GE Power Surprises to the Upside; Strazik Should Continue to Drive Value at Vernova
GE Power Surprises to the Upside; Strazik Should Continue to Drive Value at Vernova
Analyst Note | by Joshua Aguilar Updated Jan 24, 2023
Nothing in narrow-moat-rated General Electric’s fourth-quarter results materially alters our long-term view of the firm. We raise our fair value by $1 to $88 due to time value of money, though we may further adjust our assumptions when the company issues its 10-K and we hear more at its 2023 Investor Outlook.
Full-year 2022 free cash flow of $4.8 billion slightly surpassed our expectations of $4.6 billion. While fourth-quarter sales of $21.8 billion fell just short of our $22.3 billion projection, adjusted EPS of $1.24 easily topped our $1.13 estimate during the quarter. Segment operating profit margins rose a rousing 170 basis points, and off a difficult comparison from last year’s fourth quarter that saw aerospace return to 20% segment operating profit margins then.
One cause of the rapid uplift this quarter was a better-than-expected performance from the power segment, which reached a segment operating profit margin of 13.8%, and improved 710 basis points. This was a level not seen since the fourth quarter of 2016. Though the second and fourth quarters are seasonally strong for the power business, this result was simply exceptional, and we think it’s a testament to the efforts led by GE Vernova CEO Scott Strazik. One thing we like is that there were skeptical corners of the market regarding the promise of greater transactional service revenue, yet transaction volume was one of the drivers of revenue and margins during the quarter. Price/cost and productivity also helped power margins. We no longer consider this business in “turnaround” mode, though we think incremental benefits are still possible, even as 2023 will prove difficult with continued inflationary and mix headwinds related to more HA-turbine deliveries.
Business Strategy and Outlook | by Joshua Aguilar Updated Jan 24, 2023
Larry Culp is engineering a successful turnaround of GE that the market still has yet fully to appreciate. We think shares have unfairly priced in deal limbo following GE's spinoff of its healthcare business in early 2023, and its announced Vernova spinoff in early 2024.
Driving GE's turnaround process is a steadfast, cultural commitment to lean principles, like continuous improvement and voice of the customer. We believe GE has line of sight to a high-single-digit free cash flow margin and potentially higher once GE completes its spins.
Thanks to the GECAS merger, GE materially reduced its debt burden by $87 billion during Culp's tenure. Following the spinoff of GE HealthCare, we think there's an opportunity for GE to shift from debt reduction to other capital allocation options that favor the shareholder. While some portfolio decisions like the sale of biopharma were painful, they were well priced and provided the firm with this critical flexibility to shift to offense.
GE's world class assets are also underowned by investors. GE Aviation is the crown jewel of GE's portfolio. We believe there is still some pent-up demand for air travel, and that departures should fully lap 2019 levels by the end of 2023. In the U.S. alone, TSA checkpoint travel figures reveal that passenger throughput is now lapping 2019 levels on some days.
We think GE is well positioned to capitalize in the narrow-body recovery, with more narrow-bodies that are 10 years or younger than the rest of the industry, and roughly 50% of its CFM56 installed base that has yet to see its first shop visit. Additionally, we think aviation can recover to over 20% operating margins by 2025, while delivering incremental margins in the mid-20s over the medium term.
Finally, while renewables is incurring significant losses, we believe the unit can come close to breaking even by 2025 and reach profitability by 2026 given the windfall from the U.S. Inflation Reduction Act, as well as a greater focus on project selectivity as opposed to market share.
Economic Moat | by Joshua Aguilar Updated Jan 24, 2023
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 like long-term care insurance. While the firm’s Aviation segment certainly has a moat, the firm is losing one of its most highly desirable assets that generates consistent earning power in GE HealthCare 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 52% 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 three of every four commercial departures, and the firm’s installed base between GE and its joint ventures reaches approximately 66,000 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.
After GE Aviation, however, GE’s competitive position fares far worse, with its other business lines facing secular pressure. GE Power, the firm’s other large segment 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), GE Renewable Energy competes in a more fragmented industry with other wind turbine manufacturers like Vestas, Siemens, and Goldwind (onshore and offshore wind revenue 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, 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 though we expect to improve to above 30 GW in 2022. 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.
Fair Value and Profit Drivers | by Joshua Aguilar Updated Jan 24, 2023
Nothing in narrow-moat rated General Electric’s fourth-quarter results materially alters our long-term view of the firm. We raise our fair value by $1 to $88 due to time value of money, though we may further adjust our assumptions when the company issues its 10-K and we hear more at its 2023 Investor Outlook.
Full-year 2022 free cash flow of $4.8 billion slightly surpassed our expectations of $4.6 billion. While fourth-quarter sales of $21.8 billion fell just short of our $22.3 billion projection, adjusted EPS of $1.24 easily topped our $1.13 estimate during the quarter. Segment operating profit margins rose a rousing 170-basis points, and off a difficult comparison from last year’s fourth quarter that saw aerospace return to 20% segment operating profit margins then.
We now expect $4.1 billion of free cash flow in 2023, consolidated mid-single-digit organic sales growth, and model $62 billion of revenue for the year, and $5.3 billion of segment operating profit (before corporate).
Despite macroeconomic headwinds, evidence of pent-up demand in strong backlog and order strength (1.2 book-to-bill ratio) give us continued confidence that aerospace revenue will grow over 16% in 2023 relative to 2022 results. The aerospace recovery is critical to GE’s turnaround story, and we think fundamentals are strong. Larry Culp is now 6 months into his new role as CEO of GE Aerospace, and we’re very content with the lean tools he’s implemented. We think a greater focus on discrete business units and streamlined workflows will help the aerospace business continue to expand its operating margins and maintain them back at 20% levels through the cycle, despite the LEAP and 9X ramps.
For power and renewables, we see both segments benefiting from the energy transition. We expect that power will maintain a high-single-digit operating margin through the cycle and flirt with 10%, but that renewables will only profit in 2026. Eventually, we think Vernova is capable of delivering near high-single-digit operating margins through the cycle.
Risk and Uncertainty | by Joshua Aguilar Updated Jan 24, 2023
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), and its insurance liabilities (though they've been less of a concern in recent years given a rising interest rate environment). 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, or ESG, 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 is developing a next-generation sustainable engine within its CFM RISE program. The firm has also teamed up with NASA to develop hybrid electric engine technology to address climate issues. Given its technology leadership, we expect GE will remain ahead of its competitors, which should ameliorate investor concerns.
Capital Allocation | by Joshua Aguilar Updated Jan 24, 2023
We assign GE an Exemplary rating under our capital allocation methodology. GE's management has done an exceptional job bringing down leverage levels. We highly endorse its capital allocation decisions, particularly the focus on addressing the debt and organic investments (which offer the best returns profile), as well as the operational and cultural changes that management is driving, which we believe should meaningfully improve returns on invested capital during our forecast. We also approve of the board's $3 billion share repurchase authorization in 2021, though we now would encourage a larger dividend given share price gains in the back half of 2022 relative to our fair value estimate.
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. Many financial and operational improvements are already tangible three and a half years into his GE tenure. For example, GE has materially deleveraged the balance sheet by over $90 billion. 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 further deleveraging of approximately $20 billion over the next couple of years, 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 born fruit. For instance, the third quarter of 2020 was the first time all then-industrial businesses flipped to positive profitability since Culp took over as CEO in the fall of 2018. In that quarter, 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 for 317 basis-points of sequential improvement. The healthcare segment even managed to improve upon its outperformance during the fourth quarter of 2020 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). Contrary to popular belief, however, lean does not come at the cost of growth. In fact, GE is targeting 3% of gross cost annually, which should help fund its organic investments.
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. Following GE's successful debt-reduction program, with think Dybeck Happe will increasingly focus on offense in the form of organic investment and bolt-on mergers and acquisitions.
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 over time. 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 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.
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