General Electric Company (GE) Investment Thesis:
Thomas Edison’s merged his many business interests to form Edison General Electric Company in April, 1889. Later incorporated on April 15, 1892 as General Electric Company (GE), it was one of the original 12 companies listed on the newly formed Dow Jones Industrial Average in 1896. GE is the only one of the original companies still listed on the Dow Index after 119 years.
General Electric Company became one of the largest and most diversified infrastructure, Industrial, technology and financial services companies in the world. It operates through eight businesses based on the markets served: Power & Water, Oil & Gas, Energy Management, Aviation, Healthcare, Transportation, Appliances and Lighting, and GE Capital in 175 countries. The company employees ~305,000, has annual revenue of ~$146 billion, and a market capitalization of ~$300 billion.
General Electric Valuation Summary:
Well positioned to deliver on a global infrastructure build out that requires all that General Electric has to offer including: power generation, locomotives, commercial jet engines, oil and gas equipment, and water treatment equipment. As one of the world’s largest industrial companies GE is well down the road in its’ transformation back to its industrial manufacturing roots.
The valuation shows attractive 36-90% total returns may be realized in the 3-5 year investment horizon or a potential average annual return of about 12% to 30% respectively, while enjoying a 30% margin of safety. General Electric is, we believe, about to deliver significantly improved shareholder returns for years to come.
General Electric was one of the most admired companies in 2000. Investors and employees would buy the shares of this blue chip diversified conglomerate with the intent to hold them forever including members of my family. GE had interests ranging from appliances, lighting, jet engines, locomotives, entertainment, finance and insurance and produced impressive long term shareholder returns. In the 2000 annual report the company wrote; “…share owners who have held our stock for five years, including 2000, have been rewarded with an average 34% total annual return on their investment. Those who have held it for a decade, 29%; two decades, a 23% total annual return.”
That year they also continued a share repurchase program, raised the dividend 17% and split the stock 3 for 1. They were awarded for the fourth straight year Fortune’s “Most Admired Company in America,” and for the third time, “The World’s Most Respected Company,” by the Financial Times. It would turn out the company was at the top of its game that year when Chairman and Chief Executive Officer John F. Welch, Jr. was retiring and transitioning the company to then President and Chairman-Elect Jeffrey R. Immelt.
Investment guru Peter Lynch used the word “diworsification” to describe business that expanded into areas beyond their core competencies. A condition where a conglomerate becomes too unwieldy, difficult to understand, and the performance of the separate divisions become obscured.
Jeff Immelt continued with GE’s wide ranging conglomerate strategies and GE Capital, the financial business, expanded. GE Capital’s mortgage lending increased, they invested in commercial property, purchased corporate debt and grew until GE Capital’s earnings per share (EPS) made up 40-50% of GE’s total EPS.
This all came to a head during the 2008 financial crises when their liquidity dried up necessitating $3 billion emergency funding from Warren Buffett’s Berkshire Hathaway, help from the Federal Reserve Bank and a 62% cut in the dividend. Later GE would become the only “industrial” company designated a “systemically important financial institution” (SIFI) subject to oversight by the Federal Reserve.
Disappointed with GE’s ten year performance investors understandably call it the “lost decade.” Over that period the share price dropped ~50% of the level reached in 2000, total shareholder returns over the ten years were 1.1%/year and trailed the 7.4% earned by S&P 500 and significantly below the 6.9% of diversified industrial peers.
Among the many lessons learned they pointed to the need for GE to simplify the unwieldy conglomerate it had become and at an investor meeting in March, 2009 a plan to reduce the size and complexity was presented. However, the financial markets after 2009 remained unfavorable for the sale of GE Capital’s financial assets and with weary patience from the lost decade, investors had to wait for GE to begin a meaningful restructuring.
Finally in April, 2015 General Electric Announced [Source] it was time to sell most of GE Capital assets leaving behind its “hybrid” company strategy of both banking and manufacturing. A potential return of more than $90 billion to shareholders through 2018 is targeted in dividends, share buybacks and the spinoff of Synchrony Financial. The company would also work with regulators to terminate the company’s SIFI designation. Investor skepticism remains high.
General Electric’s new strategy is to simplify and focus on being the best infrastructure company delivering what the world needs. The target is 90% of earnings per share to come from core industrial businesses and financial “verticals” will be limited to 10%. It will lead in the global themes currently served to create strong industrial earnings per share by growing their service franchise, extending the business model, driving customer outcomes, and limiting financial services where they have a competitive advantage and in support of the industrial business.
Acquisition of Alstom Power and Grid Businesses:
On November 2, 2015 within two months of securing conditional approval from the European Union and U.S. Department of Justice, GE completed the acquisition of Alstom SA’s a French conglomerate power and grid businesses [Source].
The price is ~$10.6 billion and GE expects to generate $0.15-0.20 of earnings per share by 2018 and is targeting $3.0 billion in cost synergies in five years. Once fully realized, cost savings of $3 billion on the $10.6 billion investment will yield almost 30%/year.
Synchrony Financial Exchange Completed:
The spinoff of Synchrony Financial to GE shareholders, part of the divestiture of GE Capital financial assets, received approval from the Federal Reserve Board on October 15, 2015 [Source]. On October 19, GE [Source] offered shares in Synchrony Financial, the largest provider of private label credit cards in the United States, for GE shares. Participating GE shareholders would receive Synchrony common stock for each share of GE common stock accepted. On November 11 GE announced [Source] it completed the spinoff concluding an important step in its transformation.
The transaction removes 6.6%, or $20.4 billion worth, of GE stock from the market well within the previously estimated ranges. For each GE share, investors will receive 1.05 shares in Synchrony and the exchange offer was 3.2 times oversubscribed. This increases GE remaining shareholder’s ownership of the underlying business by a corresponding amount.
In June GE announced [Source] that the regulatory review for the sale of its non-core Appliances business to Electrolux continues and the deal would not close as anticipated. Electrolux and GE were not able to resolve differences with the Department of Justice on the remaining items in the clearance process and is now in court. GE expects an approximate after-tax gain of $0.05-$0.07 per share at closing should approval be obtained, but likely not until 2016. A decision from the court is expected as early as next week. Although the outcome of that decision and the timing remain unclear, if the Electrolux acquisition is blocked it is anticipated other buyers will surface.
Speed of Divestiture Transactions:
In October, just six months after GE announced it would sell most of GE Capital, the process is nearing completion. The 2015 sale of the commercial lending and leasing businesses with $32 billion in assets to Wells Fargo was at the time the largest divestiture to date. Divestitures total about $126 billion or nearly two-thirds of the $200 billion planned. Nearly all the U.S. financial businesses are sold with the remaining outside the U.S. More sale announcements are anticipated by year end.
In the 3Q15 conference call, Keith Sherin, CEO of GE Capital updated guidance to reflect progress through the 3Q15: “We gave previous guidance that we would sign $120 billion to $150 billion of deals by year-end, and we’re now raising the low end of that range to $140 billion given the progress we’ve made…our current view versus the goals that we established back on April 10. We’re ahead of plan on asset sales and we expect to largely be done with our exits by year-end 2016 instead of 2017.”
Starting from a Position of Strength:
One unusual aspect of General Electric’s transformation is doing doing it from a position of strength not weakness. Consider that GE has a number one market share in three of its largest industrial business lines: large gas turbines for generating electrical power from natural gas (45% share vs. Siemens 30%); global commercial aircraft engines (70% share vs. Pratt & Whitney 18%); and medical imaging (CT, MRI, Ultrasound combined: 32% share vs. Philips 22%).
The service part of the industrial business (GE earns more on its equipment service programs than equipment sales) helps the company maintain significant barriers to entry. These recurring revenues and customer relationships further facilitate organic revenue growth. Organic revenue growth has averaged 5.5% over the past 10 years versus the peer average of 3.1%.
Leading Research and Development expenditures of about $4.2 billion per year (vs. next peer United Technology $2.6 billion) develops leading edge products and as such, limits the threat of product obsolescence. The most telling statistic affirming GE’s product strength is the order backlog of $270 billion at 3Q15 or 250% of industrial segment annual revenues of $108 billion in 2014.
Past Industrial Performance was Diluted:
A graph is worth a thousand words. Trian Partners illustrates how past performance was diluted well in their “GE Transformation Underway but Nobody Cares” presentation [Source]. GE’s industrial earnings per share growth of 47% over the past 4 years is well above the median industry growth of 26%. However, GE Capitals anemic 13% growth diluted the consolidated growth to 32% over that four year period.
[Source]: Trian Partners
Phasing out GE’s financial assets will surface the strong performance of GE’s underlying industrial assets going forward.
Continuous Improvement Targets:
The company has also committed to continued improvements and appears well positioned to deliver. The areas below are supported in more detail in GE’s Annual Outlook report [Source]:
- Reducing GE Industrial sales, general & administrative (SG&A) costs to reach world class levels. Estimated at about 14% of sales in 2014 the commitment is to achieve 12% by the end of 2016.
- Address variable and product costs to improve segment gross margin 50 basis points (bps) or 0.5% per year from the 27% level estimated for 2013.
- The margin expansion and SG&A reductions will improve industrial returns from the approximate 15% estimated for 2014 to about 17% in 2016.
Global Infrastructure Build Out:
Globally infrastructure assets represent a mix of both public and private facilities necessary for economic activity.Examples include power generation and transmission, water supplies and treatment, rail, roads, bridges, tunnels, pipelines, ports, and airports. Investor interest in infrastructure assets increased in recent years due to global population and economic growth and the much needed spending on infrastructure renewal in mature economies. A survey of 300 senior infrastructure professionals showed infrastructure investments between $34 and $60 trillion through 2030 according to Infrastructure Investor [Source].
GE’s industrial base and global capabilities put it squarely in the center to power this global infrastructure with a leading role in power and water, aviation, transportation, oil & gas, and health care. The strong order backlog will generate increasing revenue for years to come.
The GE Store:
A number of years ago GE realized that software, engineering, and IT infrastructure could unify the company’s industrial segments and facilitate each of its industrial segments to learn how the other segments are using technology, developing products, streamlining processes, and building services. The GE Store is the means for each industrial segment access to other segments successes. We can expect operations and technological improvements to continue through GE’s investment and culture developed around the GE Store. The GE Store is described [Source] as a key differentiator for General Electric to leverage its’ global scale and capabilities across businesses and countries, a source of expertise providing share services across GE’s business units in:
Global Growth: Driving GE’s growth by leveraging global scale, building local capabilities and company to country infrastructure solutions.
Software Center of Excellence: Leads the intersection of the physical and analytical to create new sources of competiveness. PREDIX is GE’s software platform for the industrial internet.
Global Research: Driving innovation and creativity by leveraging technology across product platforms.
Culture & Simplification: Centralizing support services to work smarter & more effectively for sustainable growth; accelerating shared services to deliver better outcomes at lower costs for businesses and customers. Leadership enhances GE’s culture of leadership where their best known strategy and innovations take shape: Lean Six Sigma, WorkOut; Simplification & FastWorks.
Source: GE 2014 Annual Report
GE has invested in the Industrial Internet to bring about a profound change in the global economy, as the digital world and physical world of machines become integrated globally. The Industrial Internet previously focused on the machines and data now utilizes the Industrial Internet framework to integrate intelligent machines and advanced analytics.
GE describes [Source] how the Industrial Internet will make a huge difference servicing the machines, facilities, and fleets that makeup the global industrial system. “Millions of different types of equipment need to be operated and maintained, requiring diverse levels of expertise, tools, and time to ensure proper operation. While it is impossible to know precisely how many machines exist within this ever-expanding industrial, we can look at some specific segments to get a sense for the scale of time, money, and effort invested in maintaining these complex machines.”
The following table shows GE’s estimate of labor-hours required each year to service complex machines in several of their industry categories. “We estimate that it takes approximately 313 million labor-hours a year to service steam and gas turbines, aircraft engines, freight, and CT and MRI scanners across the world. The total estimated value of this work is approximately $20 billion per year. These numbers are based on a basic review of maintenance time and costs across these machines.”
GE itself is a primary beneficiary of The GE Store and the Industrial Internet. As an “internal customer” it is one of the most demanding original equipment manufacturing (OEMs) in the world. The company’s investment in these initiatives and its renewed focus on core industrial platforms will provide many years of industry performance improvements for customers and GE.
The new GE plans to create a simpler, more valuable industrial company by reducing the size of the financial business. The financial markets changed after the financial crises. The wholesale financial companies found it increasingly difficult to generate acceptable returns especially in the face of GE’s SIFI designation and the growing competitive shadow banking system.
The simpler new GE will deliver superior results around its core industrial capabilities including the retained financial portion “the vertical businesses” limited to supporting GE’s industrial segments. Investors will benefit as high value industrials generate more than 90% of earnings by 2018 and from the return more than $90 billion in cash through dividends, share buybacks and the Synchrony exchange through the end of 2018.
GE Capital Smaller:
GE Capital made up 40-60% of the company and the original target was to reduce it to about 25% of GE’s future earnings per share. The target was further reduced to the current 10%. Proceeds from the growing GE Capital divestitures will fund increased share buybacks or investments in GE’s industrial business to make up 90% of the company.
SIFI De-designation is a Key to Free up Capital:
The financial assets divestments are critical for GE to exit the SIFI designation and to free up the anticipated capital for share buybacks. The share buy backs may begin as early as 2016 as management’s goal is to submit the SIFI de-designation application as early as the 1Q16.
Importantly, GE Capital divestments are largely in management control and is showing strong momentum. Although the SIFI de-designation is beyond GE’s control the actions taken in 2015 position the company favorably. Management is demonstrating a sense of urgency to return capital to shareholders and back to GE’s industrial roots [Source].
The original 2015 goal of $90 billion asset sales will be surpassed at $100 billion with $126 billion in disposition agreements signed, asset sales will likely be finalized in 2016 rather than 2017, and the goal of ~$35 billion dividends is on track. The SIFI de-designation application appears very likely in 1Q16 setting the stage for share buy backs during 2016.
Capital Return to Shareholders:
The April, 2015 announcement was followed shortly thereafter with GE’s Annual Presentation to Shareholders [Source] outlining five components of the plan for creating value for shareholders. As a first step lets look at each of these value creation components to assess if they are being implemented as promised.
Source: GE 2014 Shareholder Presentation page 8
Dividend Remains a Priority:
This once dividend aristocrat (companies that increased dividends every year for at least 25 consecutive years) shocked shareholders when they cut the dividend 62% during the financial crises. The company appears to be trying to assure shareholders that the dividend will remain a priority. The current dividend is $0.92 per year and yields a healthy 3% on the current share price of about $30/share. The company said the current rate will be maintained through 2016 and reviewed for increases thereafter, and the dividend is a priority.
Divestitures to Fund the Share Buybacks:
GE’s plan called for an estimated $90 billion of capital return to shareholders in the 2015-2018 period including ~$35 billion in dividends and ~$55 billion in shares retired through buybacks including the exchange for Synchrony Financial shares. To return this capital to shareholders planned divestitures need to occur.
Share Count Reduction:
The board of directors has already approved a buy back of $50 billion GE shares over the next couple years with the goal to shrink share count to 8-8.5 billion shares by 2018. This is a 15-20% reduction from the current 10.1 billion shares outstanding. When share count declines, earnings are distributed over fewer shares increasing per share growth.
Opportunistic Industrial Mergers and Acquisitions:
Jeff Immelt, GE’s CEO during the 3Q15 conference call [Source]: “I think as we look at [acquisition] opportunities and where we are today, anything would have to hurdle above buying back our own shares. So we’ll be opportunistic, we’ll be disciplined, and we have an alternative that we think is still quite attractive for us of buying back our own shares.” He is setting the bar for acquisitions; they have to provide a greater return than acquiring shares in General Electric.
Trian Partner’s Investment in GE:
Trian Partners, activist investors recently made a large investment in GE with $2.5 billion committed. They shared their investment thesis [Source]. Trian has interacted with GE’s top management and members of the board of directors and as activist investors their due diligence resulted in a endorsement of General Electric’s new direction:
- GE is a leading infrastructure and technology company addressing society’s critical needs.
- It has a highly attractive “defensive growth” profile.
- With a compelling valuation at <14x 2015 pro forma earnings.
- Management has taken bold steps to reshape the company.
- Trian has had a constructive dialogue with management.
- Trian believes management is motivated and aligned to enhance shareholder value.
The graphic below outlines General Electric’s framework for improvement through 2018 as of May, 2015 and the pieces are falling into place. Let’s go through an analysis of what GE could be worth assuming they meet their goals and extend it to 2020 to include a three to five year investment horizon.
[Source]: GE May 20, 2015 Webcast Presentation
GE’s continued investment in research and product development position it well to maintain and grow its market share. Long term growth prospects are attractive with products built on technical innovation; share gain and higher margins are expected. The revenue assumptions are according to management’s guidance of segment organic growth in the range of 4-7% and extended through the 2020 period. This is an improvement over the past four year average of 3.7% per year. There is a wide variation within the segments from a -0.4% in healthcare to a +7.3% in aviation average per year.
Management expects to expand operating margins to 16% by 2018 and continue improving at the rate of 50 bps per year thereafter. This is consistent with progress demonstrated over the past four years where GE’s Industrial margins improved from 14.8% to 16.9% or about 52 bps per year. It is assumed managements 50 bps margin improvement per year continues through 2020.
The company has set a goal to reduce industrial staff, general and administrative expense (SG&A). The combined margin expansions through variable and product cost reductions and SG&A reduction will result in improved EBIT returns of about 18% in 2020 from an estimated 13.3% in 2015.
Trian Capital presented another illustrative graph in their presentation on General Electric [Source]. GE industrial margin composition is shifting to higher services margin, but declining equipment margins are largely offsetting this improvement in the total industrial segment margins. The margin expansion initiatives will benefit from the emphasis on GE service offerings and renewed attention to equipment margins both which can continue over a long period of time.
The acquisition of Alstom is the biggest industrial investment GE has made and it is a home run. You are encouraged to listen to the investor meeting presentation [Source] outlining the very attractive level of synergies between these formal competitors. As leaders in the industry, GE and Alstom have similar history, built on engineering, innovation and technology.
[Source] General Electric’s Alstom Presentation
The bottom line is the final price for Alstom was $10.3 billion showing an internal rate of return of 15% and $3.0 billion in annual synergies anticipated by 2020. The earnings per share impact is estimated at a deficit of $0.01-.02/share in 2015, a contribution of $0.05/share in 2016 and growing to $.15-.20/share by 2018.
General Electric’s total return will be realized from both dividend and income growth through share count reduction and earnings improvement, the Alstom synergies and some ratio expansion. We assume industrial revenue growth will be about the company’s long term guidance of 5%. Core industrial margin expansion, the Alstom synergies and favorable product mix change will contribute strongly to EBIT margin growth. Industrial margins will improve 0.5% (50 basis points) per year through 2018 per the company’s goals and then 100 basis points in the last two years approaching high technology industrial levels of 18% in 2020. The remainder of GE Capital (the “Verticals”) will grow at the rate of the industrial sales it supports.
Capital allocation has had mixed results historically and management seems to be focused on improving this. Capital spending beyond the buybacks will likely be utilized for organic growth projects. Since we don’t know what those might be, for purposes of this analysis we assume all incremental cash flow will be used for additional share buybacks. Those shares will be priced at 20X earnings and if a higher return organic growth project is available, incremental cash flow can be diverted to it a presumably a higher return than share buybacks.
During the 3Q15 conference call CEO Jeff Immelt commented in part [Source]: “…And people like — the vast majority of investors still like seeing the dividend grow in line with earnings. So I would say dividend in line with earnings.” Accordingly, we set the dividend payout ratio to 50% of net earnings.
Putting it all together and using a three to five year investment horizon the table below shows the benefit of being a long term patient investor. At today’s price of about $30/share, GE shows approximately a 36% return over the next three years and a 91% return over the five year period or an average annual return of about 12% and 30% respectively.
General Electric’s return to its industrial roots and a world class infrastructure manufacturing company faces promising prospects with the global infrastructure buildout underway. Over time as General Electric returns to its former status of a defensive growth investment it will likely command a premium earnings multiple moving it to the high valuation range.
Reasons to Consider this Investment:
- Investor’s remain skeptical and on the sidelines, unappreciative of the significant progress on portfolio repositioning, industrial execution, simplified structure, GE Capital divestments, and a focus on returns to shareholders. These are soon to be realized.
- General Electric’s financial assets (GE Capital) has overshadowed GE’s world class industrial businesses. That is changing as GE implements a transformation back to its industrial roots.
- The performance improvement’s at GE are of long duration supported by a valuable product portfolio, favorable growth, leading technology, market share gains, cost advantage, product differentiation, process improvement, simplification and expanded value from The GE Store.
- GE’s strong industrial business has an underlying intrinsic value not yet reflected in the share price of the company. Going forward GE’s world class assets will not be offset by GE Capital. General Electric will produce higher returns for shareholders for years to come.
- This transformation is in control of General Electric’s management and to a large extent not contingent on external events beyond their control.
- Current estimates of global infrastructure spending range between $34 and $60 trillion through 2030 and GE builds the equipment powering this infrastructure positioning GE well for long term organic growth.
- General Electric provides the engines for an economy’s physical infrastructure as developing economies GDPs grow decades to come. GE’s global footprint positions it to supply electric power, water treatment, Oil & Gas equipment, commercial jet engines in aviation, healthcare, locomotive transportation from a market leader.
- GE has continued to invest heavily in state of the art manufacturing, research and product development to secure its leading positions and wide competitive economic moats.
- Management is in the process of returning more than $90 billion to shareholders through share buybacks and dividends.
- The recent Alstom acquisition for $10.3 billion shows an internal rate of return of 15% and $3.0 billion in annual synergies anticipated by 2020. After 2020 with a gross annual return of 30%.
- No credit for further balance sheet leverage is taken. Credit Suisse and Trian Partners estimate with a modest increase in leverage at GE could increase EPS an additional $0.13 to $0.27 respectively adding another $2 to $5 per share.
- The capital return to shareholders is partially dependent on General Electrics ability to terminate the company’s Systemically Important Financial Institution designation. Although management is optimistic this could occur in early 2016 it could take longer.
- Investor skepticism continues to remain high after the “lost decade.” It may take years of demonstrated performance before full appreciation in the share price is realized.
- GE’s share price may respond negatively to a rising interest rate cycle or an economic slowdown. The company’s defensive investment characteristics could help insulate the company from these factors.
- GE investors will likely have to wait for a couple of years for the anticipated financial payoff. The downside of waiting however is potentially missing out on an attractive entry price. Offsetting this wait is we get paid with a secure and growing dividend currently yielding about 3% per year.
As one of the world’s largest industrial company General Electric is well on the road in its transformation. It is hard to imagine a company better positioned to deliver on the global infrastructure build out that requires all that GE has to offer including; power generation, locomotives, commercial jet engines, and oil and gas production, and water treatment equipment for decades to come.
Disclosures: No position in GE at this time; will be long GE within one week.
You are encouraged to do your own independent research (due diligence) on any idea discussed here because it could be wrong. This is not an invitation to buy or sell any particular security and at best it is an educated guess as to what a security or the markets may do. This is not intended as investment advice, it is just an opinion. Consult a reputable professional to get personal advice that meets your specialized needs of which the author has no knowledge. This communication does not provide complete information regarding its subject matter, and no investor should take any investment action based on this information.