The year 2020 is another story of fail, bleakness, and uncertainty for General Electric. Yet, our task as an investor is to seek the opportunity offered by a mismatch between consensus and reality – between expectation and fact. To exploit that, we think we need to know the competitive advantage of GE Aviation – the largest segment owned by the conglomerates.
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In This Issue
Engine That Powering The Company
In March 2019, following the Ethiopian crash, US authorities ground all 737 MAX 8 and MAX 9. This policy resulted in approximately $1.4 billion loss for GE Aviation as the sole supplier of 737 Max Jet Engine. The year 2020 is another punch. Pandemics seal the traveling business, worsening the prospect of the company turn-around.
GE Aviation has the largest contribution to firm revenue (38,1%) and earnings (65,4%). Apart from pandemics and the Ethiopian crash, the jet engine maker has a great business. This segment running at a 20,7% profit margin and supplying about $4 USD billion annual free cash flow. In the last 3 years, orders for its product and services stable at around $30s billion USD levels. Together with the Healthcare segment, Aviation takes the burden of General Electric profitability
GE’s turnaround is almost mission impossible. But we don’t want to miss the train. If there is any train. This article will cover the moat of the aviation segment. We hope it will serve as:
- Piece of GE investment thesis
- Insight to invest in those segments if and only if spun off from their parent.
Mapping The Industry
Before finding economic moat, we need to mapping the industry characteristic:
- High capital. The airline industry is a capital-intensive business. This is a big player battlefield, meaning that new players need to raise massive amounts of money just to enter the game. As consequence, we see oligopoly in almost every supply chain component. GE Aviation – Rolls Royces – Pratt and Whitney as a jet engine supplier. In the manufacturer, we see Boeing – Airbus. Then we see Buffet quartet airlines: Southwest, American, Delta, North airlines. We love to invest in an industry with these characteristics.
- High level of engineering and design.
- High and tight regulation. Safety and accuracy are the most issues in this business. Violating this will cost both financial and reputation. Thus flight has to be as safe as possible and satisfy the schedule in time.
Just to imagine how intensive the capital needed, think this: Delta Air Lines – Buffett stakes before selling it in 2020 – is the largest airline carrier in the world. It covers around 330 destinations in more than 60 countries, supported by more than 800-plus aircraft. Not to mention maintenance, repair, overhaul, and daily cargo operation.
The airline-related industry (jet engine maker, aircraft maker, airlines) are entering (or had entered?) the mature cycle – so expecting growth from this sector will end to disappointing.
Business Model to Identify Competitive Advantage of GE Aviation is at its engineering excellence and great after-sales support
Simply said, GE sells Jet engines for aircraft makers. The Jet Engine is the heart of aircraft – this is the machine that makes flight possible. GE Aviation makes money by selling this, but the fat margin isn’t in the product – here are the playbook is:
- The firm sells its engine to airliner manufacturers (e.g. Boeing and Airbus). Fact that the duo Boeing Airbus doesn’t manufacturer the engine by themselves is because the machine is very complex and needs rocket science knowledge. The demand is loud and clear – the jet engines may not fail, has precise design, durable. Simply said, there is no tolerance for this part. And GE has a long history of reputation with regard to those attributes.
- To attract buyers, GE also offers a 30% Down Payment for its engine. At a glance, it seems not cool. But this is a part of the strategy. It is a “trap” to lock the customer in a juicy contract that favors GE.
- Once the jet engine sold to the manufacturer – Boeing and gang, The firm gets paid per-flight hour over the life of a contract (usually 25 years) as maintenance service. Thanks to tight regulation with regard to safety and time constraints operation mandated by the Federal Aviation Administration. According to the Morningstar GE analysis report, this is the sweet spot of the firm business with a 61% revenue contribution.
We are ready to knock the economic moat now
Competitive Advantage of GE Aviation: Switching Cost
The most apparent competitive advantage of GE Aviation is, of course, the switching cost. Once customers use GE products, it is almost impossible to switch their preferences. Otherwise, the customer could face several serious risks:
- Imagine you are a manager of Airbus, you need to outsource the jet engine to a certain company. They have to met aircraft standards – this machine must capable to lift more than 300 tons of body in the height of 6 miles, for hours. And this aircraft brings people, not goods – the living people. This requirement is astronomically high. One failure could bury your reputation – thus, back to the question, why risking to choose another vendor if we have GE Aviation that could deliver these “rocket” things?
- Another advantage is its “lock-in”. GE Aviation has great maintenance service, this isn’t surprising – it is their jet, right? So, they must know very well. When you are operating in a highly regulated business, when the failure is unforgiven, you need a well-maintained unit. This “ecosystem”, the machine–maintenance – and apps supporting that engine, create “no way out” for customers..
By the way, we strongly believe that switching costs are one of the best examples of economic moat. The reader could refer to this here.
Financial Performance Shows Competitive Advantage of GE Aviation
As mentioned earlier in this article, Aviation operates in a delicious margin. In the last 5 years, this segment record an average 20,9% operating margin. Showing us a firm’s bargain power over customers.
Free Cash Flow
Operating in the capital-intensive industry, GE Aviation is still capable of delivering 4,2 billion free cash flow in 2018, and 4,4 in 2019. The aviation segment surely is a cash machine.
Simply stated, the GE Aviation backlog is the total number of orders that have not yet been delivered. Let say Airbus needs a jet engine and places an order on 1 January 2019. They request that the order get delivered to them on 1 January 2020. This order becomes part of your backlog between 1 January until 31 December 2019. Having a stable backlog means good for business. In the last 5 years, the Aviation segment backlog grows with a 12,5% CAGR.
Investor Key Takeaway
- GE Aviation has great business with a very strong barrier that protects profit in a long duration.
- It will be great if the Aviation segment spun off from its parent.
- GE Aviation moat stem from intangible asset and switching cost