General Electric (GE): Step Zero – Will We Ever Be Able to Value This Thing?
I apologize in advance for the disorganized and inconclusive nature of this write-up. By this point, I’ve read a little about GE. It’s a stock many of you have said you’d like to hear about. And yet, I’m not sure I have anything worthwhile to say about it quite yet. This piece is the best I can do for now.
So, this isn’t even an “initial interest” post. This isn’t step one of my analysis of GE. This is step zero. The company is that difficult to understand, value, and analyze. I’m writing this piece about GE now to sort of lay out what I would need to know later to be able to start analyzing this thing.
In preparation for this piece: I read GE’s shareholder letter, 10-K, the most recent earnings call transcript, and an investor presentation.
Of those: the shareholder letter is the easiest read. So, I recommend you read it now.
GE’s Letter to Shareholders
I’m going to walk you through the notes I took while reading this letter.
“While most of our businesses delivered solid – and in the case of Aviation and Healthcare, world-class – performances, our cash flow was challenging.”
This is our first hint that I’m not going to be able to value this thing. As an investor, I tend to limit myself to free cash flow generating businesses. It’s not real clear GE generates a lot of free cash flow. And the difference between free cash flow and reported earnings in some of the businesses GE is in – like power, aviation, and transportation – can be big. Power and aviation are two of GE’s biggest businesses and they involve the sale (usually financed) of extremely long-lived equipment. I’m ignorant of most of the businesses GE competes in. But, I have researched a couple companies related to GE’s power business: the combined Babcock & Wilcox (see the “report” section of Focused Compounding) and Aggreko. Aggreko is a stock I’ve never written about. But, I have researched it. As part of my research into Aggreko, I actually looked at a competitor that was renting out GE turbines as a source of temporary, mobile power. I don’t mean to suggest these businesses are true peers. For example, the core competency at Babcock was working with steam. GE’s power business is like 95% not steam. But, there are some similarities. And the point I’m trying to get to here is that the cash profitability of these customer relationships can be really uneven in terms of timing. You can make nothing upfront and then have very high cash profits on maintenance work you do many years later. The important figure to focus on is the lifetime value of the customer in terms of something like a DCF. Whether GE is focusing on that or not is kind of tough to tell from the 10-K. And it’s extra complicated in the case of GE, because there’s sometimes also the involvement of GE Capital. The press reports I had read about GE made GE capital sound like some separate business that doesn’t fit naturally into what GE does. But, actually, the financing of sales of long-lived equipment on which GE will have long-term maintenance contracts is very synergistic. I don’t know if it’s synergistic in a good way or a bad way though for two reasons. One, there are some risks of bad incentives here. There’s always a temptation in a business that gets maintenance work to underprice the original equipment. And there’s always a temptation in a business that sells equipment to finance those sales more aggressively when it’s your equipment being financed than if you were financing someone else’s sale. And then, finally, GE has an excellent credit rating. So, there’s always this fear in the back of my head that GE is using its strong corporate credit rating to have easy access to capital to finance the sales of equipment to get long-term maintenance contracts. That sounds like a wonderful business model to me if the company is internally being really, really honest about the lifetime value of what it’s doing including the financing risks, its returns on capital, etc. From what I’ve seen though, GE hadn’t really been that transparent or focused on discussing either returns on capital or free cash flow with investors. Maybe it’s more focused on these things internally. And the CEO is definitely saying the right things now about shifting to a focus on free cash flow. But, I’m very worried this can be the kind of business where the incentives were not to maximize the generation of the most free cash flow possible as soon as possible while minimizing the amount of assets that have to be tied up to do that.
What I’ve just described is the kind of business I normally like. I want to know how much capital is being tied up to generate how much free cash flow this year. I can tell you right now that I can’t answer that question with GE. And I don’t just mean at the corporate level. I’m not confident I can come up with any numbers I’d be comfortable with at the segment level when modeling a hypothetical break-up of GE.
“The power and oil and gas markets were tough. Our metrics were too focused on EPS and operating profits and not enough on cash.”
What the CEO is saying here is exactly what I saw when I read the investor presentation. I was really surprised at how poor GE’s cash conversion was at the business unit level. These are big businesses. And there are public peers I can compare them to. So, there were certain cash conversion numbers I expected to see at specific business segments. And I didn’t see what I was expecting. So, obviously, this pivot to a focus on free cash flow is something I like to hear. But, it may be a discipline the market imposed on GE.
”When we talk about running our businesses better, we really mean four things – customer outcomes, our business units as the center of gravity, running the business for cash, and driving a new culture for the future.”
I can only talk about two of those four things. I don’t know what to make of “customer outcomes” or “a new culture”. But, I do like to hear about running the business for cash and the business units as the center of gravity.
“We have identified more than $20 billion of assets for potential exit and currently have more than 20 dispositions in active discussion.”
This is the line that really gets me interested in researching GE. Maybe they will spin some things off. If they don’t spin them off – but sell them instead – maybe what will be left of GE will be interesting. Change and complexity are often good from a stock picker’s perspective. So, is the market’s contempt. GE seems to be ticking all of those boxes right now. It might become a mispriced stock. And it has at least a couple businesses with really strong market share. If run right, there should be some value I can understand at a couple of these units. And the overall GE might be so disliked, so quickly changing, and so complex through it all – that a lot of investors might stay away. This could be a messy overall corporate situation with some gems in there. That’s often the best kind of stock to look for.
“We are narrowing our focus to three key industries where our impact is greatest: aviation, health, and energy”.
When we combine that quote with the business units GE says it’s in now (further on in the shareholder letter): “aviation, healthcare, renewable energy, transportation, oil & gas, lighting, capital, and power” – that suggests transportation and lighting will be disposed of definitely and the company might exit some other stuff too. I don’t have enough detail on GE’s lighting business to know if it would be interesting.
“Capital enabled $14.4 billion of industrial orders…”
This relates to my point about the interdependence of GE Capital – which is shown as a financial business – and aviation, power, and transportation (which are shown as industrial businesses). If you’re financing industrial orders – that’s really an activity of the industrial group not just a separate finance business.
“….we are planning to reduce energy capacity by 30% or more…we are actually working to double our current inventory-turn performance…starting with a $1 billion inventory reduction…”
Power is potentially an interesting part of GE. You’ll remember I did a little write-up on Babcock & Wilcox Enterprises (BW) and how hard a time it’s having as a power business. This is the part of GE that could most lead to a mispricing of the stock. I’d be very excited if this business was ever spun-off. But, I’m not sure it’d be easy for GE to break-up something like Power from something like Capital and especially do it in a way where it was well-financed standing on its own. GE has a big installed base in power. In fact, they might be a little too aggressive on pricing to maintain market share. GE mentions market share a lot in this business. For example, it says it maintained 50% market share in heavy duty turbines despite pressure on margins and prices. The problem with that is, of course, that if you’re 50% of the market the reason prices are bad is in large part you. Of course, there’s no denying that a big installed base is a nice economic engine for the years ahead. And this is something that could be undervalued by investors – especially if there are both cyclical and long-term societal trends going on at the same time. Investors have a hard time telling one from the other. More than that: this industry isn’t expected to turn around anytime soon. GE’s hopes for the power industry getting better start around 2019 or so I think – so this is the kind of business unit investors might just give up on if it performs badly for that long. So, it’s a big part of GE that investors might not assign much value to.
“We are focusing on simpler reporting metrics like revenue, operating profit, and free cash flow. Compensation for our senior executives now includes a higher mix of equity, and our annual bonus program will be more closely tied to each business’ performance. These changes are designed to motivate our teams and lead to focus on execution and cash.”
It’s hard to judge how effective this will be. What you monitor and what you reward are very important in driving behavior. GE really neither monitored nor rewarded free cash flow generation. So, this is obviously a good sign. But, I’ve seen companies say a lot of things about compensation changes and then they weren’t really as extreme or as focused as the kind of incentives I’d put in place if it was up to me.
“The reality, though, is that most of the company’s capital is already allocated before getting to these kinds of topics.”
This is my big concern with GE. I’ve seen a lot of people on Twitter, blogs, etc. talk about GE’s share repurchases or acquisitions as being the problem. But, whether or not GE gets good returns on capital – and whether or not shareholders get a good return in this stock – is decided at least as much at the business unit level. It’s issues like how slow inventory and receivables turn.
That’s all I have to say about the shareholder letter. Overall, I was impressed. It was far better than I ever expected and focused in pretty plain English on some of the topics I’d be focused on as an investor. There was a lot of talk about cash, some talk on incentives, some talk of transparency, and some talk of slimming down and focusing on the businesses where GE is best positioned. I can’t imagine a letter getting me even 10% of the way to investing in some stock. But, if I had to grade this thing it’d definitely get an “A”.
Now, on to the 10-K. The CEO letter is a quick and easy read. The 10-K is not. I don’t expect most of you to tackle it. So, I’ll be brief.
First, I will point out two things. One, GE’s business is very broad. It’s diverse. So, you get lines like this one:
“The mortgage portfolio in Poland comprises floating rate residential mortgages, of which approximately 85% are denominated in Swiss Francs…”
That puts a lot of people off. You sit down expecting to read about a company that makes jet engines, gas turbines, and CT scanners, and suddenly you’re reading about Polish mortgages denominated in Swiss Francs. It’s a discontinued operation (as is a lot of what you read about in this 10-K). But, it’s the kind of thing that will get some investors to put this 10-K down.
And, then, GE’s 10-K is not just broad – it’s also complex. It’s not what I’d call transparent. And I think this passage is a good illustration of that:
“Cash used for contract assets was $4.0 billion in 2017 compared with $3.9 billion in 2016. Cash used for contract assets in 2017 was primarily due to cumulative catch up adjustments driven by lower forecasted cost to complete the contracts as well as increased forecasted revenue on our long-term service agreements and the timing of revenue recognized relative to the timing of billings and collections on both our long-term service agreements and long-term equipment contracts.”
I don’t have much to say about items that are specifically found in the 10-K but which I hadn’t seen discussed much in the shareholder letter, an investor presentation, an earnings call, etc. Really, the only thing I’d like to single out is the relationship between GE’s financial and industrial activities.
Quote #1
“In order to manage short-term liquidity and credit exposure, GE sells current receivables to GE Capital and other third parties in part to fund the growth of our industrial businesses.”
Quote #2
“In certain circumstances, GE provides customers primarily within our Power, Renewable Energy and Aviation businesses with extended payment terms for the purchase of new equipment, purchases of significant upgrades and for fixed billings within our long-term service contracts. Similar to current receivables, GE may sell these long-term receivables to GE Capital to manage short-term liquidity and fund growth.”
Quote #3
“Enabled orders represent the act of introducing, elevating and influencing customers and prospects that result in industrial sales, potentially coupled with captive financing or incremental products or services. During the years ended December 31, 2017and 2016, GE Capital enabled $14.4 billion and $13.4 billion of GE industrial orders, respectively. 2017 orders are primarily with our Power ($5.9 billion), Renewable Energy ($4.6 billion), Healthcare ($1.9 billion) and Oil & Gas ($0.7 billion) businesses. Most of these enabled orders were financed by third-parties including export credit agencies and financial institutions.”
Quote #4
“During the years ended December 31, 2017 and 2016, GE Capital acquired 50 aircraft (list price totaling $6.6 billion) and 44 aircraft (list price totaling $6.5 billion), respectively, from third parties that will be leased to others, which are powered by engines that were manufactured by GE Aviation and affiliates.”
So, I’ve taken you as far as I can go for now. I can’t assign GE an interest level yet. I can’t imagine buying the stock now. However, I know I will definitely follow-up with this company. If I had to value GE, I’d use a sum of the parts analysis. So, let’s consider what parts contributed the most profit over the last 5 years.
If we sort GE’s business units by their cumulative contribution to industrial profit over the last 5 years, the order is: #1) Aviation (33%), #2) Power (26%), #3) Healthcare (18%), #4) Oil & Gas (11%), #5) Transportation (6%), #6) Renewables (3%), and #7) Lighting (2%).
As value investors, we insist on a margin of safety before buying a stock. So, there’s a little shortcut built into how we can analyze GE. We only need to know if GE is cheap enough to promise a big enough margin of safety. While there’s some chance that Healthcare, Oil & Gas, Transportation, Renewables, and Lighting could be worth far more than we’d imagine – that’s not a big concern for us. The big concern for us is that Aviation, Power, and Healthcare aren’t worth enough to give us a margin of safety.
If you look at profit contribution, Aviation plus Power plus Healthcare is 77% of GE. And just Aviation plus Power is 59% of GE.
So, if we do a sum of the parts analysis – all we need to know is whether those 3 business units together are worth more than what the market values all of GE at. Now, there’s the risk of some negative value being attached to GE Capital and there’s the pension issue and all that. But, we don’t need to start with that.
The simplest way to start is to ask two questions.
One: How much is Aviation plus Power worth compared to GE’s market cap?
Two: How much is Aviation plus Power plus Healthcare worth compared to GE’s market cap?
I don’t like to buy a stock unless I feel I have at least a 35% margin of safety (that is, I’m buying a dollar for 65 cents). Based on the past 5 years, Aviation plus Power has been 59% of GE. So, the obvious time to buy GE would be when the sum of my individual appraisal values for Aviation plus Power is greater than the company’s market cap. In that moment, my margin of safety would be the combined value of healthcare, oil & gas, transportation, renewables, and lighting. All of that stuff taken together would then have to make up for any negative value that GE Capital would have as well as GE’s pension problems.
So, that would be my next step in analyzing GE. I’d limit myself to first considering only Aviation and Power. What are each of those business units worth? Only after I had appraisal values for each of those businesses would I sum them up and compare that sum to GE’s market cap.
Right now, if you take the best operating profit years for each of those business segments – Aviation and Power – and slap an EBIT multiple of 12 on those peak years (basically, an after-tax P/E of 16) you would actually get a total slightly above GE’s market cap. Of course, on the Power side that’s incredibly aggressive as we know the near term future will be much, much worse than the best year for that unit.
But, there is a hint in the numbers that GE might already be trading within spitting distance of its sum of the parts value. In today’s market, it’s pretty rare to find any company that is trading near where I’d expect private buyers – in a normal market environment – to bid for each part of the company if it was auctioned off.
Here, we see the possibility that GE’s not expensive right now. So, it’s definitely a stock I’ll follow up on. But, I’m not at all confident I’ll be able to understand this stock well enough to buy it.