The civil jet engine industry is an oligopolistic industry with large barriers to entry, stable market shares, and long product cycles. The engine that comprises the majority of Safran's engine business is called the CFM56, which is produced through a 50/50 joint venture with General Electric called CFMI. The CFM56 is the dominant engine on narrow body aircraft where it has a 100% share on the Boeing 737 and a 50% share on the A320 where it competes against a consortium controlled by Pratt & Whitney called IAE. Both the Airbus A320 and 737 have substantial backlogs and deliveries should grow nicely over the next several years. Moreover, CFMI (Safran) has secured its status as the sole supplier on the new version of the 737 (737 Max) and as a dual supplier on the new version of the A320 (A320 Neo), which ensures that CFMI will retain its dominant share on narrow body planes well into the 2020s.
The jet engine business model is a "razor/razor blade" business. Jet engines are sold around cost, but the real money is made on high margin (60%) spare parts, which are effectively captive to the original equipment manaufacturer (OEM), giving Safran substantial pricing power. Generic (PMA) parts represent approximately 3% of the market and have struggled to gain share for a variety of reasons, including: an expensive and time consuming certification process; leasing companies' preference for OEM parts which better preserve residual aircraft values; airline concerns related to the reputational risks associated with the failure of an engine equipped with PMA parts; and the increasing penetration of "power by the hour" contracts, whereby the OEM also performs the overhaul work. As such, once an engine is sold, it is very likely guaranteed to generate a long-term stream of spare parts revenue for the OEM. Each engine will have to visit the shop for an overhaul 3 to 5 times over its life and while there is uncertainty regarding the exact timing of the visit there is strong visibility and stability over multi-year periods.
Our research suggests that spare parts revenue for the CFM56 will experience significant growth over the next 3 to 5 years driven by an increase in shop visits, price increases, mix shift benefits, and a catch-up from deferred maintenance.
Shop visits – On average the current generation of engines stay on the wing for approximately eight to nine years before coming into the shop for an overhaul. This means that current shop visits are being driven in large part by deliveries in 2004 and 1996, which were both trough years for CFM56 deliveries. However, from 1996 to 2000 and 2004 to 2008 engine deliveries grew by more than 100% and 70%, respectively, which should drive an increase in shop visits over the next 3 to 5 years. It is also worth mentioning that as of December 2011, approximately 9,500 of the roughly 18,000 engines in the active fleet had never been to the shop.
Price and Mix – Our research indicates that OEMs are able to raise prices on most spare parts by approximately 5% per annum. Moreover, there is an ongoing mix shift from first generation engine shop visits to second generation engine shop visits, which generate significantly higher revenue per shop visit. We estimate that by 2015, second generation engines will account for approximately 66% of all shop visits as compared to 52% in 2011.
Deferred maintenance – During industry downturns airlines defer maintenance and reduce the scope of shop visits to preserve cash. Historically this has resulted in very steep recoveries in spare parts revenue when the cycle turns. Discussions with industry participants suggest that the airlines are pushing up against the limits of these deferral strategies and at some point these strategies will result in a substantial catch-up.
We don't believe the positive aspects of the civil jet engine business are reflected in Safran's current valuation. Given the quality of the business, the stability of the industry, as well as strong growth prospects for the aftermarket, we think Safran is conservatively worth 12 to 13 x forward EBITA. It is also encouraging that comparable transactions have occurred at significantly higher multiples. In October of 2011, Pratt & Whitney purchased Rolls Royce's 32.5% share of IAE (the only competitor to CFMI in the narrow body space) at an estimated high teens multiple of operating income bringing Pratt's total ownership of IAE to 65%.While we have never used a high teens comparable to value a prospective investment, always preferring to use more conservative multiples, we were delighted to see that a very high price had been paid by a knowledgeable acquirer for a business directly comparable to Safran.
From Tweedy Browne's Investment Advisor's Letter and Semi-Annual Report.