GE has been in the news
lately, as analysts have pounded on its poor performance and investors have
bailed out in trove. It is a sad state
of affairs for one of America’s great industrial companies.
How did it get to this, and
how can it regain its footing? Looking
back with the benefit of hindsight can helps spotting what went wrong.
GE in 2006
So we went back to 2006, a year
before US financial markets collapsed, and then compared that year’s results
with those of 2016. Two differences jump
out:
1.
Financial
services were the “special sauce” which boosted the company results, but at a
cost that management didn’t seem to realize, and
2.
Financial
reporting was clearer, and the books more intelligible, a decade ago.
In 2006, GE reported its
results along 6 segments: Infrastructure (Aviation,
Energy, Oil & Gas, Transportation), Commercial Finance (Wholesale Commercial and Real Estate Finance),
GE Money (Consumer Finance),
Healthcare, NBC Universal (Media) and
Industrial (Appliances, Lighting,
Plastics, Factory Systems). Some of
the manufacturing segments also reported related financial services income.
This is how the business GE looked
like:
Segment
|
Revenue (in $bn)
|
Profit (in $bn)
|
Profit Margin
|
Infrastructure
|
41.6
|
7.2
|
17.3%
|
Healthcare
|
16.5
|
3.1
|
18.8%
|
NBC Universal
|
16.2
|
2.9
|
17.9%
|
Industrial
|
33.5
|
2.7
|
8.1%
|
Financial
|
51.4
|
10.3
|
20%
|
Total pre corporate & elimin.
|
159.2
|
26.2
|
16.5%
|
Total post adjustments & taxes
|
164.3
|
20.8
|
12.7%
|
In all[1],
Financial, which reported mostly as GECS (General Electric Capital Services)
contributed over 39% of the GE’s operating profits before corporate and
adjustments.
But this profit boost from
Financial came with outsized risks. At
2006 year-end, total GECS borrowings amounted to $426 billion, 98% over group total, 40% of which short-term in
nature; $100 billion were in the form of commercial paper with an average
maturity of 48 days! And borrowings were
growing at a fast clip: almost 18% over 2005.
Borrowings
|
GE (in $bn)
|
Financial (in $bn)
|
Eliminations
|
GE consol.
|
Short-term
|
2.2
|
173.3
|
(3.4)
|
172.1
|
Long-term
|
9.1
|
253
|
(1.2)
|
261
|
So GECS profits were earned
on the back of $426 billion in borrowings which levered an equity base
of $54 billion[2]. Put in another way, GE allocated 50% of its
group equity to financial businesses which in turn piled $426 billion of debt
to earn 39% of its profits.
GE consolidated cash flows
were $24.6 billion, including a cash dividend of $9.8 billion by GECS.
GE in 2016
Fast forward to 2016. The financial reporting has become somewhat
opaque. In the annual report, the
Performance Summary’s plain English of 2006 has been replaced with tables in
which all the items are heavily annotated and presented on a non-GAAP basis. The
business segments have been reshuffled again.
After rearranging the 2016
activity segments to make them more comparable to the 2006 data, we have the
following:
Segment
|
Revenue (in $bn)
|
Profit (in $bn)
|
Profit margin
|
New Infrastructure
|
79.7
|
14.2
|
17.8%
|
Healthcare
|
18.3
|
3.2
|
17.3%
|
New Industrial
|
15.1
|
0.3
|
2%
|
GECS
|
10.9
|
(1.2)
|
(11.5%)
|
Total pre corporate & elimin.
|
124
|
16.3
|
13.1%
|
Total post adjustments & taxes
|
123.7
|
9.1
|
7.4%
|
More negative adjustments were
brought up to corporate than before. In
addition, from 2102 to 2016, only one segment showed major profit growth
(Aviation, +63.2%), one showed slow growth (Power, + 14%), two were essentially
flat (Transportation[3]
and Healthcare), while the rest (Oil & Gas, Renewable Energy, Energy
Connections & Lighting) were down.
While Power still managed a good 18.6% profit margin, over-optimism
would catch up with management in the third quarter of 2017 when it shrunk to
7%.
The most striking change from
a decade ago is the plunge in GECS’ operating cash flows[4]
to minus $7.9 billion from $9.5 billion in 2015 and $18 billion in 2014. The
following table illustrates the shrinking of the financial segment and its poor
performance.
2006 (in $bn)
|
2016 (in $bn)
|
|
Financial revenues
|
51.4
|
10.7
|
Financial profits
|
10.3
|
(1.2)
|
Financial borrowings
|
420
|
117.3
|
At the consolidated level, GE
cash flows dropped from $16 billion in 2014 to $11.9 billion in 2015 and $6.1
billion in 2016. One should also note
that pension underfunding rose from $6.5 billion in 2006 to well over $30
billion in 2016.
By the third quarter of 2017,
the overall results had deteriorated further, with non-GAAP cash flows falling
to $1.6 billion year-to-date, full year earnings-per-share forecast down to around
$1.05 vs. $1.6 six months earlier, and cash-flows expected to reach about $7
billion.
In sum, GE’s troubles are
threefold:
1.
A failed bet on
financial services to “easily” boost growth and profits which backfired badly,
2.
A culture which
seems to have gone astray, with such empty concepts as the GE Store and convoluted financial reporting, and
3.
A breakdown in
basic management which resulted in bloat and sub-par performance.
I believe that, with time,
the new CEO can fix #2 and #3. #3 won’t
be easy as it will likely result in a smaller GE, something corporate
managements and boards have a hard time accepting.
The real issue, point #1, is
whether GE can grow and improve its returns via a better mix of industrial
activities rather than via financial levering.
As great a manager as Jack Welch thought back in the 1990s that finance
and its inherent leverage was the easier way to go.
Alternative growth strategies
While GE stock price is flat
for the last 5 years, EMR is up 38%, UTX is up 53% and HON is up 139%.
Honeywell is 1/3 the size of
GE in terms of sales. Strategy-wise, it
differs from GE in that it targeted large niches of higher tech, high margin differentiated
products alongside more main stream commercial ones. Originally a heating technology firm, HON got
into precision engineering (clocks) in 1927.
From then on, it expanded into thermostats, aeronautics (autopilot in
1942), and also automation controls and fire detection. In 1986 it acquired Sperry, thus increasing
its aeronautics footprint. In 1986 HON
was acquired by AlliedSignal, a conglomerate involved in aerospace, automotive,
oil and gas and chemicals. By 1999,
AlliedSignal had spun off most of its non-aerospace and automotive businesses
and adopted the Honeywell name.
Honeywell kept acquiring new companies, focusing on its key segments of
Aerospace, Heating/Fire/Safety systems and Performance Materials.
In 3Q17, the profit margin of
its 4 segments varied between 15% and 23%.
3Q17 net earnings were 12.9% of sales. Free cash flow forecast for 2017 was
$4.6-$4.7 billion or about 11% of sales.
Honeywell runs a focused
portfolio of critical equipments and services.
It is dominant in such areas as business jet engines, cockpit automation
and flight systems (where it forms a near duopoly with Rockwell Collins),
HVAC/Fire/Security Controls. It does
best in high technology, critical, non-standardized products and services. Not surprisingly, it is comparatively less
profitable in price sensitive, standardized sectors such as HVAC controls.
United Technologies is ½ the
size of GE by revenues and another major industrial company. It is focused on aerospace, HVAC/Fire/Security
systems, and Elevators/Escalators (Otis). Its brands, such as Carrier, Otis, Pratt & Whitney, Goodrich, Hamilton Sunstrand are known worldwide. UTX is another large conglomerate which
diversified away from the military business into commercial ventures such as Otis in 1976 and Carrier in 1979. Its latest
move was the proposed acquisition of Rockwell
Collins, to further beef up its Aerospace Systems division. Of the three companies here, it is the
closest to GE in size and approach.
For 3Q17, its segment profits
were around 17%, except for Pratt &
Whitney at 6% which faces stiff competition from GE and the GE/Safran joint
venture. Net earnings were 8.9% of revenues. The free cash flow forecast
for 2017 is $3-$3.5 billion, before a pension contribution of $2+ billion, or
5-6% of sales.
Emerson Electric is another
diversified manufacturing company. It is
1/8 the size of GE by revenue, 1/5 by market value. Originally established in 1890 to manufacture
electric motors, EMR expanded to produce equipment powered by small electric
motors. Today, the company operates in a
very wide variety of niches which are regrouped into two segments: Automation, Commercial
& Residential. Such niches include
valves, actuators, regulators, flow measurement, control and safety systems,
firestops, switches, precision welding, HVAC, professional tools, etc.
3Q17 net earnings were 10.2%
of sales. Over the last couple of years, EMR has
suffered from the reduced pace of activity in the oil and gas sector. For the full year, EMR projects revenue
growth of 5% (for continuing operations), operating cash flows of over $2.5
billion (or over 17% of sales) and a 70 bps improvement in earnings before
interest and taxes to 17.9%; this should translate into an 11-12% net profit
margin.
Preliminary conclusions
The comparison between these four
companies is interesting in several regards.
While all four are industrial
conglomerates, the only one which went deep into financial services is GE. In that sense, the other three are proof that
a conglomerate can grow and prosper without leveraging its balance sheet as GE
did.
These three companies
followed different development paths.
UTX went into aviation as
well as a number of large, relatively standardized equipment and services such
as elevators, HVAC, etc. which enjoy high brand recognition. It sports a better valuation than GE, but it
is not fundamentally different. It is
also the largest.
HON is also active in a
variety of sectors, but it has focused more than the others on large, high tech/high
value added quasi niches whose products are often integrated into a broader
system, have little standardization and are of critical importance. Generally, for these reasons, price competition
is not as acute as it is for commercial jet engines or even healthcare. Size-wise, it is smaller than UTX but bigger
than EMR.
EMR is a smaller version of
HON in that it also focuses smaller but more numerous niches which share some technological
commonality. You could say that it had
found the sweet spot, although its Oil & Gas related segment has had a
tough ride lately.
Conclusion
Given GE’s crisis situation,
a comparison of price-earning ratios is meaningless in trying to explore GE’s
revaluation potential. A ratio of market
capitalization to revenues is more revealing.
To that end, we compared 2016 revenues[5]
with today’s market capitalization.
Company
|
Revenues (R)
|
Market Cap. (M)
|
M/R
|
GE
|
$123.7 bn
|
$186.1 bn
|
1.50
|
UTX
|
$57.2 bn
|
$95 bn
|
1.66
|
HON
|
$39.3 bn
|
$111.2 bn
|
2.83
|
EMR
|
$17.3 bn
|
$42.6 bn
|
2.46
|
Setting aside EMR which is
much smaller, we could argue that GE, once it upgrades its culture and
management practices AND finds an appropriate growth strategy, could earn a
value to revenue ratio anywhere between UTX and HON. Matching UTX is mostly a matter of better
management; the HON model requires greater strategic innovation.
This exercise is obviously
very rough, but it shows that GE’s stock could eventually rise to the $24-$40
range.
To succeed, this strategic refocus
will most likely require GE to shrink and shed those segments which can’t
accommodate high margins or are too capital intensive. Already, GE is rumored to explore shedding
its locomotive segment. Its Oil &
Gas business is cyclical by nature, has little bargaining power when dealing
with oil supermajors and national oil companies; it should probably go as
well. Finally, GE will have to deal with
such headaches as its unfunded pension and contingent liabilities in GECS;
these could well cost it tens of billions of dollars.
There is of course no
guarantee of success. But GE starts from
dominant positions in Power and Aviation.
These represent 50% of its non financial revenues. Its core GECS business is sound and should be
retained. Management seems determined
and so far sound in its approach. More
importantly, as daunting as the task looks, it can be done: GE can look to some
of its peers for inspiration.
[1] Earlier in the year, GE had spun off its
insurance business, Genworth.
[2] GECS net worth only, the GE consolidated net
worth at 12/06 was $112 billion.
[3] Albeit on shrinking revenues.
[4] From continuing and discontinued operations.
[5] For EMR we considered its FY 2016 which ended
in September 2016.
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