Our old GE Thesis

Published on 11/12/21 | Saurav Sen | 2,996 Words

The BuyGist:

  • This is from our early 2018 take on GE. 
  • The investment thesis covers why we couldn't get to a definitive "Yes" back in early 2018. 
  • We had pegged GE's price - at the time - at $12 per share. It was trading at $14. We passed.
  • Since then, a lot has happened in GE. 
  • This latest breakup of GE isn't so surprising to us - read on to see why.

Thesis Summary

GE is transforming itself into a simpler, more focused company. It needs to revert back to its core competency, which is distinct. Once the fat is trimmed, GE could be a lean, mean free cash flow machine.

  • Core Competency: Complex engineering – Turbines/Engines
  • Differentiator or Cost-Leader? Neither. Aviation is differentiated.
  • Profitability: Declining. Not much pricing power.
  • Resliency of Cash Flows: High. Cashflows resilient for 2-3 years per product. 
  • Competition: Heavy. GE competes as a conglomerate amongst niche players.
  • Protection: Strong. Switching costs for customers are high.
  • Strategy & Action: Saying the rights things. New CEO Flannery wants trim the fat. 
  • Financial Productivity: Mixed Bag. GE, overall, is a medium-ROE business. 
  • Sustainable Free Cash Flow: About $6 billion – assuming promises are met.
  • Alignment of Incentives: Positive. New system ties compensation to equity.

Competitive Advantage: The Castle

Core Competency: Complex engineering – Turbines/Engines – any mechanism where rotating metal blades produce energy.

GE operates in these markets – Power Plants, Wind Energy, Power Transmission, Oil & Gas, Aviation and Healthcare. It appears that new CEO John Flannery is determined to make GE a “simpler, more focused” company by reverting to its core competency. But he hasn’t yet defined “core competency” in specific terms other than saying that GE should focus on areas where it has a “competitive advantage”, especially in end-markets that are growing. In my view, GE has a competitive advantage in anything that involves manufacturing and servicing turbines, which would mean these businesses – Natural Gas Power Plants, Wind Turbines, Airplane Engines and Drillbits. But not all “turbine” businesses have been doing well. The big drag amongst these has been the Natural-Gas power-plant turbine business, and the culprit is another end-market of GE – Renewables – which is eating into natural-gas power plants’ share of the US Power pie. The disruption doesn’t end there. The other salient relationship between its “turbine” business segments is this: If Wind Power really does eat into Natural Gas’s share of the power market, it will also affect GE’s Oil & Gas business. If Natural Gas demand keeps falling short of supply, prices will be too low to justify any meaningful growth in Shale drilling. This may prove costly for GE, especially after the massive Baker-Hughes stake they recently bought. The point is that GE must pick between 3 of its turbine businesses if it wants to grow. GE must take a call in the changing power landscape. The 4th turbine business – Aviation – seems to be a well-run segment. It’s high-margin and productive. The outliers in GE’s portfolio are Healthcare, Transportation and Lighting. The last 2 are on CEO Flannery’s short-list of asset dispositions. The remaining one – Healthcare – is a business he used to run. Based on The Buylyst definition of GE’s core competency, the Healthcare business doesn’t quite fit it in. And numbers suggest that it’s not really a “growth business” as one would expect. But it is a productive business with seemingly stable 18-20% profit margins. Flannery is not likely to get rid of it. At least the macro end-market – Healthcare – is a growing market. And maybe there is a distinct core-competency within this segment in GE. Medical Imagining seems to be one area where they dominate. But their whole healthcare business is diversified enough to appear like it’s following a “see what sticks” strategy. If GE can transform itself into a company that’s the best or the cheapest in any king of turbines and in medical imagining, the castle will be strong, and moat will be wide. Then investing in GE would be an easier decision.


Differentiator or Cost Leader? Neither. The Aviation segment seems to be offer some differentiated products (ex. engines for narrow-body jets).

In each of GE’s end-markets, there seem to be at least 2-3 big players. It’s hard to find scuttlebutt reviews of each of GE’s products, but the company’s financial results suggest that GE has carved out strong inroads in each of its end-markets. GE appears to be among the top 5 players, consistently. Yes, the Natural-gas-plant-turbine business has been a laggard in 2017, but much of that is due to market conditions. Of course, GE’s management amplified that problem by mismanaging their capital allocation and inventory. In Wind and Aviation though, GE seems to mirror the obvious secular growth in those industries. That’s the volume growth story. But growth from pricing power appears to be limited to Aviation, which offers a somewhat differentiated product. That covers just 25% of total revenues. As for the other 75%, The Buylyst has a hard time finding a distinct, specific competitive advantage.  The point is: most of GE’s products are necessities in the modern world; but there are viable substitutes. On the other hand, it’s also true that GE has strong franchises that have stood the test the time. But history is no guarantee of future results. In this new world, can the castle be protected? Does it have a wide moat to keep away the barbarians at the gate?


Margin Expansion: Negligible. Not much pricing power in most of their products. Aviation seems to be the exception.

Margins have been flat over the last few years. Aviation is the exception, which seems to be holding on to its margins via both price increases and volume growth. This makes sense – of all the segments, Aviation boasts of the most differentiated products. And it’s been able to harness the industry tailwind (pardon the wordplay) with those products. The Transportation segment – mostly rail locomotives – is an odd story. Its margins have been improving but volumes have been decreasing. This is a (numerically) productive business in a state of slow-bleed, and it’s surely on the short list of GE’s promised dispositions, along with Lighting. The Renewables productivity story is just the opposite – declining margins but volume growth. And that’s maybe because it looks like a price war with 3-4 big global players like Vestas, Siemens-Gamesa and Goldwind.

Durability of Competitive Advantage: The Moat

Competition: Heavy. GE is a conglomerate that operates in oligopolistic markets. Most competitors are niche players.

In each of GE’s end-markets, competition is tough. Many of its competitors are niche players, like Boston Scientific in Healthcare or Vestas in Wind Turbines or Halliburton in Oil & Gas. GE seems to be the only conglomerate competing in many of these industries. Normally, that’s a disadvantage because conglomerates tend to be too unwieldy and bureaucratic to innovate. However, if there are obvious commonalities between each of the businesses – like, say, rotating metal blades that generate energy – I could buy into the argument that this conglomerate can turn that “synergy” into cost-leadership. But there is no strong evidence of that yet. CEO Flannery says GE wants to be a simpler, more focused company that powers the world with electricity, moves people around, and improves healthcare for everyone. That’s not really focused compared to most of its competition. Maybe he should make the case that GE can outdo its competition precisely because it is a conglomerate which can cross-pollinate ideas, spread out its costs, and cross-sell to customers. As of now, it’s unclear whether GE can, or will, do that.


Product Cycle: Long-cycle. This is an advantage. The Economic Time of its cashflows (before competition starts chipping away) is about 2-3 years.

While competition is strong, GE’s products are mostly long-cycle in nature. Financially, that means that GE’s competition will take time to erode GE’s cashflows and margins. A power plant buying gas turbines, for example, is a 2-3 year-long transaction, between order, delivery and operation. And there is a serviced contract for another decade or so, which could be terminated but often isn’t. Turbines, Engines and CT-scan machines are expensive and are usually long-term investments made by the customer. Competitive Advantage is usually determined at the point of sale. Presumably, in many cases, GE manages to offer a better price or a better product than its competition. The durability of this competitive advantage, however, rests on other factors that involve constant innovation and great service for its products. The long-life cycle in each of GE’s products gives it some breathing time to innovate and serve its customers better.


Protection Mechanisms: Strong. Switching costs for customers are high – abetted by long-term service contracts and software dashboards/plugins.

Most of GE’s products are high capital investment products for its customers. Once the money is spent and things are installed, an airplane manufacturer or a hospital is unlikely to shop around for the next best deal in a year or two. In consultant-speak, “switching costs” for these customers are high. And the nature of the products is such – long-cycle and complex – that it requires specialized maintenance and servicing. These servicing contracts are usually long-term. And they could be a bog part of the Moat. Imagine a turbine at a gas-fired power plant – doesn’t the turbine become a lot more attractive if the manufacturer offers a maintenance program at a reasonable cost? The same goes for airplane engines or wind turbines or CT-scan machines. When selling the product GE can offer carrots like top-notch services to close the sale. But apart from making the close, GE’s service reputation also fortifies the inroads that GE carves out amongst its customers. Servicing means constant interaction with customers. When done well, that becomes a way to separate itself from the pack. The other protection mechanism is software plugins. For example - that turbine for the gas-fired plant – doesn’t it become even more attractive if it come with a maintenance program and some sort of a diagnostic software or dashboard that makes the product more self-sufficient? GE had invested heavily in software development during the Jeff Immelt years. Products like Predix were heavily touted during his reign. The new CEO, Flannery, seems less enthusiastic about it. But in the earnings call and the investor meeting held in November 2017, he acknowledged that there is something to build on. Maybe he sees software as an ancillary product rather than a stand-alone offering. I think it can be both. GE’s core competency seems to mechanical and electrical engineering products like turbines. Software development may not be its strongest point. But with all the investments made into it thus far, GE probably can build software that’s good enough to serve as “bells-and-whistles”, enough to make switching costs even higher for the customer. Software, by nature, is usually deeply entrenched into an organization’s processes, that the non-monetary costs of switching (like re-educating employees and the hassle associated with it) often outweigh the monetary costs.

Management Quality: The Generals

Strategy & Action: Saying the rights things. New CEO Flannery wants to simplify GE by investing in the most productive business; while disposing off others.

CEO Flannery has been saying the right things. Most notable among them is his realization that the primary function of Management is Capital Allocation. Buffett has been saying this for years; and it’s what he does best. Flannery may not be a Buffett, but he seems to be also doing some of the right things. Cutting GE’s dividend, in my view, was the right move. Focusing more on cash flow, which is a real, tangible, number as opposed to earnings, is the right move. The decision to dispose unproductive legacy assets is the right move. Flannery values these future dispositions at about $20 billion (I assume a 50% haircut in its numbers). One major test of his management skills will be: What does he do with that $20 billion should it come to fruition? Will he reinvest in productive assets of a “simpler, more focused” company? Or will he just return all that cash to shareholders? The first step in that decision tree is answering this question: what will likely be the most productive assets of GE in 5, 10, 20 years? To answer that question with conviction, I hope that Flannery is a bit of a polymath. Justifying decisions based purely on historical numbers won’t be enough.


Alignment of Incentives: Positive. New system being introduced to tie compensation more towards equity.

From CEO Flannery’s tone in the earnings call and the November, alignment of incentives seems to be a big priority. They were formerly linked to earnings, which is a nebulous accounting concept anyway. Now they will be linked to cash flow and equity. Equity is an indirect way to link compensation with cash flow. But the rationale is simple: linking all incentive compensation directly to cash flow can, ironically, misalign incentives. Cutting costs drastically, for example, frees up cash. But often (as we see in many Private Equity buyouts) cutting costs with a vengeance cuts through muscle, eventually cutting future growth. Linking to equity is not a perfect measure either because of the vagaries of the stock market. But it seems to be the best bad system. Over the long term, the vagaries should even out. 


Financial Productivity: Mixed Bag. GE, overall, is a medium-ROE business. Data suggests Aviation and Healthcare are the most productive.

Financial productivity, and its durability, is how us shareholders evaluate management’s capital allocation decisions. In GE’s case, it’s a little tricky because there are a handful of separate business segments, and each comes with its CEO and Management. But it’s hard to find productivity data split up by segment. So much of this rumination is linked to the margin story. After all, if there is strong castle and wide moat, sales will be strong, margins are likely to be high (and improving) and management won’t find the need to overuse leverage. Based on margins and subjective information from earnings calls etc., it seems that Aviation and Healthcare seem to be the most productive assets. When it comes to capital allocation, those would be the usual suspects. It would make sense to keep fortifying those castles and keep widening those moats. As the for the other “growth” business – Renewables – we’ve discussed that the moat isn’t all that wide. That makes it a tricky decision for management. Renewables a low margin business but one that will probably benefit from tremendous industry growth. And here’s where, theoretically, GE’s conglomerate structure can be an advantage. Can it find cost synergies amongst its various “rotating blades” segments? If margins are the problem in an industry that’s quickly becoming commoditized, the answer must lie in cost management. Power segment enjoyed a great run while Natural Gas Power Plants were all the rage. And while that party was going on, GE heavily overinvested (in hindsight) into improved turbines and shoring up inventory. But then Wind Power happened. And now GE finds itself in a predicament: Should it divert more shareholder capital into the lower-margin (but high growth) Renewables business or should it keep funding the high-margin (but declining) Power business? It seems, as of the investor meeting a few weeks ago, that GE as chosen to trim its Power business and free up some cash for, presumably, Renewables, Aviation, and Healthcare.


Sustainable Free Cash Flow: About $6 billion – assuming that CEO Flannery & team can actually make GE a more focused company.

It’s hard to see GE growing much beyond that $6 billion number. Flannery and team will have to make good on their promises of cutting the fat and do a better job of capital allocation. The latter would involve making decisive bets on GE’s portfolio. We discussed that Aviation and Healthcare are the relatively easy bets. They have the widest moats. Renewables is a tricky decision, along with Power (Natural Gas turbines). Flannery and team will have make a decision: Should they bet heavily on Wind Power by diverting capital away from Gas Turbines? But then what about the margin issue? So far, it seems, that GE has been agnostic. They seemed to have bet heavily on both the Nat-Gas party and the Wind Energy party. But over time one will eat the other. Is GE prepared to make that bet early on? Only then will Free Cash Flow grow. Otherwise, I can’t expect Sustainable Free Cash Flow to grow beyond this $6 billion number.

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