|
|
|
|
||
GE on Solid Footing as it Marches Toward a High-Single-Digit Free Cash Flow Margin; We Raise FVEMorningstar's AnalysisGE on Solid Footing as it Marches Toward a High-Single-Digit Free Cash Flow Margin; We Raise FVE Joshua Aguilar Equity Analyst Analyst Note | by Joshua Aguilar Updated Apr 28, 2021 Despite the headline stock trade-off, narrow-moat-rated General Electric had a solid first quarter. We increase our fair value estimate to $15.10 from $14.10 previously, primarily due to interest rate tailwinds in GE’s pension liability, as well as time value of money. However, we also raised our fair value due to greater than expected progress in both healthcare and aviation’s margin profile (with the latter already hitting its 2021 target) in the first quarter, which itself was offset by weaker than expected top line revenue from aviation. With this latest raise, GE now is the cheapest name among our larger U.S. multi-industrials. What disappointed us, however, was not commercial aerospace sales figures, where we still expect a second-half recovery, but rather military and systems sales. GE has maintained for quite some time that military orders have been there and that it just hasn’t delivered, so it’s certainly a watch item. In fairness, management did address the supply chain and rotorcraft delivery pressures on the call. Considering GE's turnaround, we think a strong case could be made to increase our long-term earnings before interest growth assumption to be in line with peers (which would add about $1 to our fair value estimate). However, given what we perceive as mixed messaging on the timing of hitting the high-single-digit free cash flow margin (either in 2023 or just beyond), the headwinds related to GE ending its factoring program and unclear specific dynamics (we’re not alone here), as well as another major portfolio move that bears execution risk in the GECAS deal (as with any portfolio move), we prefer to see how the year develops before making such an adjustment. Business Strategy and Outlook | by Joshua Aguilar Updated Apr 28, 2021 CEO Larry Culp is engineering a successful turnaround of GE that the market has yet to fully appreciate. Driving this process is a steadfast, cultural commitment to lean principles based on the Toyota Production System. These principles include continuous improvement and the voice of the customer. We believe GE has line of sight to a high-single-digit margin toward the end of Culp's contractual CEO term in 2023. First, GE has materially reduced its debt burden by $30 billion during Culp's tenure. While some portfolio decisions like the sale of biopharma were painful, they were well-priced and provide the firm with critical flexibility to shift from a persistent defensive to offensive posture. While GE industrial net debt/EBITDA remains high, we think that the eventual aerospace recovery and continuous improvement initiatives will help drive this figure below 2.5 times by 2023. The gradual sale of Baker Hughes furthers GE deleveraging goals, while allowing the firm to focus on its core portfolio. Second, we believe narrow-body commercial revenue should recover at a more accelerated pace relative to wide-bodies given favorable domestic over international travel trends. We also expect highly profitable narrow-body aftermarket services will recover ahead of the rest of the commercial aerospace portfolio since this business is driven by departures as opposed to revenue passenger miles. Deferring shop visits can add 20%-30% to airlines' costs, and passenger survey data persistently reveals a majority of passengers are willing to travel once vaccinated. From this standpoint, GE is well-positioned to capitalize on this trend, with more narrow-bodies that are 10 years or younger than the rest of the industry, and roughly 62% of its fleet seeing one shop visit or less. At a minimum, we believe GE has an opportunity to enjoy strong incremental margins on a recovery matching decremental margins during the recession. Finally, healthcare is a global leader in precision health, with technology helping practitioners gain valuable insights and eliminating waste in the healthcare system. We expect 50-basis points of consistent margin improvement on lower mid-single-digit growth. Economic Moat | by Joshua Aguilar Updated Apr 28, 2021 We assign General Electric a narrow economic moat based primarily on switching costs and intangible assets stemming from its massive installed base of industrial equipment, as secondarily from cost advantage due to economies of scale in some of its core businesses. Nevertheless, we hold off on assigning GE a wide economic moat given our lack of confidence in our 20 year hurdle rate for excess return on capital. Three critical issues are key to our analysis: secular pressures facing and uncertainties surrounding GE Power and Renewable energy; the firm’s financial position as it pares down assets and the timing related to those disposals (though those are rapidly approaching the rearview mirror); and lingering liabilities related to GE Capital, particularly as it concerns long-term care insurance. While the firm’s Aviation and Healthcare segments certainly have moats, the firm is losing one of its most highly desirable assets that generates consistent earning power in GE Biopharma going forward. GE Aviation undoubtedly meets our highest standard of a wide-moat business and is GE’s crown jewel. The segment benefits from intangible assets, switching costs, and scale-driven cost advantage. GE essentially competes in a duopoly in both the wide-body (twin-aisle) and narrow-body (single-aisle) space against Rolls-Royce and Pratt and Whitney, soon to merge into Raytheon Technologies. Excluding GE’s 50% interest in its CFM joint venture with Safran, we estimate that GE typically commands about 43% of the combined narrow-body and wide-body engine markets, as measured by the installed base. The Aviation segment operates on a razor-and-blade model. A GE/CFM engine is present in two of every three commercial departures, and the firm’s installed base between GE and its joint ventures reaches nearly 40,000 engines. In the formative years after a new engine launch (about one third of the overall cost of a new plane), GE will typically implement an estimated 70% discount on its new narrow-body engines from their listed prices. Over time these discounts erode. A typical jet engine will then first require service in about year seven of operation at which time an engine program may pass break-even and become a recurring and enviable profit stream for GE. These bespoke service contracts typically extend 25 years into the future. We believe intangible assets are particularly critical for engine deliveries–the razor in the razor-and-blade model. The technical knowledge needed to design and manufacture a jet engine is GE’s main source of intangible assets. This technical know-how is supported by the firm’s research and development budget, of which about one third is principally funded by the U.S. government. Other intangible assets include the firm’s patents, a long track record of success, and its customer relationships with both Boeing (primarily) and Airbus. A track record of success can have a disproportionate impact in delivery wins. Relatedly, switching costs are strongly associated with aftermarket sales – the blade in the razor-and-blade model. GE’s switching costs are a result of the firm’s engines and associated equipment’s strong integration into customers’ airframes and landing systems. In the United States, aircraft engine inspections are both mandated and regulated by the Federal Aviation Administration, and unplanned downtime related to concerns over an engine’s efficacy can wreak havoc for airlines, both in terms of time and expense. This high cost of failure ultimately increases customer loyalty. By our count, nearly 63% of GE’s commercial aviation revenue stems from its services, which we believe represents strong evidence of customer reliance on GE as the original equipment manufacturer. Moreover, GE’s pursuit of rate-per-flight hour service agreements, whereby OEMs like GE receive service payments based on flight hours, both boosts returns and solidifies switching costs. With flight hour services agreements, GE receives payments over the life of a contract. Additionally, because OEMs assume the maintenance risk, firms like GE, Pratt, and Rolls Royce are incentivized to increase on-wing time. According to Aviation Week in late 2016, the LEAP’s predecessor, the CFM56-7B demonstrate an industry-leading 99.96% percent engine dispatch reliability rate, which equates to only one delay or cancelation every 2,500 departures. Furthermore, that engine can stay on-wing for as many 20,000 cycles (typically 18,000). Cost advantage from scale is also evident in GE Aviation's margins, which exceeds Pratt’s by several percentage points (aside from the benefit of a massive installed base, we think GE is particularly adept at manufacturing engines at a large scale), or in the R&D it can leverage not just across its power segment with its gas turbine units, but also previous-generation jet engine models - the LEAP engine continues the tradition begun by the CFM-56 with $1.4 billion greater residual value than its closest competitor. Healthcare is currently GE’s second-best business and one we think also merits a wide-moat rating, even with the absence of GE Biopharma within GE Healthcare's Life Sciences division. Medical imaging, which constitutes about two thirds of GE Healthcare's revenue base, is a notoriously opaque industry and increasingly commoditized, but one where we think GE also benefits from intangible assets, cost advantage from scale, and some switching costs. GE’s medical imaging installed base is large at over 4 million units. From our conversations with industry experts, GE and its competitors consolidated the industry, acquiring competitive threats like well-regarded x-ray machine maker Picker in the 1980s. Two major players have dominant share in the market, including GE and Siemens, with each trading blows for a competitive advantage. Practically speaking, moreover, our experts inform us that GE and Siemens are the only two vendors actively considered by large hospital networks (with notable exceptions like Hologic’s mammography machines). Doctors may go as far as choosing their residencies based on the reputation of these machines, particularly CT scans, both in terms of quality and service reliability. Indeed, most large U.S. hospitals will have a reputation of being either a “GE hospital” or a “Siemens hospital.” Our belief is that this reputation obviates some of the pricing pressures that may naturally occur in more rural markets, where price is far more important given availability of resources (this is a deflationary business that overall loses price about 1% per year). Given the critical functions these machines perform, their high cost of failure, and a doctor’s familiarity of use, hospitals loathe switching providers for a less expensive alternative. These switching costs are reinforced by GE Healthcare's massive footprint, which allows the firm to expeditiously service any faulty equipment and avoid any disruption to patient care. Another advantage of having acquired makers of different machines is that both GE and Siemens attempt to sell hospital procurement departments an entire suite of machines. GE’s economies of scale afford it the privilege of hiring a large salesforce of specialists for each types of units, including MRIs, X-rays, CT scans, ultrasounds, and mammography machines. Moreover, while it is our understanding hospitals will often pool procurement resources to increase bargaining power when negotiating with medical imaging providers, GE mostly continues to directly negotiate with each hospital. We suspect it retains its bargaining power by not disclosing pricing and requiring hospitals to sign non-disclosure agreements regarding any pricing information, keeping confidential what was once common knowledge in the industry two decades ago. Finally, GE’s digital software is well-integrated with machines, which also reinforces these switching costs. Physicians less often read x-rays from hard copy film, but instead rely on GE technology to read these images digitally in a single image repository, often in a different location from where a machine may be located. While a third-party software vendor could in theory operate with GE machines, our understanding is that this solution is far less than optimal. After GE Aviation and Healthcare, however, GE’s competitive position fares far worse, with many of its other business lines facing secular pressure. GE Power, the firm’s other large segment (it was once the largest by revenue, but is now third in GE's sales mix inclusive of GE Biopharma) faces three long-term issues: 1) overcapacity in the industry; 2) pricing pressures; and 3) a shifting energy mix in its end markets toward renewables (as well as operational issues). Grouping together its Power and Renewable Energy segments, we think of this super-segment as a no-moat business. While Power operates in a three-way oligopolistic market (along with Siemens and Mitsubishi-Hitachi), GE Renewable Energy competes in a more fragmented industry with other wind turbine manufacturers like Vestas, Siemens, and Goldwind (onshore and offshore wind revenues represent the brunt of Renewable Energy’s portfolio, even when including its Grid Solutions business). Moreover, while GE Power touts its 7,000-plus gas turbine installed base, and the fact that it currently powers more than 30% of the world’s power (as of 2018), the segment has at times fallen to number three of global gas turbine orders by energy capacity behind its other competitors. Furthermore, GE was late to realize the inevitable transition from fossil fuels to renewables, which is predicted to compete with fossil fuels subsidy-free from a levelized cost of electricity standpoint. Wind turbines don’t require the same maintenance needs as gas machines, which is where GE has traditionally made money on its long-term service contracts. We think these cost dynamics threaten to obviate the competitive benefits GE derives from its massive installed base in gas turbines, particularly as renewables also offer a far more attractive and minimal carbon footprint. According to the Financial Times, while natural gas narrowly beat wind power for new generation capacity in 2016, worldwide GE sales of large gas turbines dropped appreciably over a nine-year cycle (from 134 in 2009 to 102 in 2017). Using data from statista, market expectations, including the U.S. Department of Energy, materially under-forecast, by 383%, the energy usage and production of wind generation over a ten-year period. Under Jeff Immelt, GE failed to appreciate these risks, and we suspected its ill-time purchase of thermal energy provider and grid company Alstom will continue to weigh down the segment’s ROIC, including goodwill, for years to come due to this overcapacity. Power is forced to continue restructuring efforts to counteract this dynamic as demand for new gas orders fell down to 25 to at most 30 gigawatts in 2018 compared with 40 to 45 GW articulated at the start of 2017, a rate which persisted in 2020 and likely will for years to come. GE Renewable Energy suffers from many of the same competitive dynamics that plague GE Power, including even greater price competition to gain market share, and cheaper alternatives from other forms of energy, like solar, and depends heavily on production tax credits. As such, we don’t believe it’s a business with durable competitive advantage. Finally, GE Capital has been an albatross around the company’s returns, and in our view, is not only a no-moat business, but ultimately has been a liability for the company. The exception would be GE Capital Aviation Services, or Gecas, which has been the one bright spot for the segment. Gecas retains number-two market share behind AerCap in terms of estimated market value of its owned and managed fleets. In financial services, however, what matters is asset quality, which can hamper profitability during a recession. On this metric, Gecas has fared well, with reported segment profits declining only 14% from 2008 to 2009 (Gecas typically earns just over $1 billion per year). Even so, this is a competitive business without any natural barriers to entry, and Chinese lenders are willing to underprice competitors like Gecas and AerCap. Other portions of GE Capital, moreover, have not fared nearly as well. Most notably is its long-term care insurance business. While GE has not originated any new policies since 2006, the Kansas Insurance Authority is requiring the firm to contribute an additional over $7 billion to its insurance reserves over the next five years after already contributing $3.5 billion in 2018 (after a $3.5 billion injection in 2018, a 1.9 billion injection in 2019, and a $2 billion injection in 2020). These problems are exacerbated in a low interest rate environment as investment income can fall below projected returns. On the expense side, GE is also encountering claims that were underwritten with poor assumptions, including the life span of policyholders, or the cost of healthcare. Bottom line, we expect that GE Capital will continue to incur charges, particularly from the impact of GAAP insurance accounting rule changes in 2023. In the short term, we believe this will mask the earning power of the firm’s moatier assets. That said, we conclude that by 2024, GE Capital will no longer produce negative earnings. Fair Value and Profit Drivers | by Joshua Aguilar Updated May 28, 2021 After reviewing Airbus' announcement that it's increasing production rates for the A320 family to 64 per month by the second quarter of 2023, we raise our GE fair value estimate to $15.70 from $15.30. Airbus may ask suppliers to enable production rates to as high as 75 per month by 2025. However, we would like to see Airbus build a bigger backlog before increasing our forecast to these levels. Even so, we think this supports our view that the back half of 2021 should witness a rosier commercial aero outlook based on the domestic travel data we previously highlighted. Even with an estimated $3.7 billion headwind from the end of most of GE's factoring program, we're expecting just over $4.6 billion of industrial free cash flow. We also model adjusted EPS of $0.28 for 2021, just over the top end of management's guide. Nonetheless, we still value GE at over 20 times 2023 adjusted EPS, or about 17.5 times 2023 industrial free cash flow per share. In our view, the two most important contributors to GE’s earning power lie in GE Aviation and GE Healthcare. Aviation will have significant headwinds in the front half of 2021. Nonetheless passenger survey data and airline booking data suggest significant pent-up demand. Longer term, we think global middle income class growth will drive demand once more and help GE commercial aviation recover lost sales by 2024 to year-end 2019 levels. GE's fleet is young and strongly positioned in narrow bodies, which should help GE as domestic travel recovers ahead of international travel. Further, a majority of its fleet is still yet to see over one shop visit. Airlines deferring maintenance, moreover, can add considerable costs to their bottom line. As for GE Healthcare, we assume key market drivers include increased access for healthcare services from emerging economies and an aging U.S. population, coupled with digital initiatives that save practitioners' time, while protecting them from risks. Rolling this up, we believe these factors will help drive lower mid-single-digit sales growth, coupled with a minimum 25 basis point improvement in year-over-year margins. For Power and Renewables, we see both segments benefiting from the energy transition, but with the lion's share of the sales growth opportunity flowing through to renewables. That said, we expect minimal contributions to profitability over the next couple of years from either business, before ramping up to mid-single-digit plus margins by midcycle. Risk and Uncertainty | by Joshua Aguilar Updated Apr 28, 2021 GE's principal risk is related to COVID-19 fallout on its commercial aerospace business, including government interventions and acceleration of infections which ultimately affect both revenue passenger kilometers (demand) and load factors (utilization). Additional risks include GE's significant cash burn amid pricing pressures in some of its operating businesses, including renewable energy (which burned through negative $641 million in 2020); liabilities at GE Capital, particularly from its legacy insurance operations; and additional capital contributions from GE required to support GE Capital's operations amid asset sales. We remain vigilant over GE's insurance liabilities at GE Capital, as well as the amount of cash needed to support Capital from the parent company. Nevertheless, while we continue to believe that GE Capital's tangible book value is overly inflated, we're less concerned over this item than we were in prior years. Finally, GE has large key-person risk in CEO Larry Culp. Losing him before a successful turnaround would pose both critical headline and fundamental risk, in our view. From an environmental , social, and governance standpoint, we think GE faces a few risks that by now are well known to investors, including government investigations into its accounting practices, shareholder lawsuits, potential embargos from defense sales, and the impact of the global energy transition on GE's gas and steam turbine business (though GE exited its new coal build business and the energy transition mostly helps them with sales of renewables). However, we think the greatest ESG risk relates to fallout due to the climate impact from aerospace engines, though we don't think the fallout is enough to be material and we point out that GE has teamed up with NASA to develop a hybrid electric aircraft engine to address climate issues. Given its technology, we expect GE will be a leader in this field, which should ameliorate investor concerns. Capital Allocation | by Joshua Aguilar Updated Apr 28, 2021 We assign GE an Exemplary rating under our new capital allocation methodology. While GE's balance sheet clearly still remains overly leveraged and therefore weak, management has done an exceptional job bringing down leverage levels, and our thesis continues to be an all-out bet on Larry Culp's leadership in GE's turnaround efforts. We highly approve of his capital allocation decisions, particularly his focus on addressing the debt and organic investments (which offer the best returns profile), as well as the operational and cultural changes that Culp is driving, which we believe should meaningfully improve returns on invested capital during our forecast. Our thesis continues to be an all out bet on Larry Culp's leadership. Culp was previously the CEO and President of Danaher Corporation from 2000 to 2014. Under his stewardship, Danaher's stock rose about 465% against the S&P 500's approximately 105% gain. We maintain our faith in Culp's abilities has been rewarded. Many financial and operational improvements are already tangible two and a half years into his GE tenure. For example, GE has materially deleveraged the balance sheet by $30 billion, and GE Capital's debt/equity ratio now sits below 4 times. We applaud Culp for taking decisive action, particularly in selling GE's Biopharma business to his former firm Danaher for what was then a favorable price. We expect improvements to both balance sheets over time, coupled with increasing flexibility for other capital allocation priorities--most notably organic investments through R&D and capital expenditures. Furthermore, many of Culp's lean initiatives have clearly born fruit. For instance, the third quarter of 2020 was the first time all four industrial businesses flipped to positive profitability since Culp was named Chairman and CEO on Oct. 1, 2018. In that quarter, for instance, Power and Renewables produced 490 and 600 basis points of sequential operating margin improvement on a GAAP profitability basis (after each producing negative operating margins in third quarter 2019). Furthermore, healthcare turned in 16.2% GAAP operating margins in the third quarter of 2020, good for 317 basis-points of sequential improvement. Impressively, the healthcare segment managed to improve upon its outperformance during the fourth quarter, with GAAP operating margins of 19.7% a 350 basis-point sequential improvement from a strong third quarter. Based on management's guidance from its December 2019 healthcare investor day, the healthcare "remainco" was only supposed to improve organic operating margins about 50 basis points at the midpoint (off a base of about 14.5% when stripping out GE biopharma). On Nov. 25, 2019, GE announced that it appointed Carolina Dybeck Happe as its new chief financial officer and executive vice president. She started her role in March of 2020. We supported the addition of Dybeck Happe then and like it even more now given the value she brings as a strategic partner to Culp and her familiarity with running a lean organization. As we suspected, GE continues to benefit from her outsider's view of the firm. We spoke with her on March 31, 2020 along with other sell-side analysts at a virtual gathering. At the time, we figured GE would value her background related to both short- and long-cycle industrial businesses, her experience related to portfolio transactions (Maersk incidentally divested its own oil & gas business this year), as well as familiarity with a digital business in the case of Assa Abloy’s, and her board service for electrical equipment and energy businesses. We believe these have all served her well in her new role. Perhaps one of the most critical attributes about her background, however, is Dybeck Happe’s familiarity with debt reduction strategies. Given the importance of GE’s credit rating to valuation, as well as its financial flexibility and stability, her number one priority will likely continue to be bringing down GE’s industrial net debt/EBITDA to under 2.5 times. The company's financials, while still amongst the most difficult to read, have significantly improved thanks to the disclosures worked on by Dybeck Happe and Steve Winoker (a former sell-side analyst) and his team in Investor Relations. We expect further improvements as GE moves to reporting industrial and financial services in one reporting structure once it closes the sale of Gecas. And finally, Larry Culp has also been improving GE's culture by implementing many of the principles he took from his time at Danaher, including a laser-like focus on the customer and use of lean tools and workshops. We now believe GE is moving past its prior record of Poor stewardship that was anchored on the Jeff Immelt era, which included opaque accounting, overly aggressive targets, a watered-down culture that discouraged candor, and disastrous capital allocation. |
return to message board, top of board |