GE Aerospace: Shares Have Flown Too High (Rating Downgrade) (NYSE:GE)

For years now, I have been a big fan of General Electric Company. But in a real sense, the company no longer exists. Earlier this month, the company split off for a final time, creating GE Vernova (GEV) and GE Aerospace (NYSE:GE). In a separate article, I already detailed my thoughts about the former. But now, with new data out that covers pro forma results for the 2023 fiscal year, I feel it’s appropriate to visit GE Aerospace. Given that it inherited the “GE” ticker symbol, and it has largely been viewed as a continuation of the industrial conglomerate, it does help to look back at how shares have performed in prior years.

The first article in which I rated General Electric a “buy” was published in July 2018. For years, there were many who thought the business would never see meaningful upside. Some even thought the industrial conglomerate as a whole would collapse. I remained bullish all this time and the result has been positive. Even if we exclude both GE Vernova and GE HealthCare Technologies (GEHC) that ended up being spun off from it, shares are up an impressive 155.2% since the time that initial article was published. That’s comfortably above the 80.1% seen by the broader market. Even since my most recent reiteration of my “buy” rating in January of this year, shares have jumped 57.7% compared to the 3.7% rise seen by the broader market.

In that most recent article, I lauded the company for attractive growth, both from a revenue and profit perspective. With the split that ultimately created GE Vernova and GE Aerospace on the horizon, I concluded that some additional upside likely still existed for investors. And that ended up being spot on.

But now, for the first time since my initial “Buy” rating on the firm in July 2018, very close to six years ago, I am not feeling all that bullish. Fundamentally speaking, the company seems to be doing well. And if all goes according to plan, the future for GE Aerospace will be positive. But based on my own assessment of matters, it’s difficult to imagine further upside still existing. Because of this, I have finally decided to downgrade the company to a “Hold.” And have shares continue to rise from here, it wouldn’t take much for a further downgrade to a “Sell.” This is all despite new and robust data that management just came out with covering the first quarter of the 2024 fiscal year.

Upside… perhaps even more… is priced in

One of the really cool things about large conglomerates is that you can dig deep and find many smaller businesses by definition operating within them. Each firm is a new discovery that educates you on how the broader operation works. Obviously, the General Electric that many of us knew growing up is, for all practical purposes, dead. And what remains are three separate publicly traded firms. The one that is of most interest to me right now is GE Aerospace, the part of the former conglomerate that focuses on the production, sale, and maintenance of aircraft engines.

As simple as this business might sound, one could argue that what remains here is, in itself, a very complex organization. At a high level, though, it is a massive enterprise with a sizable market share. According to management, last year, an estimated 3 billion passengers flew using the technology that the company produced. Management claims that around 900,000 people are flying at any given time using an aircraft powered by its engines. This works out to three out of four commercial flights.

All combined, this company generated about $31.9 billion in revenue during 2023. The largest chunk of this involved the Commercial Engines & Services business. About 44,000 engines made for commercial aircraft are currently installed across the globe. Not only has this represented a massive amount of revenue. It also opens up the opportunity for service-related sales. In fact, around 70% of revenue generated by the company as a whole in 2023 came from services, including about 70% of revenue involving this particular piece of the company.

For a few years, global air traffic took a beating. This was because of the COVID-19 pandemic. However, we are finally up to the point of not only matching the prior high, but also surpassing it. According to management, about 8 billion commercial passengers flew last year. That number is expected to grow to roughly 11.3 billion by 2028. This will cause an increase in demand, not only for commercial aircraft and the engines the company produces, but also when it comes to the services the company provides. The most prolific of its engines has been the LEAP, but the company does have other engine types that are significant to it. Examples would be the GEnx and GE9X models.

The LEAP, however, is specialized for narrow-body aircraft. And considering roughly 50% of the revenue associated with this particular unit came from those types of aircraft, it’s not surprising that it is the shining star of the enterprise. In all, the LEAP engine accounts for only a small portion of the 25,500 narrow-body units installed. But by 2028, it’s expected that enough customers will transition from the older CFM56 engines to it. This should help to drive services related revenue up at a low double-digit rate per annum.

To prepare for this, management is ramping up production. In 2023, the company produced 1,570 LEAP engines. That number is expected to grow by between 20% and 25% this year. This doesn’t mean that other engines won’t do well. In fact, for wide-body platforms, the company has over 900 of the GE9X engines that it has to deliver. But of course, this is a long-term play. Management is not expecting this particular engine to be profitable until the early 2030s, services revenue starts to flow in for them.

To be honest with you, multiple articles could be written about this particular type of topic alone. But for the sake of brevity, I would also like to point you to the rest of the company. This is the Defense & Propulsion Technologies part of the business that, in 2023, generated about $9 billion worth of revenue. As illustrated by the image below, even this smaller part of the enterprise has plenty of working parts to it. You have defense and systems related revenue, as well as propulsion and additive technologies sales. To keep things simple though, it’s best to know that, under this part of the company, there are around 26,000 engines currently installed. And about 55% of all sales associated with this unit can be attributed to services.

Over the long haul, playing to the defense sector will probably be quite positive for the company. After all, the defense budget for the US Department of Defense was $817 billion last year. It’s expected to hit $841 billion this year. There’s also international growth that can be had. While US defense spending is expected to grow at the low single digit rate, international defense budgets are expected to grow, in the aggregate, at the mid-single digit rate. There are several different types of aircraft engines that the company produces under this umbrella. Examples include the F110, T408, F108, and the LM2500. This segment of the company also provides goods and services outside of propulsion, including electrical power offerings that help with power generation, distribution, and more.

You also have multiple subsidiaries, such as Avio Aero under the propulsion and additive technologies part of the business. With about $1.8 billion in revenue (45% of which is revenue associated with its parent company) coming from it alone, it’s far from insignificant for the company and shareholders. It focuses on the production of gearboxes, as well as low-pressure turbines. Add on top of this other subsidiaries such as Unison and Dowty, which collectively produce magnet generators, ignition systems, heavy-duty propellers, and more, as well as GE Additive, which claims to be the only OEM in metal additive manufacturing that offers a “fully end-to-end solution,” and it’s clear that GE Aerospace is a large and complex firm on its own.

Moving forward, management believes that it can capture significant value for all of these operations. For 2024, for instance, the business was forecasting operating profit of between $6 billion and $6.5 billion. That’s up from $5.6 billion reported for 2023. Some of this would be because of price increases and productivity improvements that will boost margins. But the price increases, combined with higher volumes and a change in product mix, will help to boost revenue at the low double-digit rate.

Toward the end of this article, this necessitates a revision because, on April 23rd, the management team at GE Aerospace announced financial results for the first quarter of the 2024 fiscal year. And while I don’t see any upward revisions for 2025, 2024 has seen an increase in guidance for operating profit.

But I digress. By 2025, the expectation is for operating profit to grow even further to between $7.1 billion and $7.5 billion. And by 2028, management is targeting annual operating profit of around $10 billion, with a similar amount of free cash flow. Revenue growth leading up to that point should be around the high single-digit rate.

To be perfectly honest with you, I believe that some of this improvement will not be able to be replicated eventually. This is because management has been clear about how some of the improvements will be had. In particular, they are looking at “working capital opportunities” to boost cash flows in the near term.

The image below shows exactly what I mean. In short, by playing around with various accounts such as accounts receivable and accounts payable, cash flows can be altered in the near term. There’s nothing illegal about this. For instance, though, if you decrease inventory outflow, keeping all else the same, cash flows will be higher than if you did not.

The beautiful thing about this is that, in the near term, it can cause a lot of extra cash on hand. In fact, between the $13 billion in cash the company had at the time of the most recent spinoff, as well as the equity stake that it has in AerCap (AER) (which includes a nearly $1 billion note that matures in 2025), it’s believed that the firm’s cash flow efforts will help to yield about $34 billion to $36 billion in available cash between 2024 and 2026. About $25 billion of this is expected to be returned to shareholders in the form of dividends and share buybacks.

This does, however, make valuing the company a bit tricky. What I did, for the sake of clarity, was look at two different scenarios. The first was to calculate pro forma (for 2023) and expected (for 2024 and 2025) operating cash flow and EBITDA based on growth assumptions that management has provided. And the second was to do that after stripping out changes and working capital from the baseline year of 2023. In the table above, you can see the result.

In the chart above, you can see how shares of the company are priced in both scenarios. Clearly, there’s a big difference in valuation that needs to be factored into the picture. But even if we are generous and assume that the lower valuation is appropriate, shares do look quite pricey. I determine this by comparing the company to five similar enterprises, as shown in the table below. Using the results from 2023, I found that GE Aerospace ended up being the most expensive of the group, even under the generous scenario.

Click to enlarge

Recent results don’t change things… much

As I mentioned earlier in this article, before the market opened on April 23rd, the management team at GE Aerospace announced financial results covering the first quarter of the company’s 2024 fiscal year. The financial picture is complicated because that quarter still included results from GE Vernova in the mix.

But we do have some data regarding GE Aerospace on its own. It is worth noting that the combined enterprise ended up reporting revenue of $16.1 billion. That was $400 million higher than what analysts anticipated. Earnings per share, meanwhile, hit $1.38, which far surpassed the $0.74 that analysts thought we would see. On an adjusted basis, earnings totaled $0.82, which ended up being $0.12 above what was expected.

On a standalone basis, GE Aerospace generated sales of $8.06 billion. This was 15.5% above the $6.98 billion reported one year earlier. Segment profits skyrocketed 15.3% year-over-year from $1.33 billion to $1.53 billion, while orders came in at $11 billion, approximately 34% greater than what the company saw a year ago. GE Aerospace also reported net profits of $1.7 billion, with adjusted profits of $1 billion and operating cash flow of $1.9 billion on a standalone basis.

To be honest, while reviewing the data, the only thing that really changed materially, when it comes to a forward-looking view, was that operating profit for GE Aerospace for this year was revised higher to between $6.2 billion and $6.6 billion compared to the prior expected range of between $6 billion and $6.5 billion. My analysis in this article does take that extra profitability into account when it comes to valuing the company. Management did also, for the first time, provide earnings per share guidance for the year, with an outlook for profits of between $3.80 and $4.05. But since I’m not using earnings in my assessment, I don’t find this terribly significant.

Takeaway

Fundamentally speaking, GE Aerospace is a very interesting company. I suspect that, operationally, its best days are ahead of it. I understand why investors are optimistic now. But even if management can achieve the kind of growth they are forecasting, I struggle to imagine shares warranting any real upside from here. In fact, I would argue that GE Aerospace stock is quite pricey, almost to the point of downgrading it substantially to a “Sell.” For now, I have settled on a more modest downgrade to a “Hold.” But it wouldn’t take much for me to become quite bearish on the enterprise.