When General Electric announced what amounts to a corporate breakup on June 26, it came as little surprise that one business management wants to hold onto is GE Aviation. The press release describing the new strategy said that Aviation's jet and turboprop engines share similar technology with power systems and wind turbines, and thus that the three business lines together can provide the nucleus for a smaller, more manageable enterprise.
Well maybe, but Aviation clearly is the biggest prize in GE's portfolio -- a business that could just as easily have been spun off as a free-standing enterprise the way GE Healthcare will be. Aviation's LEAP replacement of its highly successful CFM-56 turbofan is the fastest-growing narrowbody engine in history. The unit has a diverse military portfolio. Revenues have grown steadily since the beginning of the decade, and the unit's profit margin last year was a respectable 24%.
Some might say that the other two units to be wrapped together with Aviation -- Power and Renewable Energy -- will just dilute the underlying value of the engine business. Their margins are not impressive. However, betting on the future success of GE Aviation with or without the extra baggage is an increasingly speculative exercise for one key reason: the resurgence of Pratt & Whitney.
The main battleground on which GE's LEAP engine and the Pratt & Whitney PW1000 series geared turbofan will be fighting is the Airbus A320neo. Boeing does not offer a geared turbofan option on its 737 MAX.
Pratt & Whitney, the aircraft engine business of industrial conglomerate United Technologies, is eating into markets GE Aviation has grown accustomed to dominating. Despite the early success of LEAP and respect that GE Aviation has earned from its military customers, it is going to be harder to sustain revenue growth and hefty margins in the future. The unit may do well for years by providing aftermarket support to its installed base of engines, but the notion that it offers the best new technology in the business is becoming debatable.
Consider, for example, the LEAP engine (produced in partnership with Safran of France). No doubt about it, LEAP is the most fuel-efficient conventional turbofan ever built. GE expects to be producing over 2,000 per year by 2020. However, it will be competing against Pratt & Whitney's PW1000G series of geared turbofans, which are not conventional engines and offer intrinsically better fuel efficiency. Pratt (a contributor to my think tank) has introduced 3:1 reduction gears between the fan at the front of the engine and the compressors and turbines in the back, so that each section operates at optimum speed.
What this means from a operator's perspective is that the geared turbofan can produce at least a 16% fuel savings over legacy turbofans, and that benefit will likely grow to over 20% as the technology is further refined. LEAP is an impressive technological achievement, but with all of the moving parts in the engine spinning off the same shaft, the preferred lower speed of the front end must necessarily be traded off against the preferred higher speed of the back end.
This doesn't just give the geared turbofan an edge in fuel efficiency. The engine is also much quieter than a conventional turbofan and emits fewer harmful pollutants. So imagine that you are a low-cost carrier like Indigo that flies into congested airports and must devote over 40% of operating costs to fuel. Wouldn't you rather have the most fuel-efficient propulsion technology available -- a technology that generates less noise and pollution? With geared turbofans, the same amount fuel will allow you to fly further or carry more passengers.
This dynamic has been obscured by the start-up issues the Pratt product has experienced on Airbus A320s, but the issues will be resolved quickly and when the smoke clears, so to speak, there won't be much debate about which company has the most fuel-efficient technology. GE and British rival Rolls Royce will both have to develop engines with gearboxes to compete over the long run, and meanwhile Pratt will be scaling up its geared technology for widebodies -- a critical market for GE, and the heartland of Rolls Royce's business.
Now consider the military side of the business, which can be crucial to financial performance when commercial demand softens. GE Aviation only gets 14% of its revenues from military customers, in part because Pratt keeps winning competitions. Pratt & Whitney built all the engines for the Air Force's F-22 fighter, and now it is building all the engines for the tri-service F-35 fighter. The latter program will eventually require over 4,000 engines for three U.S. military services and overseas allies.
Pratt is also supplying all the engines for the Air Force's next-generation aerial refueling tanker and next-gen bomber. Thus, GE Aviation's Air Force business is largely confined to supporting the legacy fleet, rather than the next generation of aircraft. It remains the sole supplier of engines for Navy and Marine Corps F/A-18 fighters, but those will be increasingly eclipsed in future years by the Pratt-equipped F-35. And now its lucrative T700 engine business on Army helicopters is also endangered by competition for a replacement.
The latter competition pits GE against a Pratt-Honeywell team, with an award expected in fiscal 2019. The Army operates thousands of helicopters that could eventually receive the new engine, and allies operate hundreds more. If Pratt's team wins, it will be icing on a cake that is already growing revenues at a rate of over 10% annually. But losing would be a big blow to GE Aviation, which needs some program wins on the military side.
The biggest military opportunity going forward for GE's turbofan technology is an Air Force competition called the Adaptive Engine Transition Program, which is supposed to deliver a 25% gain in fuel efficiency over existing fighter engines. However, competitor Pratt has a decided edge in technology, and Pentagon managers say that the new technology might just be incorporated into existing (Pratt) engines rather than result in production of an all-new engine. The outcome of the competition won't be known for years.
Aftermarket revenues are so important in both the commercial and the military engine businesses that companies can keep turning in decent results long after they have lost their innovative thrust. So GE Aviation isn't going to see major profit erosion anytime soon; about 80% of its backlog is in services rather than equipment. But there aren't many industries more competitive than the aircraft engine sector, and lately Pratt has been making some deft moves. So GE's dominance of the sector ten years hence is by no means assured.