GE: Little Engines That Could
Representatives from four of the world's top jet-engine makers did their best last October as they made their final presentations to Chinese officials at Shanghai's Portman Ritz-Carlton Hotel. The leaders of the most populous nation had said that despite past failures, China would once again try to build a fleet of 500 regional jets in time for the 2008 Beijing Olympics. And each plane, of course, would need engines.
So executives from Rolls-Royce (RYCEY ), Pratt & Whitney (UTX ), Snecma--a French-government-owned engine shop--and General Electric (GE ) waited nervously to see who would win the prize. Months of preparation had led up to that day. "I don't think there was a night that I didn't go to bed with heartburn," says David L. Joyce, GE's vice-president for commercial-engine operations. Now, Joyce can throw away the Tums: GE won the $3 billion contract.
Chalk up another victory for GE Aircraft Engines (GEAE), based in Evendale, Ohio, near Cincinnati. GE already controls 64% of the world market for commercial-jet engines, largely on the strength of its popular CFM56, which is used on narrow-body planes such as the Airbus A320 or Boeing Co.'s 737, and the GE-90, which carries Boeing's (BA ) big 777 aloft. Yet GEAE executives believe the explosive growth in regional jets--those with up to 100 seats and ranges of up to 1,500 miles--will be the division's future.
Why? Mainly because air carriers appreciate their lower operating costs. Bankrupt airlines such as US Airways Group Inc. (U ) and United Airlines Inc. (UAL ) will probably end up replacing many big jets with the smaller, cheaper ones. And on short hops, consumers prefer them to propeller planes. The number of regional jets in service has swelled to 1,300 from 85 in 1993. And with airlines mothballing big planes in the desert, that number is expected to grow.
The story behind the successful gamble on regional-jet engines illustrates one of the big strengths of a diverse company such as GE--and one of its typical strategies. With both short-cycle businesses, which pay off quickly, and long-cycle ones, whose payoffs are years down the road, GE can invest heavily in new technologies it believes in, even when the payoff is not imminent. In the '90s, GE could afford to invest in new jet-engine technologies because of the strong performance by some of its shorter-cycle businesses--primarily NBC (GE ) and GE Plastics. "When we had tough times, we didn't cut back on R&D or on product support," says Brian H. Rowe, retired CEO of GEAE.
True, the current airline slump has slowed total revenues from GE's jet-engine unit to $10.6 billion in 2002, a drop of 7% from the previous year--although operating profits remained constant at $2.1 billion, thanks in part to $500 million in cost-cutting. And GE regional-jet engines totaled only $660 million in sales in 2002, along with $200 million in service fees--only about 10% of GEAE's revenues. That represents deliveries of 584 regional-jet engines this year.
But that's just the start. GE already has orders and options over the next decade for nearly 5,600 CF34 engines--those that power 50- and 90-seat jets--not including any orders from the $3 billion China contract. David L. Calhoun, the current chief executive of GEAE, believes that an additional 5,000 regional jets could be sold over the next decade. With just one competitor in the 50-seat market, for instance--Britain's Rolls-Royce PLC--GEAE has a virtual lock on one of the few growing segments in commercial aviation. This year, in fact, GE will ship 69% of all regional-jet engines. Says Teal Group Corp. aerospace analyst Richard L. Aboulafia: "That market is not only growing but could be crucial to the survival and recovery of the airline industry."
GE's stock price is down 40% in the past 12 months, to about $25. So GE Chairman and CEO Jeffrey R. Immelt clearly appreciates that the payoff for GE's long-ago investment is beginning to kick in. "In 20 years," he says, "we have gone from being a follower to being an extraordinarily strong No.1." But perhaps the best is still to come. Because GEAE will sell spare parts and service contracts for its engines, Immelt believes that the rapid growth of the regional-jet market creates "an aggressive services play that will contribute significant income for decades." Service revenue just for regional-jet engines is expected to hit $1.4 billion by 2010 and climb much higher after that.
Few in the industry paid attention to the regional-jet market in the early 1990s. Bombardier Inc. conceived and put on the market its 50-passenger regional jet, powered exclusively by GE's CF34--originally intended to feed airline hubs from small airports. With GE rolling the dice by investing more than $1 billion in new engine technology, it took early adopters Lufthansa (DLAKY ) and Comair, a large regional carrier now owned by Delta Air Lines (DAL ), to get the market going. Then, in the late '90s, Bombardier and Brazilian rival Embraer expanded to 70- and 90-seat jetliners. Two lessons became clear: Passengers preferred small jets to turboprops, and operating costs for regional jets were lower.
That has become especially true with the decline in air travel following the September 11 terrorist attacks. A recent study by Raymond James & Associates Inc. (RJF ) found that a 50-seat regional jet carrying 43 passengers could generate a 16% profit margin, compared with a 27% loss for a 120-seat 737 carrying 76 passengers. "Full-service carriers will continue to shrink, and [regional jets] and low-fare products will continue to grow," says Fred Buttrell, CEO of Delta Connection Inc., the largest regional-jet operator.
GE's plans for higher regional-jet-engine profits could unravel, however. Its business model is based on the assumption that air travel will overcome the downturn and start growing again at 5% annually. Yet analysts expect the major airlines to lose $4 billion in 2003, with no recovery until 2005 or 2006. A longer slump or a Chapter 7 bankruptcy filing by a major carrier would continue to depress results.
Another worry: GE could lose more of its lucrative service business in the regional-jet market to cheaper competitors. Delta Connection, for one, already buys engine maintenance from among the handful of GE's small, privately held rivals. GE cannot afford to ignore that: Its most lucrative service contracts are in markets such as regional jets, where it faces the least competition. It is a hallmark of GE to profit not only from the sale of goods but also from the sale of services. So Calhoun says he will aggressively fight to keep GEAE's 95% market share for regional-jet-engine maintenance intact.
China is another question mark, say analysts. The Chinese have failed three times in the past decade to develop a 100-seat regional jet. The country lacked the industrial infrastructure to build top-quality modern jets, and it was difficult to make a deal without being in the World Trade Organization.
But this time, the bidding was straightforward, without the complicated negotiations that hobbled
prior attempts. "China was a huge win for us," says Immelt, "and illustrative of our overall strategy there." He adds that the win sets a successful pattern for all of GE's businesses in China. GEAE is slated to be a big part of GE's presence in China in the future. But the nicest part for the engine maker: If the Chinese deal should fall apart, the division should be able to do fine without it.
By Stanley Holmes in Evendale, Ohio