Given the complexity of its business mix and financial structure, valuing GE is not an easy exercise even under benign economic conditions. The task is made even more difficult when there is considerable uncertainty about prospects for the global economy.
Up until the emergence of the coronavirus, investors and analysts were better able to take the global economic outlook as a constant and consider the changes in GE’s operating and financial performance as mostly self-inflicted. After GE disclosed its problems in 2017, valuing GE primarily required assessing how long it would take for the company to get back on track.
Over the past month, however, the near-term outlook for the global economy has worsened considerably. Although much of the uncertainty about GE’s efforts to restructure its operations has subsided, the company now faces a global economy that almost certainly will see a sharp drop in activity over the next couple of quarters and possibly beyond. Now, valuing GE requires us to assess its prospects in a far more uncertain global economic environment.
On March 4th, GE held its annual outlook conference call. CEO H. Lawrence Culp said that the company’s 2020 priorities include solidifying its financial position, strengthening its businesses and driving long-term profitable growth. The first two priorities are repeated from 2019; the third – driving growth – is new this year. GE still has work to do to improve its financial strength and the operating efficiency of its businesses; but the heavy lifting to achieve these goals is closer to completion. Going forward, the company will maintain its focus on improving efficiency –through the continuous application of “lean” principles, for example – but it is now turning its attention to growing its industrial businesses again.
Management’s guidance anticipates adjusted EPS of $0.50-$0.60 per share in 2020, down from $0.65 in 2019. The decline is due to industrial dispositions, primarily the sale of BioPharma ($0.11), and lower expected earnings at GE Capital ($0.05-$0.07), partially offset by improvements in other businesses ($0.02-$0.07) and lower interest and tax expense ($0.01-$0.04). The guidance incorporates the expected effect of COVID-19 on the company’s 20Q1 performance, but not for the balance of the year.
With the sale of BioPharma, the 2020 adjusted EPS guidance range represents a modest downward reset of the company’s earnings base. GE is still looking to sell its remaining 36.8% stake in Baker Hughes (BKR), which is now worth $4.8 billion (at a $10.96 BKR share price, including a $706 million promissory note due to GE), down from $10.4 billion at the beginning of the year (when BKR share price was $25.62). Other than BKR, GE’s disposition program appears to be nearly complete. GE may continue to look for ways to peel off smaller assets or operations from GE Capital, but any major dispositions would be a surprise.
Management’s adjusted EPS guidance reflects an accumulation of the outlooks for each of GE’s industrial segments and also for GE Capital. These were discussed in some detail on the 2020 Outlook conference call. My summaries and observations on the outlook for each of the segments, except for GE Capital which I will cover in a separate post, are provided below:
Power. GE’s Power team sees encouraging signs of progress across the business, but it is still too early to declare its multiyear turnaround effort a success. It expects that a stable gas turbine market and recently reclaimed market share will produce low single-digit growth in revenues and modest margin expansion in 2020, driven by improved performance on outages and ongoing cost-out efforts.
The power industry booked orders for 39 gigawatts (GW) of gas turbine capacity in 2019, up from 29 GW in 2019. GE Gas Power’s gas turbine orders increased from 8 GW to 13.6 GW, as reported in GE’s 10-K, which translates into a market share recovery of 730 basis points to nearly 35%.
Management says that it is underwriting new projects with greater discipline, including fewer turnkey projects (which have suffered cost overruns), improved risk assessment and more built-in cost contingencies. The business has made significant strides in improving quality and on-time delivery.
Gas Power expects to ship 45-50 gas turbines in 2020, up from 38 in 2019. It is also looking to take another 10% out of fixed costs this year. Management believes that the increase in volume, which helps absorb fixed overhead, coupled with the efficiency gains from the application of lean management techniques, will improve Gas Power’s competitiveness further in 2020.
The gains in Gas Power in 2019 were partially offset by ongoing challenges in the Power Portfolio (PP) division, which includes GE’s steam power, nuclear and power conversion businesses. New construction of coal and nuclear power plants has virtually ceased in the U.S. and coal plant closures have reduced upgrades and maintenance work. This has hurt sales of new steam power units, forcing a downsize of PP’s manufacturing footprint, a shift of some of its manufacturing capacity to lower cost regions (e.g. Asia) and an increasing focus on the services business. Likewise, with almost no new construction of nuclear plants, PP has been focusing on services, helping customers improve operating efficiency and lower refueling costs.
In contrast, PP’s Power Conversion is a growth business benefiting from the increasing trend toward electrification. It has refocused its sales effort to concentrate on the most profitable opportunities, exiting unprofitable business and targeting growth niches, such as medium-voltage projects in marine, oil & gas and industrial applications. It is applying lean principles to improve cycle times and reduce costs. While the business remains unprofitable, these efforts provide a path to profitability.
On balance, GE’s Power business has made significant strides over the past few years; but a sustainable rebound in its revenues and profits still requires further recovery in demand for new turbine units and related services from electric power producers. This, in turn, depends upon continued growth in global electricity usage. Early signs from regions affected by COVID-19 suggest that overall electricity demand has declined between 5% and 20%, with a sharp drop in commercial and industrial usage offset partially by increasing residential usage. As long as this contraction is short-lived, the recovery in global power industry demand should continue.
For 2020, I project that Power’s segment EBITDA will increase 10% (off of a low base) to $1.4 billion, which is consistent with management’s guidance.
Renewable Energy. GE is a market leader in onshore wind, hydro and grid solutions: three out of the four businesses that comprise its Renewable Energy (RE) segment. It is also aiming to gain significant share in offshore wind with the introduction of the Haliade-X, a 12-megawatt prototype, which will be the most powerful offshore wind turbine in the world.
As with all of its businesses, GE aims to build, maintain or improve its leadership positions through the application of emerging technologies to its existing products. In wind, it seeks to increase competitive advantage by incorporating technologies that drive down the cost of producing electricity for its customers, who are predominantly utility-scale operators. Grid Solutions, which was transferred from the Power segment in 19Q2, is not a renewable energy business per se; but it stands to gain from the efforts to incorporate decentralized and intermittent renewable energy power sources and battery storage into the power grid. a challenge for many utilities, 90% of which already utilize Grid Solutions’ products and services. Similarly, GE is looking to enhance the efficiency of its hydropower technology by incorporating digital solutions. GE’s existing hydropower customers represent 25% of global installed capacity.
Onshore wind, RE’s largest business, produces two-thirds of its revenue and is profitable. The business is supported by LM Windpower, a leading supplier of blades to the wind power industry, which was acquired in 2017. In the U.S., onshore is benefiting from the positive effects of the Production Tax Credit (PTC) cycle, which will lift U.S. wind turbine sales to a record in 2020 before falling and levelling off in 2021; but the extension of the PTC to 2024 could provide some upside. Outside the U.S., onshore likewise continues to grow rapidly, but industry sales are also expected to fall and level off in 2021 and beyond. RE anticipates stronger onshore sales in 2020 with expanding profit margins.
Offshore wind is a growth opportunity. RE took 5GW of orders in 2019 for the Haliade-X, which offers lower development and operating costs for offshore operators. Besides its 12MW generating capacity, which leapfrogs competitors’ 10MW turbines, the Haliade-X has a high capacity factor, giving it the potential to produce more than 60GW hours of electricity annually, enough to power 16,000 European homes. When the initial units are shipped in 2021, RE anticipates $2 billion of profitable sales.
In contrast, RE’s Hydro and Grid Solutions businesses are turnarounds in progress. Management says that the two businesses, which account for a third of segment revenues, have both suffered from poor project execution, subpar quality and poorly underwritten deals before 2016, about $1.5 billion of which remain in backlog (but down from $7 billion a few years ago). RE has installed new leadership in each of these businesses and expects them to return to profitability, probably in 2021.
GE’s Renewable Energy segment is a leader in what remains a competitive market. While many of the profitability challenges that it faces are internal, the segment’s profitability has been sub-par for quite some time. RE’s profit has declined steadily from $0.7 billion (on $14.0 billion of revenues) in 2017 to a loss of $0.7 billion (on revenues of $12.3 billion) in 2019. As noted, much of the segment’s woes are attributable to the acquisition of Alstom’s Renewables and Grid businesses in 2015. The poor profitability of the acquired Alstom joint ventures was masked to a degree until late in 2018, when GE bought out the noncontrolling interests (who previously were allocated their share of the joint ventures’ losses in accordance with contractual terms).
Besides the internal problems and despite rapid growth in industry sales, RE cut prices to match competitors and retain share, which squeezed margins. Importantly, its price index on orders has recovered, due to both market dynamics and improved pricing discipline. If this continues in 2020, as management expects, a significant headwind on margins should begin to subside.
Management is laser-focused on improving RE’s profitability. Although it expects improvement in 2020, it does not anticipate a return to breakeven profitability until 2021.
Healthcare. With the expected March 31 sale of the GE BioPharma business, Healthcare’s portfolio will consist of Healthcare Systems (imaging, ultrasound, life care solutions and enterprise software and solutions) and Pharmaceutical Diagnostics. In 2019, these businesses generated an estimated $16.6 billion of revenues and an estimated $3.4 billion of EBITDA. (My EBITDA estimate assumes that BioPharma generated $1.2 billion of EBITDA in 2019.)
GE estimates that the combined global end markets served by the remaining Healthcare businesses had 2019 sales of $47 billion, growing at a 3%-4% annual rate. Management anticipates that those businesses will grow their combined 2020 revenues at a similar rate, with the Healthcare Systems businesses gaining share in stable market conditions and Pharmaceutical Diagnostics sustaining its mid-single-digits growth rate. It also expects modest improvement in segment margin, driven by continued productivity gains and cost reductions, partially offset by increased R&D spending.
Healthcare sees new product introductions as essential to winning share in stable markets. At the Radiological Society of North America Conference in December, it showcased 61 new products and solutions. Digital analytics and artificial intelligence applications, which are the backbone of the push toward personalized medicine, are key focus areas for its new product development efforts.
Healthcare has responded to the challenges posed by COVID-19 first in China and now across the rest of the world, especially in the US. While seeking to protect its workforce, it has been expanding production (and in some cases manufacturing capacity) for products such as CTs, ultrasound devices, mobile X-ray systems, patient monitors and ventilators that are used in the diagnosis and treatment of the disease. Last week, it announced a plan to work with Ford Motor Company to scale up the production of ventilators in the U.S. Revenues generated from this effort will probably not be significant and will not offset the product and service revenues lost from its customers taking steps to cancel elective procedures in order to concentrate on caring for those infected by the virus.
At this time, I project that Healthcare will generate 2020 EBITDA of $3.7 billion, down 20.5% from $4.6 billion in 2019. All of the decline is due to the sale of BioPharma. I anticipate that EBITDA on the remaining Healthcare businesses will grow 9% for the year. My projections do not reflect any loss of sales or profits from the impact of COVID-19.
Beyond 2020, management believes that its focus on better commercial execution, cost cuts, productivity improvements and product innovation, as well as modest market growth will allow Healthcare to continue growing revenues, expanding profit margins and increasing free cash flow. Its ongoing expansion in China, where it is adapting many of its products to local market needs, expanding manufacturing capacity and diversifying its supplier base, is key to achieving these goals.
Aviation. As GE’s Power and Renewable Energy segments have struggled, its Aviation segment has picked up the slack. In 2019, Aviation accounted for 38% of GE’s total industrial segment revenues and 65% of its profit. That’s up from 30% of revenues and 47% of profit in 2017. Despite the challenges posed by the grounding of the 737 Max and COVID-19’s impact on air travel, management sees strong underlying fundamentals in the business.
2019 segment revenues increased 7.6% to $32.9 billion. Equipment revenues rose 11.3% to $12.8 billion, while service revenues rose 5.2% to $20.1 billion. Commercial engine unit sales were up only slightly, as strong growth in deliveries of the LEAP, which powers Boeing’s 737 Max, offset a decline in the legacy CFM product family. Military engine unit sales increased 6.4% to 717 engines, even though Aviation missed its forecast because of supply chain delinquencies. Service revenues rose due to higher prices, higher spare part shipments and higher revenues on long-term maintenance agreements.
Aviation’s 2019 segment profit increased 5.5% to $6.8 billion, slower than the growth in sales. Most of the increase came from services. Equipment profits benefited from the internal sale of LEAP-1b engines to GE Capital Aviation Services (GECAS) in anticipation of the 737 Max’s recertification, partially offset by lower margins on LEAP and Passport engine sales, which are still early in their product life cycles, and a bad debt charge.
Aviation has successfully transitioned its three biggest commercial product families – the LEAP, GE9X and GEnx – for the future. Having been specified on the Boeing 737 Max (sole source), Airbus A320neo and China’s Comac C919, the LEAP is well positioned for future orders. Aviation also has high hopes for the repositioned GE9X, which will power Boeing’s 777X in 2021, and the high-thrust GEnx , which is the best-selling engine on the 787 Dreamliner. GE’s Passport engine powers Bombardier’s Global 8000 business jet.
Aviation’s installed base now includes nearly 40,000 engines. 63% of the fleet has seen one shop visit or less. The expected growth in these three product families will increase the installed base further over the next several years, raising the growth prospects for service revenues and profits.
In military, Aviation’s T901 was named as the replacement engine for the Army’s Black Hawk and Apache helicopters. This represents a life-of-program opportunity of $20 billion. Its F404 engine will also power the new advanced T-7A red Hawk trainer aircraft, a $5 billion life-of-program opportunity.
In its March 3 2020 Outlook Presentation, Aviation forecasted higher segment earnings this year, despite the headwinds of the 737 MAX and COVID-19. From its original production goal of 2,000 units, it has cut LEAP annual production capacity to 1,400 engines, based upon an assumed return of service of mid-year for the MAX. At this level, Aviation believes that it has sufficient capacity to handle the anticipated ramp in MAX production into 2021.
Aviation also expects that, based upon the expected decline in global air traffic caused by COVID-19, shop visits from its installed base of commercial engines will slow this year, which will reduce service revenues. Aviation’s March forecast was based mostly upon the 35% decline in air travel experienced in Asia following the response to COVID-19’s rise in China. Since airlines have cut flight schedules worldwide by as much as 50% since then, it may revise its guidance downward on the 20Q2 earnings conference call, now scheduled for April 29.
While Aviation has reduced commercial production capacity, it is ramping up military aircraft engine capacity, in part to complete deliveries on those 2019 orders that experienced supply chain delinquencies. Although military sales of $4.4 billion fell short of its original plan of $4.7 billion, Aviation has reaffirmed its 2025 sales target of $7.5 billion, which equates to annualized growth of about 10%.
On balance, while Aviation has a well-positioned product portfolio that should ensure that it maintains its dominance in the industry, its future performance still very much depends upon the prospects for the global economy and especially in the near-term, the 737 Max recertification. Management’s guidance anticipates that revenues will rise at a low single-digit rate in 2020, with flat commercial revenues and a double-digit increase in military revenues. Within commercial, a low single-digit increase in services revenue offsets a double-digit decline in equipment. Segment margins are expected to be about 20%, down slightly from 2019’s 20.7%. The combination of the low single-digit gain in revenues and the slight decline in segment margin should result in a small lift to segment profit in 2020. My projections for Aviation, which reflect management’s guidance, anticipate that segment EBITDA (i.e. segment profit plus depreciation and amortization) will increase by about 3% to $8.2 billion from just under $8.0 billion in 2019.
Other Posts in this “Deep Dive on GE” series:
Projected 2020 Consolidated Results (March 31, 2020)
Consolidated Enterprise Valuation (March 31, 2020)
GE Capital (April 3, 2020)
Sum-of-the-Parts Valuation (April 5, 2020)
March 31, 2020
Stephen P. Percoco
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Linden, New Jersey 07036
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