General Electric sees fruits of diversification

Oil and gas weakness is offset by the rest of the portfolio in the fourth quarter.

Barbara Noverini, CFA 26 January, 2015 | 6:00PM

 General Electric's GE industrial portfolio delivered a solid quarter of growth as ongoing momentum in several U.S. end markets more than offset weakness in the energy sector. Industrial revenue grew organically by 9% year over year to $32.2 billion (all figures are in U.S. dollars) in the fourth quarter, reflecting robust equipment sales in power and water, shipment and services growth in transportation, and ongoing improvement in health care. Strength in these segments offset weakness in oil and gas, which managed to hold sales flat on an organic basis amid challenging industry conditions. The quarter's results closed 2014 with about $108 billion of industrial revenue, reflecting a 7% year-over-year organic growth rate.

The industrial segment operating margin improved 50 basis points year over year to 18.8% in the quarter, as cost-reduction efforts intensified companywide. Oil and gas in particular stepped up efforts to rationalize the cost base as segment order growth slowed, anticipating the need to operate a leaner footprint in the near term. For 2014, industrial operating margins expanded 50 basis points to 16.2%, as the business mix skewed toward lower-margin equipment sales; however, analytics expanded service margins an impressive 220 basis points to 32%, underscoring the attractiveness of expanding services as a percentage of GE's revenue over time.

In our opinion, GE's resilience in the face of uncertain global macroeconomic conditions supports our belief that despite increased concentration on industrials, the portfolio's end markets and geographic exposure are well diversified. Persistent weakness in oil prices will probably continue to affect order growth and sales in the oil and gas segment; however, we've built near-term weakness into our discounted cash flow model and remain optimistic that demand in power and water, aviation, transportation, and health care will continue to produce solid results for GE in 2015. As such, we reiterate our fair value estimate of $30 per share.

Portfolio repositioning should enhance moat

General Electric's efforts to reposition its portfolio appear to be working, with the company close to achieving its targeted earnings mix of 75% from GE Industrials and 25% from GE Capital. Harking back to the company's 100-year old roots as a pioneer in energy distribution, GE's seven core industrial segments still share the common theme of infrastructure development, powering the "industrial Internet" that has come to symbolize the company's future growth platform.

Expansion of GE's established product categories, such as turbines, aircraft engines, locomotives and medical imaging, is likely to continue to follow the overall pace of economic growth. As such, increasing the attachment rate of service contracts is an important factor in sustaining average organic revenue growth in the mid-single-digit range. With services generating attractive 30%-plus margins on average, upselling customers with long-term maintenance agreements is another key driver of future profitability growth and enhanced returns on invested capital over time.

Over the past several years, shedding underperforming businesses freed financial and human capital resources, both of which we believe are better reinvested in GE's research and development organization. Through predictive analytics, we see GE's R&D evolving to harness the Big Data generated by its installed base, ultimately translating information to support new product development, increase asset efficiency in existing systems, and enhance customer utility of the services portfolio. We believe this paves an additional pathway for growth that really wasn't available to the company in any meaningful way until recently.

Since the collapse of the credit markets in 2008, GE has transformed its captive finance arm from a volatile yet significant driver of earnings into more of a complementary service. Areas of focus will remain middle-market commercial and industrial loans, as well as equipment and aircraft leasing. Each of these segments has clear ties to the company's core industrial business, and we believe investors should benefit from a better-capitalized bank with higher asset quality over the long run.

Barriers to entry are high

GE's ongoing portfolio repositioning has positively placed the company's competitive advantages front and centre, in our view. The company's massive installed base of industrial equipment remains the physical representation of a wide Morningstar Economic Moat Rating that poses formidable barriers to entry. Each of GE's industrial segments benefits from a strong foundation that is difficult for competitors to replicate at scale. Furthermore, GE's network of physical assets has evolved into a software-supported ecosystem capable of capturing useful operational data. In our view, GE demonstrates three main competitive advantages that allow it to sustainably generate economic profit despite the asset intensity of the industrial portfolio: intangible assets, cost advantage and switching costs.

We believe intangible assets in the form of patents, long-lived customer relationships and a strong brand all support GE's wide economic moat. With R&D at the heart of GE's industrial core, it would take vast amounts of capital and, more important, time to match the value of GE's R&D organization. Patents, technology, and capitalized software represent about $7 billion worth of assets on the balance sheet, with an average estimated economic life of nearly 25 years, 21 years and five years, respectively. However, we consider engineering expertise and organizational memory--the difficult-to-quantify human element that extracts the real value from these assets--to be an equally important component of GE's R&D advantage. From a customer relationship standpoint, we believe that long, reliable histories lead to secure futures. Few companies can report decades of performance data in particular product categories, supporting a distinct advantage when bidding for new contracts to supply equipment for mission-critical systems. Furthermore, service contracts play a major role in lengthening GE's customer relationships. Finally, GE remains one of the best-known brands in the industry, built through more than 100 years of operating history.

GE's global footprint allows the company to source materials and services for internal use at scale, demonstrating an advantage over new entrants hoping to unseat GE's market leadership in an already established product category. However, while we're likely to find many examples of scale advantages throughout GE's operations, we believe economies of scope do even more to lower operating costs across the enterprise. With research and development an embedded part of GE's overall corporate culture, spreading R&D costs across multiple divisions allows GE to pursue projects that might otherwise be uneconomical for smaller firms. GE's Global Research Centers serve as centralized hubs, working to understand how proprietary technology in one segment can provide solutions for another. For example, one subsea drilling platform in GE's oil and gas segment may use turbines from the power and water segment, distribution networks from energy management, and imaging technology created in the health-care segment. The ability to source from within, rather than relying on outside vendors for materials, parts, specialized products or expertise, supports a cost advantage and, increasingly, a time-to-market advantage.

In our view, a growing services backlog, which has long eclipsed growth in product backlog, is the greatest evidence of GE's high switching costs. In certain sectors, such as aviation, specified products become entrenched in particular platforms. Redesigning an incredibly complex system in order to accommodate a competitor's product doesn't happen often, given the immense expense the customer would have to bear. This gives rise to robust service revenue, which ultimately protects the customer's capital investment over time. Service contracts secure regularly scheduled maintenance, upgrades, and repairs, ensuring reliable operation of mission-critical equipment. As examples, catastrophic failure in an aircraft engine, or a malfunctioning MRI, can cost lives as well as profits, motivating customers to enter into service agreements that span 10-20 years, depending on the length of the asset's useful life. While third-party maintenance offers an alternative for customers looking to save on operating costs, we believe that original-equipment manufacturers know their equipment much better, can source parts more easily, and oftentimes have a working knowledge of the customer's particular systems. These factors provide the customer with greater assurance that the high cost of asset failure will be avoided, ultimately cementing long relationships with GE.

Innovation takes investment

Our stable moat trend rating reflects our confidence in the durability of GE's three main moat sources, which we believe remain firmly rooted in the core industrials segment. That said, we believe the establishment of GE's Software Global Research Center in San Ramon, California, in 2012 may prove to be a trend-enhancing game-changer over time. Combining software expertise with GE's existing prowess in engineering and new product development creates a stronger ecosystem that could strengthen switching costs as a moat source. Furthermore, we believe that additional investment in an already world-class R&D organization will give rise to better intellectual property, providing GE with greater potential to commercialize technology.

Innovation coming out of the San Ramon GRC gave rise to GE's new Predix system, which offers proprietary predictive analytics solutions branded as Predictivity. Combining physical sensor technology with proprietary software allows GE to collect even greater quantities of real-time data from its installed base of equipment, giving customers better ability to proactively monitor the health and efficiency of their systems. Real-time monitoring can identify previously hidden system inefficiencies and pinpoint additional sources of customer cost saving or revenue realization. Furthermore, real-time monitoring alerts customers of potential outages in between scheduled maintenance in order to better prevent unplanned downtime.

Along with new products offering integrated analytics, we believe launching Predictivity on an aging fleet will increase customer reliance on GE over time, as customers seek to optimize asset efficiency of their existing systems. Furthermore, access to good data is addictive. Selling the ability to network all of the customer's assets on one platform is enticing. In sum, whereas growth in GE's existing services portfolio increases customer reliance through scheduled or reactive maintenance, proactive monitoring increases customer stickiness by offering solutions that make the customer's system better.

Returns on invested capital in the industrial segments have come down in recent years, due to heavier-than-normal investment in these Predictivity initiatives as well as in other new product development. But if GE's predictive analytics offerings increase customer switching costs, we should see pricing power strengthen and customer relationships lengthen over time, ultimately translating to stronger future returns on invested capital.

Cyclical end markets pose risk

We assign a medium fair value uncertainty rating to General Electric. Portfolio repositioning has increased the company's exposure to cyclical industrial end markets, and many of GE's flagship products are subject to long sales cycles. That said, healthy order rates, a strong backlog and recurring revenue streams from the services business increase our confidence that GE can manage through cyclical downturns, supporting its longer-term ability to generate strong cash flow and attractive returns on invested capital. Furthermore, we believe that a well-diversified product portfolio and broad geographic exposure mitigate some of the earnings volatility inherent in GE's industrial core.

GE Capital originates and underwrites loans for its own portfolio, as opposed to securitizing these loans in the open market; we think this reduces liquidity risk. The firm's credit rating gives it access to lower-cost financing, and a lower rating could hurt profitability and make growth more difficult to achieve. It is, however, exposed to the creditworthiness of its counterparties and may experience steeper write-downs as delinquencies rise. Strides made toward improving the segment's overall asset quality should mitigate this risk over time.

Shareholder value is increasing

CEO Jeff Immelt took the reins from the legendary Jack Welch just days before 9/11. While his tenure to date has been characterized by a stronger balance sheet, significant acquisition spending and the divestiture of most of the firm's noncore assets, shareholders are hard-pressed to forget GE Capital's distress during the financial crisis. Diluting shareholders to support GE Capital and an unprecedented dividend cut remain unfortunate consequences of managing through one of the most difficult recessions the company ever faced; however, we believe General Electric has since made great strides toward increasing shareholder value, supporting our Standard Stewardship Rating.

We believe that repositioning the portfolio to support GE's industrial core is prudent, as this corrects years of overexpansion in GE Capital and allows GE to reinvest financial and human capital back in businesses where it maintains clear competitive advantages. Management's commitment to this ultimate goal can be seen in the recent divestiture of GE's consumer-focused appliance business, despite the segment's strong brand and historical significance. What remains is a lighter portfolio, unencumbered by overdiversification and primed to benefit from natural adjacencies among the company's seven core operating segments. Over the past five years, GE-funded R&D expense as a percentage of industrial segment sales averaged 4.5%, almost half a percentage point higher than the 10-year average of 4.1%. With many of GE's products subject to long sales cycles, heavier investment in new product development may explain why recent returns on invested capital have come down; nevertheless, returns still remain comfortably above the cost of capital, despite the asset intensity of GE's portfolio. Over time, as these investments gain traction and strengthen GE's ability to commercialize technology, shareholders should benefit from enhanced value creation.

Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
General Electric Co8.96 USD-0.88

About Author

Barbara Noverini, CFA

Barbara Noverini, CFA  Barbara Noverini is a senior equity analyst for Morningstar.