GE: 40% Upside Potential With Limited Downside Risk
GE is a simple business. An investment in GE is a bet on the continued flourishing of human civilization.
GE's recent acquisitions and divestments conform to what we term its PIT Strategy.
The PIT Strategy will lead to renewed revenue growth, and if it does not, we all have more to worry about than a poor investment in GE.
GE's corporate catch-phrase, "Imagination at Work" is apropos, but not in the way you probably think.
Our valuation suggests a 40% likely upside potential with a less likely 20% downside risk.
The Symbol of American Business
When the Sage of Omaha announced that his Berkshire Hathaway would buy $3 billion worth of General Electric's (NYSE:GE) preferred shares after the Lehman Shock of 2008, Buffett was quoted as saying that GE was "the symbol" of American business.
Indeed, GE is so symbolic of American business, it is almost a caricature of it.
Once insular and focused on providing goods and services for domestic consumption, GE has transformed into a highly efficient, super-national entity intent on being integral to the growth and stability of every corner of the world.
Chastened and refocused after a brush with financial disaster post-Lehman, the direction GE is heading in speaks to the present and future of the U.S. corporate environment as well.
GE Made Simple
You may think that GE is a phenomenally complex firm, but you are mistaken. At its core, GE is simply betting on and allocating resources to profit from the continued flourishing of human civilization in all corners of the world.
Thanks to the indelible imprint that Jack Welch left on the firm's corporate culture, and Jeff Immelt's realization that consumer-facing businesses were volatile and highly competitive, GE has settled on a strategy concentrated on two main areas:
Providing the aging developed world the power and technologies to maintain its standard of living.
Providing the young developing world the power and infrastructure to develop.
These two areas involve overlapping offerings in power provision, infrastructure build-outs, and highly engineered high-tech solutions. Due to the emphasis on Power, Infrastructure and Technology, we will nickname GE's present operating focus as the PIT strategy.
Each of the segments listed as Commercial are those that do not sell to individual consumers, but rather to an organization that provides products and services to end-consumers. Any segments listed as "Inputs" are those mainly involved in the business of power provision or in the build-out of critical infrastructure (the "P" and "I" of the PIT strategy). "Services" include financial services and the entertainment services of former subsidiary NBC.
Note, in the table above, the degree to which the company is tilted toward the provision of Commercial, rather than Consumer products and services. The only two remaining Consumer-focused business are Appliances & Lighting and Consumer Finance, the remains of both of which are on the auction block now. (Twenty percent of the Consumer Finance division was sold in an August IPO, and now trades under the name of Synchrony Financial (NYSE:SYF). Foreign Consumer Finance subsidiaries have already been wound down. The winding down of the foreign financial subsidiaries has contributed to the recent revenue headwinds, which we detail in the graphs section of our full report -- email registration required.)
With those two divisions gone, virtually the entire business will be focused on providing products and services to organizations rather than individuals. The only part of the business that doesn't directly fit into the PIT strategy is GE Capital, but that division fulfills a special role, which we discuss below.
The following graph estimates the value of the 45 major acquisitions the company has made since 2004, split into the above classification structure.
(Figure 1. Source: Company Statements, YCharts Research Analysis)
In this graph and the one below, a positive number means a net cash inflow from a divestment; a negative number shows a net cash outflow from an acquisition or acquisition-related capital expense.
Note that the aggregate divestments are all classified as "Consumer," and that the aggregate capital expenditures are all classified as "Commercial."
Even though Commercial High Tech shows the largest portion of the graph above, a look at these data disaggregated and spread over time gives a more accurate picture of the present PIT strategy.
(Figure 2. Source: Company Statements, YCharts Research Analysis)
Note that pre-financial crisis, the firm was continuing to spend cash on Consumer Services (both financial services and entertainment assets). However, since the financial crisis, there was only one net capital expenditure for Consumer-related categories, and that was actually related to the eventual divestment of NBC.
Commercial Inputs seems smaller in the aggregation, but we can see this is because of a single divestment (of GE Plastics - Jack Welch's springboard) in the pre-Financial Crisis days - before the PIT strategy was fully formed.
This view suggests that GE has been making strategic but smaller investments in the Tech part of the PIT strategy, but pouring more attention and capital into the Power and Infrastructure areas. We believe that this strategy is likely to be successful in turning the tide on the divestment-related revenue declines detailed in our full report on the company (email registration required).
Why Not Get Rid of GE Capital Altogether?
It is telling that before Jack Welch became CEO, financing revenues counted for a miniscule portion of GE's revenues and profits (somewhere around 0.005% of total revenues in 1978).
One of the first strategic moves Welch made upon becoming CEO was to buy around $10 billion worth of equipment, such as tankers and railroad cars. These assets became the core of the commercial leasing business that we now know as GE Capital. Over the years, Welch realized that financial transactions were handy in smoothing profits, and in his turn, Immelt became enamored with the brisk growth rates in the consumer mortgage business.
However, during the financial crisis, the GE Capital business fell victim to the mighty and terrible backstroke of the double-edged sword of leverage.
GE Capital and its subsidiaries (including a sub-prime mortgage broker that submitted fraudulent paperwork on behalf of borrowers in somewhere around 75%-80% of cases) almost sank the ship during the crisis, and was responsible for GE losing its coveted AAA bond rating in 2009.
A rational (but uninformed) investor might ask: Why not divest it and focus solely on the PIT Strategy?
The answer is simple: The U.S. Tax Code.
Unless the power brokers on Washington D.C.'s K Street decide they have "helped" their nation enough and voluntarily shut their doors, leading to major structural change in the U.S. tax code, GE Capital will remain an integral profit center for the firm - not because its business has a high return on assets (it doesn't), but because it allows the rest of GE to virtually avoid paying taxes.
The details are not pretty, but as far as this author can tell, all true and (until proven otherwise in a court of law) consistent with present IRS regulations and court rulings.
GE has set up a complex web of wholly-owned subsidiaries, partnerships, Cayman Island registered LLCs, and difficult-to-track business arrangements which allows it to engage in "transfer pricing" and other schemes, which result in it recording very low tax expenses and - as long as the firm does not repatriate funds from overseas - paying even less taxes than it records in its financial statements.
The recent agreement to purchase French power generating equipment giant Alstom ($17 billion, listed in Figure 2 above as an estimated outflow in 2015) is - while being in line with GE's refocused PIT Strategy - almost certainly motivated in part by the desire to make sure that portion of the firm's overseas cash hoard will forever be free from taxation.
While this author is careful not to carry the analogy too far, GE's Byzantine web of tax-sheltering offshore entities seems positively Enron-esque. We have found no evidence of the type of fraudulent transactions which brought Enron down, but some of the shelters do stretch a reasonable person's definition of ethical corporate activity, even if they have not been found to run afoul of the law.
The degree to which earnings are "managed" may have decreased since Welch's heyday, and the stagnating earnings power and simultaneous deleveraging of the American middle class makes consumer credit less appealing, even if GE had not had such a close call during the mortgage crisis. That said, considering the tax benefits alone, GE Capital's business is a critical piece of the company's continued profitability levels and business strategy.
The Dark Side of American Exceptionalism
GE's transformation from a pioneer in electrical power and radio in the early twentieth century to an ungainly conglomerate in the post-War boom years, to a scientifically managed bureaucracy in the post-Nixon years, to a wheeling-dealing quasi-hedge fund run by a celebrity manager in the 1980s and 1990s shows an uncanny parallel to the development of ascendant American economic empire in the twentieth century.
Starting with Welch's tenure, GE began to expand overseas and derive more and more revenues and profits through its international operations. This trend has continued and expanded under Immelt's tenure, with the majority of GE's revenues now generated outside the U.S.; again displaying a trend that is uncannily and - for middle-class Americans - unhappily reminiscent of current American business culture.
This author admires the technical and commercial competence of General Electric, but is irked by the larger trends symbolized by this company's business practices.
Even while the GE tax department brings new meaning to the catchphrase "Imagination at Work" and allows the firm to capture tax refunds that supplement its formidable operating profits, GE happily bids for (and wins) contracts with U.S. federal, state and municipal governments. Nearly a third of GE's Aviation business's revenue is generated from defense-related work, for instance.
In economics, a situation in which a person or entity receives benefits without paying the costs associated with those benefits is known as the Free Rider Problem. GE certainly receives enormous benefits from American society, such as Aviation revenues, legal and regulatory certainty, beneficial tariff arrangements and the like, but is relying upon others - including this author and readers of this report - to subsidize the costs associated with providing those benefits.
GE's PIT Strategy is sound, and its technology and products serve a vital role in a developing and aging world. That said, this author is ready to invest in the company for no other reason than to recoup some of the tax he is paying to implicitly subsidize the company's vast operations.
This article is the introduction of a larger report that looks not only at the general business strategy of GE, but also digs into its past operating performance - revenue growth, profitability, and investment level and efficacy - and provides a transparent, data-driven valuation for the firm. It is this valuation that gives us the valuation ranges listed in the headline of this article. Interested readers are encouraged to download the report here (email registration required).
 Jack Welch did one thing phenomenally well: insisted upon only running businesses that were or plausibly could be #1 or #2 in their industries. Managers of Bronze Medal businesses would have to be content working for an acquirer, because Neutron Jack had no room for #3. Thanks to Welch's long tenure, this focus on feeding the winners and killing the losers meant that the business that form GE's core are impressive competitors with formidable moats. These moats differ from business line to business line, but generally rely upon intellectual property, network effects and governmental access built over years of concerted effort. Don't believe me? Imagine you are the purchasing manager at Boeing BA and need to buy some jet engines. How likely would you be to go with a state-sponsored Chinese jet engine maker that was offering you a 20% discount on your order compared to GE? Quod Erat Demonstrandum.
 Most of the "water" part of this segment should be read as "hydroelectric power," though there is a bit of infrastructure water - desalination, wastewater treatment, pumps, valves, etc.
 Not all of the sale or purchase amounts were made public, so these figures are estimates, and will not agree with figures listed on the financial statements - especially in the early years. Directionally, however, we believe them to be representative of the company's investment activity and strategic focus.
 In an interview in the mid-2000s, Immelt actually paraphrased the now infamous quote of Citi's CEO, Chuck Prince, about having to dance as long as the music was playing. This delusion was apparently popular among finance-focused CEOs at the time, unfortunately.
 K Street is famous for being the location of all the high-power political lobbying firms.
 For an illustration of this contention, the dogged, accounting- and legalese-savvy reader is encouraged to read this Journal of Accountancy article and this blog posting by a professor of Tax Law at the University of Houston.