The Red Dragon Spreads Its Wings

Investing Daily Article of the Week

by John Persinos, InvestingDaily.com

By wielding carefully calibrated mercantilist policies, China increasingly dominates the world economy. The country’s economic mandarins now consider aviation to be a strategic investment, important not just for economic reasons but also for national security.

In China’s 12th Five-Year Plan (2011-15), the central government stipulated that aviation must be a pillar of the country’s economic and military development. China wants to boast of a top-shelf, indigenous aviation sector that matches its emergence as a world power.

As part of this bold initiative, China is taking on the two giants that dominate worldwide aircraft manufacturing: Boeing (NYSE: BA) and Airbus SAS, a subsidiary of the huge Franco-German conglomerate European Aeronautic Defence & Space Co, or EADS (Paris: EAD).

The biggest beneficiary of China’s soaring ambitions: Fairfield, Connecticut-based multinational General Electric (NYSE: GE).

China may have codified its aerospace pretentions in its latest five-year plan, but it can’t magically create in a relatively short amount of time an industrial base capable of producing world-class engines and other sophisticated aviation gear.

GE has shown a sustained willingness to extend a hand. GE is the largest conglomerate in the US and the world’s largest manufacturer of aircraft engines; it’s also a leading maker of aeronautical components and electronics as well as a significant defense contractor. This highly diversified colossus has is fingers in many pies around the world, but it has established a particularly large and growing presence in China, with a focus on aviation.

The aviation industry’s recovery in 2013 will be driven by overseas activity, especially from China, which now stands as the world’s fastest-growing aviation market.

Experts anticipate demand for $4.5 trillion worth of passenger jets over the next two decades, with about two-thirds of new planes sold in the Asia-Pacific region. In value terms, China comprises the single biggest regional market.

China now has more than 40 new airports under construction. The combined fleet of China’s state-run airlines, currently about 2,600 aircraft, is predicted to expand to 4,500 by 2016.

According to the International Air Transport Association (IATA), the number of air passengers traveling internationally from China will grow by nearly 11 percent a year until 2014, while cargo volumes will increase annually by 12.2 percent.

In a move underscoring China’s importance to the aviation sector, American International Group in December announced it would sell almost all of International Lease Finance Corporation (ILFC), the global leader in the leasing and remarketing of advanced technology commercial jet aircraft, to a Chinese consortium for up to $4.8 billion.

This deal is the biggest to date in the aircraft-leasing realm; it would allow China to easily and cheaply tap a global network of about 200 airlines in 80 countries. With 180 planes operating in the country, China already is ILFC’s biggest market, accounting for 35 percent of its leasing revenue.

Tailwinds from the East

As GE continues to streamline its overall operations and return to its engineering and industrial roots, demand from China’s red hot and well-funded aviation sector will provide a sustained revenue boost, more than compensating for the economic vagaries and risks in North America and Europe.

GE has weathered recent economic uncertainty and is positioned to benefit from improving conditions. The company reported third-quarter 2012 revenue of $36.35 billion, an increase of $1 billion or 3 percent from the same quarter a year ago. Earnings rose 49 percent in the third quarter to $3.49 billion, or 36 cents a share, roughly in line with analysts’ expectations and up 13 percent from the same year-ago quarter.

The stock’s price-to-earnings (P/E) ratio hovers at about 17, compared to the P/E of 13 for GE’s sector of industrial goods. That’s not too high a price to pay for the company’s growth prospects, especially in China.

Third-quarter revenue at the GE Aviation division dipped 1 percent to $4.8 billion compared to the same period in 2011, but earnings increased 7 percent to $924 million.

GE Aviation’s orders dropped largely because of weakened demand from the recession-plagued euro zone, but its backlog of $98 billion in orders in the reporting month of October was 10 percent higher compared to September 2011, a clear indication that 2013 will be a banner year.

GE currently generates about $5 billion in revenue from China, for all products and services. The company has set the goal of doubling that amount by 2014, largely on demand related to aviation.

China represents the major growth area for GE Aviation. The division plans to increase the production of its energy efficient GEnx engine by 25 percent in 2013, largely to meet growing demand from Asian economies, particularly China.

The energy efficient GEnx is the quietest commercial engine GE has ever produced and it serves as the powerplant on the 787 Dreamliner, Boeing’s latest-generation passenger aircraft. The Dreamliner is a game-changing, composite-built airliner that made its debut in China in 2011.

But China is no longer content to simply lease or import aircraft. The country is on target to conduct its first test flight of a domestically developed large commercial airliner by 2014 and to begin deliveries in 2016, according to recent statements by the top brass of state-run aircraft manufacturer Commercial Aircraft Corporation of China (COMAC).

COMAC has broken ground on an aircraft assembly plant near Shanghai that’s capable of producing 20 of the large homegrown jets, code-named the C919, as well as 50 regional ARJ21 jets per year by 2016. GE is a major technology partner in this endeavor, representing a $6 billion opportunity for the company’s aviation division.

GE-made engines have the inside track to outfit these aircraft, a potentially gigantic order. GE already has won a series of significant order wins for US-made, China-bound aircraft that are powered by its engines. And GE has signed a deal to sell avionics technology to COMAC.

Despite the high barriers to entry in the aircraft original equipment manufacturer (OEM) field, the Chinese have set a goal of manufacturing large passenger jets with more than 150 seats and freighters capable of handling more than 100 tons of cargo. After delivery of its first C919 passenger jet, China will begin manufacturing even bigger jets with 250 seats.

China still hasn’t unveiled any orders for the C919 but it does have 208 orders for the ARJ21, including five firm orders from GE’s aircraft leasing arm, GE Capital Aviation Services (GECAS). All of this activity means that China will propel demand for new engine and cockpit technologies from GE.

China already is obtaining highly valuable next-generation technologies developed by GE, as part of a joint venture between GE and the state-owned Aviation Industry Corporation of China (AVIC). These technologies include flight simulators and engine manufacturing. Over the years, GE has established a significant aviation-oriented footprint in China that will be hard for its competitors to match.

Those who scoff at China’s aviation know-how shouldn’t underestimate the shrewdness of that country’s aviation decision-makers and their ability to learn from previous mistakes.

Once derided for making poor-quality “knock offs” of Western and Soviet aircraft, Chinese OEMs are making strides—with the vital assistance of GE’s highly regarded engineering prowess. Within the next few years, China is expected to boast a strong domestic base for the production of state-of-the-art aerospace manufacturing. Indeed, this leap in capability also has military ramifications that are starting to trouble Pentagon officials.

Beijing has pulled no punches about its intentions to go head-to-head with Boeing and Airbus, but it needs to avail itself of the engineering excellence of an American corporate icon—General Electric—to pull it off. This demand from the world’s second-largest economy will provide strong, consistent tailwinds for GE for many years to come.

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