast in 2013, this analyst isn’t worried. To illustrate, the analyst used the list price of a GE9X of $22m-$24m and a production rate of the 777X of 2/mo, a not unreasonable production rate given the lower demand. The current backlog of 320 (setting aside iffy ASC 606 orders) represents six years of production.
This adds up to $1bn a year in revenues against $33bn in the spin-off company. The 3% loss of revenue isn’t chicken feed, but the analyst believes the loss can be made up by higher sales prices of engines and other products.