This has been an eventful year for General Electric (GE), one that brought about the most significant changes that the company has seen in its 127 year history. The company has repositioned its business mix, drastically reducing its profile in financial services and emphasizing its industrial core. It has also stepped up its drive to infuse its products with sophisticated technology (e.g. internet of things (IoT), additive manufacturing and advanced software) that can help its products run harder and longer and give customers greater insight into their utilization efficiency.
This transformation is taking place in an increasingly uncertain global environment characterized by (1) slow growth and volatility, (2) geopolitical uncertainty (and increasing hostility toward business, and globalization), (3) depressed prices for natural resources (which has hurt many emerging, resource-dependent countries), (4) increased regulation (which has restricted capital access) and (5) the transition of China away from export-oriented growth and infrastructure development in favor of increasing personal consumption and raising the value added to its manufactured products.
In this environment, General Electric knows that it has to remain competitive to maintain market leadership. It must deliver its products at lower cost, help customers increase productivity, capture growth in every available product niche, increase the speed of its business processes, including new product development, and infuse technology throughout all of its products and processes. Management thinks that the company is well prepared for these challenges.
General Electric has accomplished quite a lot in 2015. It is well on the way toward completing the pivot away from financial services toward industrial. It has also exceeded performance expectations, returning $32 billion in cash to investors while continuing to invest in its future.
Its industrial businesses will deliver operating EPS toward the higher end of its initial guidance. Management has narrowed the range to $1.13-$1.20 from $1.10-$1.20. Together with the $0.15 in EPS expected from the retained vertical financing businesses (aviation and energy) at GE Capital, General Electric expects to deliver consolidated operating EPS of $1.28-$1.35. (Operating EPS excludes $0.03 of uncovered restructuring costs, due to the failed sale of its appliances business, and $0.05 of foreign currency headwinds.)
With continuing opportunities for both growth and cost reduction, General Electric believes that it has built the foundation for continued double-digit earnings growth, which will take EPS above $2.00 per share in 2018.
General Electric expects to close $104 billion in GE Capital asset sales in 2015, much better than its original target of $90 billion. This does not include the $65 billion reduction in ending net investment (ENI) realized from the swap of Synchrony shares for GE shares that was completed in August. Overall the company expects to generate $14 billion of free cash flow (inclusive of dispositions) and return $32 billion in cash to shareholders through dividends and buybacks. Having signed contracts worth $155 billion for GE Capital asset sales going into 2016, GE will have more cash for future investments and returns of capital to shareholders.
With the winding down of GE Capital, General Electric has returned to its industrial core, now with a revenue base of $130 billion and good growth potential. All of its industrial businesses draw from and contribute technological know-how and intellectual property to the “GE Store.” In this way, each business maintains and sharpens its technological edge, which is key to sustaining market leadership. The company has a legacy of organic growth through the business cycles. Over the past five years, organic revenue growth has averaged 5% annually.
While each business has hit its own “rough patch” at various times, General Electric has become adept at managing through business cycles. Its businesses have often emerged from downturns with new, technologically advanced products that have driven their recoveries and raised market shares. In aviation, for example, a 20% drop in engine sales in 2000-2002 was followed by a 13 year period of sustained growth, led by the introduction of the CFM and GEnx engine families.
Similar cycles have occurred at other GE businesses. Power had to contend with the “power bubble” in the early 2000s; Healthcare with the pressure on customer costs in the lead up to and implementation of the Affordable Care Act; and Oil & Gas is now in the midst of its toughest down cycle yet following the plunge in oil & gas prices. Diversification and financial strength give General Electric staying power in these long-cycle businesses, which it has used to gain competitive advantage.
The company has used its market leadership and disciplined approach to investment to generate sustainable, high returns on capital, estimated at 17% for 2015. It has pulled out all stops to improve its cash conversion cycles. By maintaining its sensitivity to environmental and corporate sustainability issues, it has also bent down the curve on social costs.
Alstom Power & Grid Acquisition. General Electric has great expectations for the integration of Alstom’s power and grid business, its largest industrial acquisition to date. The $10.6 billion acquisition closed on Nov. 2. Alstom has become part of GE’s Power and Energy Management businesses. Like GE, Alstom manufactures and services gas and onshore wind turbines and electricity grid solutions. It also produces and services steam, offshore wind and hydroelectric turbines.
The Alstom acquisition will have a small negative impact on 2015 results; but GE projects that it will add $0.05 to per share earnings in 2016 and $0.15-$0.20 in 2018. It ultimately expects to realize a 15% internal rate of return on its investment in Alstom.
As with its core businesses, its plan for achieving higher profits has both growth and cost reduction elements. Management says that it expects the Alstom integration will realize $3 billion in cost synergies within five years (by 2020). Its plan for achieving those synergies is well ahead of those made for other acquisitions. The $3.0 billion target does not include a potential $600 million from growth synergies.
The Alstom power and grid business is a great fit for General Electric. Alstom is a global producer. 85% of its business comes from outside the EU, its home territory, mostly in emerging markets.
The combination increases the content that GE can sell into newly constructed power plants. For example, GE’s gas turbines can be paired with Alstom’s heat recovery steam turbines and sold as a package along with related services. Accordingly, Alstom will raise GE’s supplied content percentage in a typical combined cycle power plant from 30% to 70%. It also adds about $10 billion of sales in key growth markets, like Brazil, India, China and the Middle East. Alstom expands GE’s installed base in gas turbines by 35%. It will both contribute to and benefit from the GE store. Management now sees better growth opportunities with Alstom than it originally envisioned.
GE Capital Wind Down. As already noted, the scaling down of operations at GE Capital is progressing at a faster-than-anticipated pace. Already, GE Capital has closed on $170 billion of divestitures, including the $65 billion ENI reduction from the spin-off of Synchrony (SYF). $155 billion of contracts for additional divestitures have been signed and another $50 billion is on tap. Including the $20 billion GE-SYF share swap, GE Capital will return about $23 billion to GE in 2015 and another $18 billion in 2015. It is on track to return a total of $55 billion to GE (to be distributed to GE shareholders) by 2018. With the scaling down of GE Capital’s operations, General Electric plans to apply to de-designate GE Capital as a Systematically Important Financial Institution (SIFI) in the 2016 first quarter.
After all divestitures are complete, GE expects to be left with the financial verticals, primarily in aviation and energy, whose missions are to provide financing to facilitate customer product purchases. GE estimates that the total ENI of the verticals will be not more than $90 billion and that these business will deliver a combined return on equity of about 13%.
Oil & Gas Business. GE’s Oil & Gas business, which provides products and services to oil & gas drillers, with a special focus on undersea exploration & production (E&P), has been struggling to maintain revenues and profitability in the face of sharp cuts to E&P budgets in the wake of the steep drop in oil and natural gas prices. In 2015, the business expects to generate $17 billion in revenues, down 9.1% from 2014, while at least holding the line on “organic” operating profits. With the steady decline in its backlog, however, Oil & Gas revenues and profits will most likely fall 10%-15% in 2016.
The business is on track to take out $1 billion of costs in 2015 and 2016. During this time of declining demand, it continues to focus on developing new technologically-advanced customer solutions. It will use the financial strength of its parent to pursue both organic growth opportunities and acquisitions, including the recently announced acquisition of Metem. As it has in the past with most of its businesses, General Electric expects to enhance the business’s competitive position during this downturn.
Update on the Appliances Business. The acquisition of GE’s appliances business by Electrolux was scuttled over antitrust concerns, specifically the market share concentration for sales to residential developers. GE expects to find another buyer in short order and to sign and close a deal early in 2016, perhaps even at a higher price. In the meantime, the business is performing well, with revenues up 8% and EBITDA up double-digits through the first nine months of 2015.
2016 Performance Framework. General Electric expects to deliver operating EPS of $1.45-$1.55 per share in 2016, free cash flow (including dispositions) of $28-$30 billion and return $26 billion to shareholders (including $8 billion of dividends). Consolidated industrial operating profit should be up mid-single digits, with double-digit gains in Energy Management and perhaps Aviation, single-digit gains in Renewable Energy and Healthcare and flat-to-down profits elsewhere. Profits will be impacted by the ongoing integration of Alstom and two major new product rollouts: the LEAP jet engine and the H-Class gas turbine. Other obvious factors that may affect GE’s profitability include the strength of the economies in the U.S. and China, the success of internal restructuring and cost out programs and movements in commodity prices and in the U.S. dollar.
Major issues facing each of General Electric’s business segments and management’s expectations for revenue and profit growth (using GE’s shorthand: “++”=double-digit gain; “+”=single-digit gains; “=”=flat; “‑“=single-digit declines and “—“=double-digit declines) include:
Power: (R:++,P:++) The Alstom integration and the expanded scope that it brings in power plant projects will be key performance drivers for Power in 2016, along with the ramp up of sales and production for the H-Class gas turbines. As with all GE businesses, product cost out, growth in services and increasing digital integration are priorities.
Renewable Energy: (R:++,P:+) The Alston integration and its impact on GE’s onshore wind turbines, as well as ongoing efforts to drive cost out of the business are the big issues.
Energy Management: (R:++,P:++) The Alstom integration and continuing efforts to grow the business, drive out cost and expand product offerings, especially through the GE Store, are priorities. EM is also seeking to grow its grid solutions business.
Aviation: (R:+,P:+/++) Low fuel costs and better operating policies have improved customer demand and profitability at airlines, facilitating their purchases of aircraft. The role out of the LEAP jet engine should offset expected declines in military jet engine volumes; but new product initiatives in military and advanced turboprop engines are well underway.
Healthcare: (R:+;P:+) In a flip-flop, business has been stronger in the U.S., but weaker in emerging markets. Life Sciences and digital solutions are expanding. Funding for customer purchases is more uncertain. Focus remains on reducing product costs and administrative expenses.
Transportation: (R:-/P:-) An exceptionally strong 2015 will make for tough prior year comparisons in 2016. GE sees a slower rail freight market in North America next year. Mining and oil & gas markets will remain challenging. Longer term, GE sees big opportunities for its Tier 4 locomotive in Russia and Latin America.
Appliances & Lighting: (R:–/P:–) Projected declines in revenues and profits reflect the anticipated sale of the Appliances business in the first half of 2016. Otherwise both businesses will be up. GE has one of the fastest growing LED lighting businesses, with projected 33% CAGR in revenues to $5 billion in 2020. It will use advanced technology to create products that will save customers money, for example, by giving streetlights the ability to shine less brightly when no one is near.
GE Capital Verticals: (R:=/P:=) Aviation is in a strong position, with no delinquencies or assets on the ground and a young fleet. Energy Financial Services is coping with the sector downturn, aided by its disciplined lending approach and diversified portfolio. GE has launched the Industrial Finance vertical to promote its offerings from the GE store and enhance the value proposition of its product offerings with customers.
Corporate: 2015: $2.5-$2.6B, 2016: $2.0-$2.2B. 2015 corporate expense totals include $0.3 billion of restructuring costs. GE expects to reduce corporate costs by $0.2 billion in 2016. Gains from asset sales should offset anticipated restructuring costs.
Outlook for 2016 and Beyond. General Electric expects mid-single digit growth in consolidated revenues and operating profits in 2016, but a double-digit increase in EPS (to a projected $1.52), due to share buybacks. The company is pulling out all stops to grow revenues organically and improve margins. The Alstom acquisition enhances GE’s overall growth prospects. GE anticipates that it will have another $165 billion of capital, including $20 billion of additional borrowings, to deploy in future acquisitions and share buybacks. All of this drives a 2018 EPS target above $2.00 per share, which represents a three-year CAGR of 15% from the mid-point of the expected 2015 EPS range of $1.28-$1.35.
In my mind, among the risks facing GE and its investors, its profit target presupposes a continuation of and eventually at least a modest pick-up in the global economic recovery. On the top and bottom lines, GE is currently outperforming the global industrial sector. While it has become adept at finding growth and profits wherever they can be obtained, it is unlikely that it will be able to grow EPS at an accelerated pace going forward without more of a tailwind from the global economy, especially improvement in emerging market economies.
Furthermore, double-digit EPS growth is driven in large part by share buybacks, which have been facilitated by dispositions at GE Capital. Share buybacks generate a lower quality of EPS growth (compared with organic growth in operating profits). Beyond 2017, with GE Capital’s divestitures nearly complete, GE’s operating profit will have to grow at a faster rate, if the company is to sustain its double-digit growth in EPS.
Courtesy of StockCharts.com
Year-to-date, GE’s share price is up 23.8%, much better than the S&P 500’s 0.9%. Its stock has delivered a total return of 28.1%, much better than the S&P’s 3.1%.
At the current price of $31.28, GE’s stock offers a 3% dividend yield and trades at 24 times estimated 2015 EPS of $1.33 and 21 times projected 2016 EPS of $1.52. This is appropriate, even somewhat cheap, for a company that is growing earnings at a 15% annual clip. If General Electric can sustain that earnings growth pace through 2018, the stock should deliver an average annual total return of 15%-20% over that time frame.
December 29, 2015
Stephen P. Percoco
Lark Research, Inc.
P.O. Box 1543
Linden, New Jersey 07036