GE Aviation Is Not As Good As The Market Thinks

|
About: General Electric Company (GE), Includes: UTX
by: Edward Ambrose
Summary

Investor expectations of the strength of GE Aviation, which is the source of 60% of operating income, are inflated.

Investors were very favorably impressed by GE’s announcement of $55 billion of orders for jet engines at the Paris airshow. In reality, GE will receive about $18 billion.

GE's stock is very volatile, so a disappointment could result in a sharp drop in price.

GE Stock price

GE (GE) stock reacted very well to the announcement of $55 billion of orders from the Paris Airshow. This is good news but it is not as good as the market thinks. The $55 billion of orders will produce only $18 billion of orders from 2020 to 2025. GE is overvalued and it is a sell.

Wall Street Reaction

Following GE Aviation’s $55 billion in sales, Zacks Equity Research named General Electric as the Bull of the Day, on June 28. It said, “Their aviation group, which focuses on manufacturing plane engines, has been this firm’s “knight in shining armor”, growing GE’s top and bottom line for years and now makes up 60% of the firm’s operational profits.”

The Paris Orders

The LEAP-1A engine accounted for 90% of the orders as shown below. The LEAP is built by CFM, a 50 -50 joint venture with Safran (OTCPK: SAFR.F). LEAP competes with the Geared Turbofan Engine (GTF) made by Pratt and Whitney division of United Technology (UTX). GE won 74% market share in the market for Airbus A320neo and A321neo engines.

GE won a $23 billion IndiGo order for LEAP engines and service for 280 aircraft. IndiGo had used the Pratt and Whitney GTF engines on its first A320neos. This led to the following comments at the show:

“GE was willing to be more aggressive than we were in cutting its price to win the order.”

Pratt President Bob Leduc

“Those of you that have read the press over the last two years know the trials and tribulations that IndiGo has had. They’ve had their fair share of problems.”

GE Aviation president and GE vice chairman David Joyce

So who is telling the truth? They both are. The Pratt and Whitney GTF engine had more reliability problems than the CFM LEAP. As a result, the airlines backed away from the GTF and went with the LEAP engine even though the Pratt and Whitney engine was slightly more fuel-efficient. IndiGo experienced costly problems with the GTF engine. Now, most of those problems have been fixed. The reputation is gradually improving. For Pratt & Whitney a 26% market share is an improvement, particularly since most of GE orders came from the two-mega orders that will be difficult to repeat. GE wanted a win, and they were willing to shave price to get it. Most of the price shaving appears to come on the service contract.

The Jet Engine Business Model

After a prolonged and costly development program, the new jet engine is sold at a discount of about 50%. Aftermarket sales are the source of the profits. Engine maintenance accounts for forty percent of the cost of maintaining an airliner. However, maintenance costs do not rise until the engine ages, so it may be several years after service begins that the new program starts to produce cash. General Electric was the manufacturer with the ability to wait about five to ten years for a new program to pay off. Using their superior cash resources, GE became the dominant supplier of commercial airline engines.

LEAP vs. GTF

The GTF engine is a $10 billion program to rebuild Pratt and Whitney’s commercial jet engine business. GE responded by cutting the LEAP price to thirty percent of list. Pratt and Whitney followed. This complicated production with both companies launching cost reductions of new and not very well tested engines. Pratt and Whitney had fewer resources so their reliability was worse in the early years.

The Real GE Order Level

GE reports the CFM Orders at list price but engines sell for thirty percent of list. Service discounts are small but, on a large multiyear deal, larger discounts have to be given. Fifty billion dollars at list price provides CFM orders of about $32 billion or 64% of list price. GE only receives half of CFM revenue, so it gets roughly 32% of the announced orders. Almost none of this business will occur in 2019. The engine sales are spread out over a number of years and service revenue builds up after the engine is installed. An exception to this is at Air Asia where CFM will get service revenue for existing airplanes going forward.

As a reality check, GE aviation revenue is about $30 billion. The orders will turn into revenue from 2020 to 2025.

Pratt and Whitney only received 26% market share of engines on the narrow-bodied Airbus aircraft. However, that is a dramatic improvement over the time when their service problems were overwhelming. Given that the huge orders like IndiGo and Air Asia are hard to repeat, Pratt Whitney‘s market share of the Airbus narrow bodies next year should be much higher.

Prospects for GE Aviation

Some analysts have questioned whether GE Aviation can afford the research and development expenses given the financial condition of the firm and the difference and size between GE and the merged United Technologies and Raytheon. David Joyce addressed this by pointing to developments coming out of military contracts.

The more basic issue is how GE can afford to develop new engines with the long cycle before cash flow. This can be seen in the case of the engine bids for Boeing‘s new Mid-Market Airplane. The engine for this plane generates more than fifty thousand pounds of thrust. The joint venture agreement gives GE the right to make engines of that thrust; however, that bid will come from CFM because GE does not have the cash to spend five years developing an engine and several years after that before cash break even.

GE Aviation Profitability

GE Aviation 2019 cash flow will be down $300 million because of low 737 Max productions. It also faces higher development costs of GE9X engine for the 777X. Test flights for the 777X have slipped from February to October because of engine problems.

However, GE makes money on old engines that require a large amount of service. GE aviation may have a flat year compared to its usual 12% growth in revenue. The business is strong, but, it will not meet investor’s expectations

Late this year the engine contract for Boeing’s new NMA will be decided. Most observers expect that GE will win the order. However, GE has had problems of late with the GE9X and 737 Max engines, while Pratt & Whitney‘s reliability is improved. A GE loss would be taken as a sign that Aviation is weaker than they anticipated, reducing the value of GE stock.

GE’s P/E is 24, as the prospects for recovery are offset by fears of further problems. The margin is only 3.3% of Revenue in the first quarter and the cash flow is negative. Events, both good and bad, will move the stock sharply. So, if the expectations for Aviation, which produces 60% of operating income, drop, so does GE stock.

Conclusions

GE is subject to swings in price driven by changes in investor confidence. That makes overestimates of growth very dangerous. GE has more downsides than upsides. The stock is overvalued, so it is a sell

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.