General Electric (GE) management has made it abundantly clear that, in the wake of the financial crisis, the company is acutely aware of the stress GE Capital, or GECC, puts on the company's earnings. GECC is an enormous banking operation by any measure with more than $500 billion in total assets and when compared to the company's core industrial operations, earnings often overtake that of the traditional GE business. This has been particularly true of late and excluding the financial crisis, GECC's earnings have actually bested that of the industrial company, including the nine months so far in 2013. With GE's stated goal of a 70/30 earnings mix as a result of downsizing GECC, this article will take a look at what that mix could potentially do to the consolidated company's earnings.
To start, we should determine the current mix of GE/GECC earnings and look at some historical data in order to see where GE has come from. Note: all data is from company SEC filings.
As we can see, in 2002, GE's industrial business made up about 80% of consolidated earnings but that year was clearly an outlier. After that, and leading up to the financial crisis, GECC made up between 40% and 50% of earnings each year. Once the financial crisis began, GECC earnings plummeted, as we are all very aware, and GE's industrial business once again made up 80%+ of the consolidated company's earnings. However, 2011 to the present has seen a return to the old way of doing business for GE as GECC is once again making roughly half of the company's profits and by my calculations so far in 2013, GECC is more than half of the company's net earnings once again.
So we've established that, apart from "crisis" periods, GECC is roughly half of the company's earnings on a regular basis. This gets interesting when you're talking about management's goal of cutting that down to 30% of earnings as that is an enormous undertaking. There are a couple of ways that could happen and we'll take a look now at some possibilities.
The first way is that GE could simply limit the amount that GECC produces each year. It could do this by downsizing the company's operations, which it has already begun doing, which would produce less income, thereby making the industrial business' share of income larger. This isn't the most favorable of the options as it means that, all else equal, the consolidated company will be producing less total income than it is now. However, GE has already taken some steps to do just this including its planned spin-off of GE Money Bank later this year. This method would likely result in an earnings multiple expansion, as discussed here, but would also result in less total earnings. Under this scenario, I believe GE's market cap would likely shrink as the earnings reduction would overtake the multiple expansion and the revaluation would be less than it is today.
The other way that GE could increase its net earnings mix to 70/30 is by increasing the amount of money its industrial business makes. This is easier said than done of course because there are so many moving parts to GE's industrials business and competition is so fierce. In light of this, it is instructive to understand the amount of money GE's ex-GECC business has made over the past 11 full years in order to determine if it is realistic to expect the industrial business to simply overtake the GECC business to get to the desired earnings mix.
The trend we see here isn't great as GE's industrial business has seen its profits dwindle from the height of the boom prior to the financial crisis to the bottom in 2011. The good news is that 2012 saw a very strong rebound in industrial profits so I believe it is safe to say the bottom is in. However, if we recall the earnings mix for 2012, 55/45 in favor of the industrial business, if we assume for simplicity's sake that GECC earnings will be flat in 2013 and 2014, in order to raise the mix to the desired 70/30, GE's industrial business would need to make over $14 billion. That would represent a near doubling of industrial earnings from current levels and even with the company's record backlog of $229 billion, which is one tall task. GECC's earnings are likely to be lower due to a smaller asset base but the idea of this exercise is to show that GE's industrial business is likely unable to grow enough to reach the desired earnings mix on its own; doubling earnings on a business that size in a short period of time is simply unrealistic.
There are some ways, however, that GE could soften the blow of that particularly discouraging news and that is through a mix of the two strategies. The spinoff of GE Money Bank, for instance, will provide additional capital that can be invested in the industrial business via expansions of current lines or acquisitions. We all know GE loves to acquire and I think what we'll see in 2014 and beyond is more industrial acquisitions as GECC continues to downsize. This period of transition will likely take some patience on the part of shareholders as acquisitions are expensive to fund and integrate but few are better at that than GE.
Even though GE would need to double its industrial earnings in order to reach the desired earnings mix right now, the transition will likely happen gradually and through a mix of new investments in industrials and asset divestitures from GECC. The company has begun the long process of shifting its earnings mix away from the volatile GECC and into the more stable industrials business. The implication for shareholders is that this transition may result in temporary drops in earnings because as GECC is downsized, which is a very large profit center for the consolidated company, industrial investments may take time to materialize into earnings. Be patient if you are a shareholder and if shares trade down in 2014 on reduced profits, consider it a great opportunity to pick up shares more cheaply and build your position. The company's buybacks will continue and the great dividend will continue; you just have to be willing to pick up shares when the going gets tough. GE's world class industrial business is very strong and with a record backlog, customers still believe in GE as well. As a shareholder, you just have to be patient through the transition period and know that when it is complete, GE will no longer be a bank with an industrial side business.