General Electric (GE), the largest U.S. conglomerate, surprised everyone in its second quarter earnings release, when it disclosed that its industrial businesses were gaining momentum, despite the collapse of the European economy, from where the company derives almost 20% of its total business. Not only that, the company also announced that it will restructure its energy unit, postpone its unpopular solar factory plans and restart paying a dividend to its parent company; announcements that were welcomed by investors. Additionally, industrial margins are also predicted to improve by 100 basis points this year.
GE is one of the most popular examples of thorough diversification. The company has the following divisions:
- Technology Infrastructure
- Energy Infrastructure
- GE Capital
- NBC Universal
- Home and Business Solutions (H&BS)
Technology Infrastructure was split into Aviation, Healthcare and Transportation, in 2010. Energy Infrastructure consists of Energy and Oil and Gas. Recently, Energy Infrastructure was split into GE Power and Water, GE Oil and Gas and GE Energy Management. Following shows a brief overview of the diversified operations of the company:
Before discussing the segment-wise revenue generation of the company, and its progress, it is important to first highlight GE's industrial margin trend, the topic which has attracted investors the most. Despite a crumbling European economy and a sharp fall in sales of wind turbines, the company's industrial margin beat the market expectation of 30-50 basis points increase this year. The incremental margin for the next half is expected to be more than 30%, much greater than the last year and a half.
*Incremental margin = (op margin current- op margin last year)/(revenue current - revenue last year)
Margins are on the rise because of the recent cost cutting that has been achieved due to restructuring in Europe and consolidating certain administrative functions.
Additionally, favorable pricing has helped boost industrial margins. All of the company's industrial segments (Aviation, Healthcare, Transportation, Energy and Oil and Gas) recorded favorable pricing over the last year, except for healthcare, which relies heavily on European sales. GE's order book showed that pricing had improved 120 basis points YoY.
Following shows the pricing effect on worth of orders:
*1.5% in third quarter of 2011 for Aviation shows that the increase in pricing has led to an increase of 1.5% in the value of orders for Aviation.
The following shows the industrial margin trend, along with sell-side expectations for the next two quarters. The graph shows the upward inclination of the curve in the fourth quarter of 2012.
The company plans to improve margins by 100 basis points for FY2012-2013.
This segment, along with the Healthcare segment, brings 30% of the company's profits. Aviation has seen a 34% decline in order rates YoY due to the weak European economy. However, this segment experienced a boost at the recent Farnborough Air Show, where it booked orders worth $17.5 billion in its partnership with CFM International. GE enjoys a 60% market share in the aircraft engine market, in terms of the units sold. According to a Credit Suisse (CS) analyst, GE will sustain this market share for the next 4-5 years, despite the tough rivalry it is facing from Pratt & Whitney, which controls 30% of the market share.
The Healthcare segment is the only industrial segment that declined when prices were increased. Currently, U.S. and European markets for these products are falling. However, as an offset, the Asian markets, especially China and India, are showing high growth rates. The forecast shows that sales will not rise this year. However, from the next year onwards, the Asian sales are expected to rise for the next 5-7 years, therefore shifting the focus of revenues from North America and Europe to emerging markets.
Transportation, along with the H&BS segment, generates 7% of the company's profits. The transportation segment, as explained in the table of company overview, depends on sales of mining equipment, which in turn depends on demand for commodities. The segment experienced growth in the trailing year. However, for this year, sales are expected to decline due to lesser rail deliveries and shrinking demand for construction equipment, as depicted by the stagnant Architectural Billing Index (ABI). Two related deals are seen upfront:
- Acquisition of Joy Global Inc, the machinery manufacturer - According to sell-side prediction, this is not going to materialize by the end of 2013.
- GE's recent agreement with the Kazakhstan Rail Company to build a diesel engine manufacturing plant in Kazakhstan. The engines are expected to be out in the market by the start of 2014. GE plans to penetrate the CIS (Commonwealth of Independent States) region through this tactic.
Home & Business Solutions (H&BS)
The segment's sales are based on Appliances, Lighting and Intelligent Platform. Intelligent Platform (IP) deals with ERP and computing systems. Margins for lighting have been declining, and the same is expected to happen over the next year. Margins for Appliances and IP are expected to remain stable over the next year.
This segment has been the most debated among all GE segments, as investors are wary of its performance in the current global financial crisis. The segment, however, has outperformed all expectations and is currently generating more than 50% of GE's profits. GE has also actively trimmed its lending business since the crisis, and is considering shrinking it further. In June, GE's chairman hinted the possibility of selling the private label credit card business. However, this segment is unduly criticized, as it brought in a majority of the company's earnings, even in the midst of a crisis. The following chart shows GECC's performance.
Importantly, GECC has also resumed the payment of dividends this year, after a break of three years. GECC is expected to pay $7billion this year and $20 billion over the next few years. These funds can help GE to repurchase its shares, or spend the money in acquisitions or dividends to shareholders. Following shows the earnings and dividends pattern.
In the future, this division is likely to grow in light of the gradually recovering commercial real estate and declining provisions.
Recently, the energy infrastructure business was split into three different divisions - Power and Water, Oil and Gas and Energy Management. A whole layer of management has been removed, which is expected to save $200-$300 million per year. This was done in order to break down the massive segment into smaller chunks for operational efficiency. According to CEO Jeff Immelt:
"We had kind of a $50 billion company within a company."
The Oil and Gas business have the following segments and expected growth rates:
The company eyes this segment as a potential $100 billion opportunity by the end of this decade. Sales from wind turbines need to be mentioned here. Revenues from these turbines are expected to fall by 30% in 2013, which will reduce the company's earnings.
Energy Management will offer smart grids, breakers, converters and uninterrupted industry energy. This segment will address a $150 billion worth market.
The current quarterly revenue growth was negative YoY. However, growth is expected to be positive in the future, as earnings are expected to rise by an annual rate of 12% for the next five years. In last 12 months earnings have grown by 11%. Currently, the stock is trading at a forward P/E of 13x. On a historical P/E of 15x, the stock is expected to have following valuations:
The company has no debt/financing problems. Given the recent restructuring in the energy infrastructure segment, the organic growth in industrial margins and the rising profitability of GE Capital, the stock is expected to grow in the future and therefore is recommended as a buy. GE offers a healthy dividend yield of 3.4% as well.
Few other industrial companies like Caterpillar (CAT) and Terex (TEX) have also posted better than expected numbers. TEX is up 13% in pre-market trading. The beat was a result of margin expansion. In case of CAT, the company was able to show growth in emerging markets.