Business Strategy and Outlook| by Joshua AguilarUpdated Aug 08, 2023
We believe Larry Culp is engineering a successful turnaround of General Electric. We think there's still upside in GE's turnaround story, particularly with the passage of the Inflation Reduction Act.
Driving GE's turnaround process is a steadfast cultural commitment to lean tools. We believe GE has line of sight to about a 7% free cash flow margin in 2023 and will reach double-digit free cash flow margins next year.
After multiple portfolio moves, GE has reduced its debt burden by over $100 billion during Culp's tenure. We think there's an exceptional opportunity for GE to shift from debt reduction to other capital allocation options that favor the shareholder and provide the firm with strong flexibility to shift to offense.
GE Aerospace remains the crown jewel of GE's portfolio. We believe that there is still some pent-up demand for air travel and that commercial aerospace revenue should overtake 2019 levels by 2024. TSA checkpoint travel figures reveal that U.S. passenger throughput is lapping 2019 levels on many days.
Joint venture CFM has more narrow-bodies that are 10 years or younger than the rest of the industry, and nearly half of its CFM56 installed base has yet to see its first shop visit. Additionally, we think GE Aerospace can recover to 20% operating margins by at least 2025 (and perhaps 2024), while delivering incremental margins in the mid-20s over the medium term.
Finally, while the renewables business is incurring significant losses, we believe GE Vernova CEO Scott Strazik can help drive the spinoff to profitability in 2024, including breaking even in renewables by 2024. Favorable U.S. legislation provides a backdrop of more certainty around timing of wind-related projects, and a combination of better project selectivity, a focus on the North American market, and rightsizing should help drive the profits GE investors have long been clamoring for.
Economic Moat| by Joshua AguilarUpdated Aug 08, 2023
We assign General Electric a narrow economic moat rating based on switching costs and intangible assets stemming from its massive installed base of industrial equipment and differentiated technology. We hold off on assigning GE a wide economic moat rating because of our lack of confidence in our 20-year hurdle rate for excess return on capital.
GE Aerospace meets our highest standard of a wide-moat business and is GE’s crown jewel. The segment benefits from intangible assets and switching costs, and we think it is the premier commercial engine manufacturer that can deliver at scale. GE competes in a virtual duopoly in both the wide-body (twin-aisle) and narrow-body (single-aisle) space against Rolls-Royce and Pratt & Whitney. Excluding its 50% interest in its CFM joint venture with Safran, we estimate that GE typically commands roughly half of the total commercial engine market, 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. 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 breakeven and become a recurring and enviable profit stream for GE. These bespoke service contracts typically extend 25 years. 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 record of success, and its customer relationships with both Boeing (primarily) and Airbus. A 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 mandated and regulated by the Federal Aviation Administration, and unplanned downtime related to concerns about an engine’s efficacy can wreak havoc for airlines in terms of time and expense. This high cost of failure ultimately increases customer loyalty. By our count, roughly 69% 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 service 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. The Leap engine boasts an industry-leading 99.97% engine dispatch reliability rate, which equates to only one delay or cancelation every 2,500 departures. Furthermore, Leap has 6% better utilization (a value proposition of over $2 million for airline customers) and 15% better fuel burn than its CFM56 predecessor. GE Aerospace's operating margins exceed Pratt’s by several percentage points, which demonstrates the benefits of having a massive installed base in the aerospace industry.
After GE Aerospace, GE’s competitive position fares far worse, with its other businesses facing secular pressure. GE Power faces pricing pressures and a shifting energy mix in its end markets toward renewables. GE Vernova (power with renewables) is 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 a host of other competitors (onshore wind revenue represents the brunt of Renewable Energy’s portfolio). 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 in global gas turbine orders by energy capacity.
Furthermore, GE was late to realize the transition from fossil fuels to renewables, which are 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. Under previous CEO Jeff Immelt, GE failed to appreciate these risks, and its ill-time purchase of thermal energy provider and grid company Alstom weighed down the segment’s return on invested capital for years. Power was forced to continue restructuring efforts to counteract this dynamic as demand for new gas orders fell to 2530 gigawatts from 40-45 GW articulated at the start of 2017. 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 a durable competitive advantage.
Fair Value and Profit Drivers| by Joshua AguilarUpdated Aug 08, 2023
After updating our model for our aerospace demand forecast, we lift our fair value estimate to $118, but that's due to time value of money. Our long-term view remains essentially unchanged. We've also updated our sum-of-the-parts valuation to $118, suggesting that pricing GE yields a similar conclusion to our DCF-derived intrinsic valuation. We still model 2023 adjusted EPS expectations of $2.42 (or 12 cents above the high end of management’s revised range) and free cash flow of $4.6 billion, or the high end of the guide. We value GE at 49 times our 2023 adjusted EPS, but 2023 is a down year from lost healthcare-related earnings. We think the market is looking to 2025 when valuing GE, and we value the firm at 20 times our 2025 adjusted EPS expectations. We think GE aerospace will trade for about $100 billion in equity value, while GE Vernova will trade for about $30 billion in equity value.
Commercial aerospace remains the most important driver of our valuation. Its fundamentals are still strong. Most of GE's fleet of narrow bodies have yet to see their first shop visit, and travel remains a continued priority in people's budgets. Continued evidence of pent-up demand in strong backlog and order strength (1.2 book/bill ratio) gives us continued confidence that GE Aerospace revenue will grow at a low-20s percentage in 2023 relative to 2022 results. We’re content with the lean tools Culp has implemented as CEO of GE Aerospace. 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 at 20% through the cycle, despite the LEAP and 9X ramps, though we expect mix headwinds mean they will be only marginally better than 2022 levels in 2023.
We expect Vernova will benefit from the energy transition at a top-line level, as well as the Inflation Reduction Act. We expect its profitability will improve on better project selectivity, a focus on the North American market, and additional rightsizing. We expect that Power will maintain slightly over a 10% segment operating profit margin through the cycle, but that Renewables will only begin to profit in 2024, eventually reaching mid-single-digit operating margins. Eventually, we think Vernova is capable of delivering at the lower end of high-single-digit operating margins through the cycle.
Risk and Uncertainty| by Joshua AguilarUpdated Aug 08, 2023
GE's principal risk is related to COVID-19 fallout on its commercial aerospace business, including government interventions and acceleration of infections that 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, and its insurance liabilities (though they've been less of a concern in recent years, given rising interest rates). Finally, GE has large key-person risk in CEO Culp. Losing him before a successful turnaround would pose critical headline and fundamental risk, in our view.
From an environmental, social, and governance 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 embargoes 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 it with sales of renewables). However, we think the greatest ESG risk relates to fallout from the climate impact from aerospace engines, though we don't think this 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 AguilarUpdated Aug 08, 2023
We assign GE an Exemplary Capital Allocation Rating. 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. GE only deployed about $1 billion of share repurchases in 2022, and we would have liked to have seen more then.
Our thesis continues to be an all-out bet on Larry Culp's leadership. Culp was previously CEO and president of Danaher 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 $100 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 increasing flexibility for other capital allocation priorities—most notably organic investments through R&D and capital expenditures.
Many of Culp's lean initiatives have born fruit. For instance, in the first quarter of 2023, GE's free cash flow flipped positive—the first time it produced positive free cash flow in the first quarter since 2015, long before Culp took the helm. Furthermore, GE's earnings in the first half of 2023 alone have already surpassed its earnings from the prior 2022 year, when excluding GE HealthCare's contributions. We expect he and Vernova CEO Scott Strazik can help bring back renewables and the broader Vernova business to profitability by the end of 2024.
GE Aerospace CFO Rahul Ghai will assume the consolidated GE CFO role on Sept. 1, 2023, taking over from current CFO Carolina Dybeck Happe. We think GE will miss Carolina's experience, which was uniquely suited to its difficult operating enviroment a few years back. Carolina brought a wealth of industrial experience, including debt reduction, working through short- and long-cycle industrials, and use of lean in operations. While much has rightly been written about CEO Culp's contributions, we think Dybeck Happe was the perfect partner for him during a trying time. Incoming CFO Ghai certainly has a wealth of experience given his successful (albeit brief) tenure at Otis following its spinoff from what was then United Technologies, but we'll wait to pass judgment as he fully immerses himself with the greater responsibility.
The company's financials have significantly improved thanks to the disclosures worked on by outgoing CFO Carolina Dybeck Happe and Steve Winoker and his team in investor relations. Fortunately for investors, Winoker and his excellent team will continue on with GE Aerospace. We expect further improvements over time. Culp has also been improving GE's culture by implementing many of the principles he took from his time at Danaher, including a laserlike focus on the customer and use of lean tools and workshops. We believe GE has moved past its prior record of poor stewardship that was anchored in the Immelt era, which included opaque accounting, overly aggressive targets, a watered-down culture that discouraged candor, and disastrous capital allocation.