Dismembering a Fallen Giant
Tuesday 26th June, 2018 was an historic day for General Electric (“GE”). Before the market opened on that day GE was removed from the Dow Jones Industrial Average Index after 110 years of continuous membership. It was the last remaining member of the 12 original constituents of the Dow at its launch on May 26, 1896. This symbolic blow crowned the end to an underwhelming 24 months for GE, over which period the shares have lost more than 60 per cent of their value.
There was a second historic event which took place that morning. GE’s then new management team released their plan for restoring credibility and realising the significant value in the portfolio. Having spent a year studying the available options, management settled on break-up plan, slimming the Company down to a portfolio centred on GE Aviation, the jewel in GE’s crown, which is the world’s leading developer of the design and maintenance of commercial and military aircraft engines.
Since that point management has again changed with Larry Culp, the highly respected former CEO of Danaher, succeeding John Flannery as Chairman and CEO. Mr Culp is the first outsider to lead the Company, and we view his appointment positively. We believe that Mr Culp will pursue the strategy laid out by his predecessor, albeit with a greater focus on the operational excellence which was a hallmark of his time at Danaher.
We believe in both the plan and the management team and see the shares as significantly undervalued at current levels.
Before we look forward, we should consider the past and what has gone wrong at GE. This is a combination of historically poor capital allocation, the burden of their legacy insurance business and a downturn in the market for power equipment. The combination of these items has meant that GE currently carries too much debt, has taken meaningful charges against its legacy insurance liabilities and suffered significant earnings downgrades in the Power business. Having gone to great lengths to understand each we believe the point of maximum pain has passed.
Historically GE has been an organisation with a powerful central function which took decisions on the part of the divisions, with a remuneration policy which was too closely tied to group rather than divisional performance. Capital allocation has been both prescriptive and questionable. The new management team have resolved to dismantle large parts of those central functions whilst increasing divisional autonomy and self-determination. This has been allied with a change in the remuneration policy that increases the focus on both divisional results and cashflow, something which has been underwhelming for too long at GE.
Whilst most of GE’s businesses are executing well in buoyant markets, the Power business is facing a severe industry downturn, most notably in the market for large gas turbines for utility-scale generation where the number installed globally in 2017 was the lowest it has been since 1986. Both new installations and utilisation have been under pressure, squeezing earnings for both the original equipment and service businesses. In response, capacity and capital are being withdrawn from the sector, whilst utilisation of the existing fleet is rising, suggesting better times ahead even if there is no immediate volume recovery. The market appears convinced that the downturn in large gas turbine demand is structural rather than cyclical, with which we strongly disagree. As global attempts to decarbonise gain pace, we see it as almost inevitable that gas powered generation displaces existing coal plants. Global LNG prices have been buoyed by strong demand from Asia, whilst the surge in the carbon price in Europe is approaching the point where it should begin to incentivise switching from coal to gas, which was its ostensible purpose since the European carbon market was introduced in 2010 – but which has only started to have an impact post changes to market structure in 2017. Natural gas is the fossil generation fuel source of the future, and GE have a compelling offering.
GE hasn’t written an insurance policy since 2006 but continues to suffer the impact of the pre-existing book of business. In late 2017, the Company took an after-tax charge of over $6 billion and agreed to contribute approximately $15 billion of capital over the next seven years to rebuild the reserve base. Management assert that they are now well reserved, a claim which the available information supports – albeit in an industry which has suffered a very adverse claims history. In response the management of GE Capital and the approach to both the assets and liabilities have been changed, whilst the business remains very sensitive to higher rates which both boost assets and diminish liabilities. Management are also exploring the possibility of moving the liabilities off GE’s balance sheet. The market believes that the cost of such a move would be exorbitant, and doubts it’s even possible, but this is a well reserved block where liabilities have potentially been marked at what may prove to be the low point of the global rate cycle. Resolving this issue may not be as expensive as the market fears.
MULTIPLE WAYS OF WINNING
Competitive Dynamics & Product cycle
What has been lost in the current share price malaise is the strength of some of the businesses inside the conglomerate, notably Aviation and Healthcare which are the assets in which the bulk of the value lies. These are leadership businesses with high barriers to entry in structurally growing industries – the kind of businesses we look for at Antipodes – and it’s rare to find such assets trading at such lowly valuations compared to peers.
The management team are breaking up the Company, an entity which had only really expanded in scope from formation up until the financial crisis. At the heart of what will be left is the Aviation business, the quality of which is currently obscured by the travails of the broader group. GE’s jet engine business powers, either directly or through the CFM joint venture, 70 per cent of the world’s operating fleet of narrow body planes and nearly 50 per cent of the world’s fleet of wide body planes.
FIGURE 1: GLOBAL NARROW BODY AIRCRAFT MARKET SHARE
FIGURE 2: GLOBAL WIDE BODY AIRCRAFT MARKET SHARE
Booked orders point to market shares persisting at around the current level. GE’s scale and presence across the thrust range represent an advantage in manufacturing cost and breadth of customer offering.
Over the long time-term, the commercial aviation industry has grown at approximately 1.5 times underlying economic expansion, with that excess growth visible in both mature and developing markets. Increasing affluence, rising propensity to travel and a persistently declining cost of aviation are all significant contributors.
It is that latter driver of air travel that the engine makers including GE have been instrumental in delivering to the airline industry, as the improved efficiency of subsequent generations of engines have arguable done more to lower the cost of air travel than any other single item. As fuel is, and is likely to remain, the largest single cost for airlines globally, the returns on efficiency driving innovation remain high and technology leadership remains sustainable. This innovation helps force a natural upgrade cycle as airlines seek to remain competitive on fuel efficiency, a dynamic which only intensifies in high oil price environments.
Whilst industry practice is that the initial sale of an engine happens at either a low margin or a loss, the engine makers extract their returns as those engines are overhauled and have parts replaced through their operating life, which can be more than 30 years. The majority of engines that GE sells, have an associated service agreement which gives them contractual lock over the sale of future spares. For those sold without such a contract, customers have little incentive or ability to source alternatives, particularly given the return enhancing incremental improvements to parts the original equipment makers implement through the decades an engine is in production for.
Put simply, each engine delivered today has significant earnings and net present value associated with it, neither of which are adequately reflected in the current financial performance.
Most of GE’s major businesses are of similar quality to Aviation, innovative leaders in consolidated industries with a rational competitor set, significant aftermarket content and little prospect of new entrants disrupting those oligopolies. Even the Power business may meet these criteria in a more benign market environment.
The bulk of GE’s value today lies in the Aviation and Healthcare businesses, two highly regulated and safety critical industries. Staying with Aviation, selling an engine today gives GE visibility over a multi-decade stream of spare parts sales as the engines are used, both as parts wear out and as stringent safety legislation mandates their replacement at specified intervals.
Management & Financial
We view the recent management change positively. The former CEO addressed many of the problems inherited from his predecessors, changing remuneration to be more aligned with shareholder interests and refocusing the Company. The new CEO has a long and proven track record of shareholder value creation. Management, like us, believe the intrinsic value of the business is well above the current share price and we share their view that considered and deliberate actions, rather than knee-jerk ones in response to temporary challenges, are the best way to realise that value.
At the core of GE’s plan is the intention to monetise part of the Healthcare business and divest the majority holding in Baker Hughes, a GE Company which provides products and services to the oil and gas sector. These actions will reduce the debt burden to a more sustainable level. At the end of the process, GE will comprise 3 divisions compared to the current 7 – that is, Aviation, Power and Renewables. Management will also cut corporate costs and further reduce the size of GE Capital. At some point in this process, GE shareholders will likely become shareholders of both the Transport and Healthcare businesses, exposures we would be keen to take on.
Style & Macro
In a market that is prepared to pay a very high valuation multiple for structural growth, our investment in GE represents a remarkably cheap way of gaining such an exposure. For Antipodes, this would represent a potential style tailwind that should accelerate a rerating of the Company assuming our fundamental case is sound.
FIGURE 3: ANTIPODES PARTNERS INDUSTRIALS VALUATION HEAT-MAP
MARGIN OF SAFETY
Whilst GE represents a complex asset, the new management team is focused on simplifying the structure and realising value. Our proprietary quant tools clearly show that within GE are businesses which would trade at higher multiples if they were separately listed. The Antipodes proprietary heat map lends support to this view. Developed world Aerospace and Defence companies are the most expensive relative to their history of any industrial sector globally, whilst North American industrial conglomerates are the cheapest. Buying GE today therefore represents an inexpensive route into a very highly valued sector, a discrepancy which we believe will close as management execute on their plan.
At the end of management’s disposal process, GE will be a business which on our estimates will derive more than 70 per cent of operating profit from Aviation, an industry in which the median valuation of industry peers is 14-times EV to EBIT. GE could be trading on as little as 9-times EV to EBIT in 2020.
This methodology is just one way to value GE given the flux in the portfolio. We believe it looks materially undervalued on nearly all of them. Should we assume no further contributions to the insurance business beyond those already announced then we can justify the current share price with the Aviation and Healthcare divisions alone. By implication, at the current price the market is discounting that all of GE’s other assets (Power, BHGE, Renewables, Transport, Lighting, Capital) are either worthless or consumed by the insurance liabilities. We cannot say categorically that will not be the case, but the risk reward is incredibly favourable.
Listed below are the other original 11 members of the Dow Jones Industrial Average. That their names are long forgotten by most is testament to the constant innovation and self-reinvention that has been the hallmark of GE since its formation. Another reinvention is required. The current reinvention is not one of product, where they have ample technical capabilities in attractive industries, but one of normalising the balance sheet for questionable past capital allocation decisions and realising the value in the portfolio. We believe they have the right management team to do that.
Whilst GE has idiosyncratic issues our conviction in the value proposition leverages our work on the European power market, our work justifying our belief that gas is the fossil generation fuel of the future and our work on the wind sector.
It also leverages the detailed work we have done on Siemens, another portfolio holding, on the Power and Healthcare businesses. In the case of both GE and Siemens a globally dominant franchise in an attractive growth industry is undervalued in the current corporate structure. In GE’s case that asset is the Aviation business, in Siemens case the automation business. We expect that in both instances the undervaluation will be exposed and eliminated over time.
 The other original members of the Dow were: American Sugar; North American Company; United States Rubber Company; Chicago Gas Company; National Lead Company; Tennessee Coal, Iron and Railroad Company; United States Leather Company; American Cotton Oil; American Tobacco Company; Distilling & Cattle Feeding Company; and Laclede Gas Company.