General Electric (NYSE: GE) has been one of the most hotly debated battleground stocks over the past year or so. Bulls think that the struggling industrial conglomerate will eventually turn itself around and believe the stock's 76% plunge from over $30 at the beginning of 2017 to less than $10 by the end of 2018 was overdone. Bears disagree, seeing GE as a fundamentally broken company that is burdened by way too much debt.
The valuation of the GE Aviation business is one of the key sticking points. Many analysts think GE Aviation could be worth as much as $100 billion. With GE's market cap currently sitting near $90 billion, a high valuation for GE Aviation would almost singlehandedly kill the bear case.
Sure enough, notable GE bear Stephen Tusa recently argued that the aviation unit may be worth as little as $30 billion to $40 billion. However, this valuation fundamentally underestimates GE Aviation's long-term growth trajectory.
General Electric's main profit driver
Sharp revenue and earnings declines in GE's power business and a series of divestitures have made GE Aviation the company's largest segment by revenue and its main source of profit. In 2018, the segment posted a $6.5 billion operating profit (up 20% year over year) on $30.6 billion of revenue (up 13% year over year). All of GE's other industrial segments combined posted a paltry operating profit of $4.3 billion on $85.1 billion of revenue.
GE Aviation has become GE's largest and most profitable business unit. Image source: General Electric.
In its 2019 guidance, management projected that GE Aviation will deliver high-single-digit revenue growth this year. Free cash flow will be roughly flat at around $4.2 billion and segment margin will decline to roughly 20% from 21.2% a year earlier, due to a less favorable mix. Segment margin and free cash flow trends should start to improve again beginning in 2020.
At last week's Paris Air Show, GE and its CFM joint venture won a stunning $55 billion of orders, confirming the aviation unit's strong growth trajectory. This included deals with IndiGo and AirAsia valued at more than $20 billion each at list price.
Some programs are declining -- but others are taking off
In his recent critique of the GE Aviation business, Tusa noted that GE Aviation gets nearly all of its profit from aftermarket services rather than engine sales. Furthermore, the CF6 and CF34 engines, which are nearing the end of their production runs, represent a substantial proportion of GE Aviation's services revenue. Thus, Tusa sees slower profit growth ahead for the business.
However, GE has many engine programs, and while some are declining, others are just starting to ramp up. Total engine shop visits -- the main driver of services revenue -- are set to rise from around 5,500 this year to 8,000 a decade from now, a roughly 45% increase. This growth is being driven by an uptick in aircraft production that began near the beginning of this decade.
Strong demand for narrow-body jets is driving growth at GE's CFM joint venture. Image source: Airbus.
It's important to note that engine shop visits come at fairly predictable intervals. Airlines may stop buying new jets and reduce aircraft utilization during periods of economic weakness, but they must continue to maintain the engines. As a result, this forecast is probably quite accurate.
GE Aviation is also on pace for tremendous growth in its military business, thanks to some key contract wins. The company recently increased its growth forecast for this market, projecting that revenue will double to $8.3 billion by 2025.
Cash flow is primed to soar
As noted above, GE Aviation produced $4.2 billion of free cash flow last year, including taxes and most corporate overhead costs. Even if the business didn't grow at all over the long term, it would likely be worth more than $40 billion just based on its current cash flow.
Yet GE Aviation is in position to post strong cash flow growth beyond 2020. Right now, its CFM joint venture is producing the new LEAP family of engines at a loss, but GE expects the program to reach breakeven in 2021. The cash profits from that program will improve steadily thereafter.
GE is also beginning the transition from its GE90 engine (which powers the Boeing 777) to the next-generation GE9X, which will power the 777X. That transition is another reason free cash flow isn't expected to grow much in 2019 and 2020. However, as output ramps up over the next few years, production costs should decline, reversing the current cash flow headwind.
With strong growth expected in its commercial services and military businesses and engine production likely to turn cash positive, GE Aviation's cash flow is set to surge over the next decade. Considering that growth will likely continue into the 2030s and beyond, $100 billion seems like an entirely reasonable estimate of the segment's value. That makes GE stock look like a bargain right now, despite the difficulties in some of its other businesses.
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