While General Electric (NYSE:GE) has struggled mightily in recent years, the company's aircraft engine business has been a reliable profit generator and cash cow. In 2018, GE Aviation produced $4.2 billion of free cash flow on $30.6 billion of revenue. Revenue grew to $32.9 billion in 2019, while free cash flow reached $4.4 billion. Entering 2020, GE Aviation was on track for another year of revenue and cash flow growth, despite the negative impact of the Boeing (NYSE:BA) 737 MAX grounding.
However, that momentum evaporated earlier this year as global air travel demand cratered because of the COVID-19 pandemic. (Global passenger traffic plummeted 94.3% year over year in April, according to the International Air Transport Association.) As a result, GE Aviation has been experiencing revenue declines of 50% or more for both commercial aircraft engines and aftermarket services.
It will probably take several years for global aviation demand to return to 2019 levels. That could lead to years of weak results at Boeing and other aircraft manufacturers. Fortunately, profit and cash flow should be able to recover much sooner at GE Aviation.
GE Aviation is mainly a services business
The commercial engine business accounts for the vast majority of GE Aviation's revenue: $24.2 billion in 2019. Of that sum, $15.2 billion came from services (such as repairs at GE-owned shops, spare parts sales, and long-term service contracts). Engine sales only contributed $9 billion of revenue.
Moreover, GE Aviation operates on a razor-and-blades model. GE typically sells engines at very low margins -- sometimes even at a loss -- while earning the vast majority of its profit (and cash flow) from services. A large proportion of its services revenue is locked in through long-term contracts. In fact, at the end of 2019, GE Aviation boasted a $226 billion commercial services contract backlog: equal to more than a decade of revenue.
In the short term, that backlog hasn't protected GE Aviation from massive revenue and earnings pressure. Airlines with engine service contracts are typically billed either at a flat rate per flight hour or when engines come in for particular service events. Right now, airlines across the globe have grounded large portions of their fleets, leading to huge reductions in both flight hours and service events. But as those planes return to the skies, the services business will get back on its feet.
Services demand will snap back before long
GE Aviation's focus on services rather than product sales distinguishes it from aircraft manufacturers like Boeing. In a typical year, Boeing gets many times more revenue from selling aircraft than from commercial services. Moreover, profit margins are similar for the two sides of Boeing's business. Of course, if GE Aviation's commercial engine sales were to become deeply unprofitable (rather than running around breakeven or a little better), that would offset profits from the services business. Fortunately, GE has addressed this risk with aggressive cost cuts, including reducing headcount at GE Aviation by about 25%.
As for GE Aviation's core services business, revenue, profit, and cash flow could recover very quickly. Airlines don't need to return to 2019 levels of profitability for GE Aviation to make a full recovery. They just need to start consuming engine services at 2019 rates.
In China, departures have already recovered to down 30% year over year, compared with down 75% during the worst part of the crisis. Conditions are improving in the U.S., too. American Airlines will increase capacity to 40% of 2019 levels in July, more than double what it offered last month. Southwest Airlines recently said it plans to resume a full schedule, roughly in line with 2019 levels, by November. In Europe, Ryanair is looking to return to growth next year after grounding nearly its entire fleet in recent months.
This all bodes well for GE Aviation. Furthermore, flight activity doesn't have to go back to 100% of 2019 levels for the services business to return to health. Newer aircraft -- in their first 15 years of life, roughly speaking -- drive the bulk of GE Aviation's services revenue. (Airlines are less likely to pay for pricey new parts or expensive engine overhauls for jets that are near retirement age.) With airlines using the current crisis to simplify their fleets and retire older, less-efficient jets, utilization of newer aircraft could be closing in on 2019 levels by next summer and recover fully by 2022.
Military sales will also provide a near-term boost
One continuing bright spot within GE Aviation is its military engines business. Last year, GE's military business was hamstrung by capacity constraints. The sharp drop in commercial engine demand is allowing the company to devote more capacity to its military business in 2020.
GE Aviation booked $4.4 billion of revenue from its military business in 2019 and is on track for double-digit growth in 2020. Management expects military revenue to continue growing rapidly over the next few years, reaching $8.3 billion by 2025. That would complement an expected return to strong growth on the commercial side of the business by then.
General Electric can manage through the headwinds
At an investor conference last week, CEO Larry Culp said GE is likely to burn between $3.5 billion and $4.5 billion of cash in the second quarter and would probably post negative free cash flow on a full-year basis. Just a few months ago, the company had expected to generate at least $2 billion of (positive) free cash flow this year. That guidance change highlights the severe short-term impact of the COVID-19 pandemic on GE's business.
Had the pandemic struck a couple of years ago, GE would have been ill-prepared to withstand it, because of the weakness of its balance sheet. However, the conglomerate has made great strides since then, capped off by the $21 billion sale of its biopharma business a few months ago. As a result, it ended the first quarter with over $47 billion of cash on hand, giving it ample liquidity to cover near-term cash burn and other cash needs.
In short, GE's big cash buffer means there's little risk of running into short-term liquidity issues. And with the company's business primed for recovery and a return to growth over the next few years -- led by GE Aviation -- GE stock could get back on track soon.