17 Jul General Electric – Turning Point?
Top Holding ‘GE’ has been in the portfolio since 2011 and has recently come under significant pressure due to being the worst performing Dow stock since Chairman Jeffrey Immelt took over the reins from legendary CEO Jack Welch in 2001. ‘Oakmark Funds’ manager Bill Nygren commented during an interview on ‘GE’s past and future prospects in his June 30th 2017 quarterly letter. I believe he is spot on in his analysis and that after multiple years of bad timing regarding investment decisions and the unwinding of the financial mess inherited from Jack Welch, newly announced CEO John Flannery is in an outstanding position to reap the future benefits and credit. ‘GE’ is due to announce 2nd quarter earnings this Friday at which time the new CEO will likely reset his targets lower and more realistic. At the current price of $27 the stock is trading at a very modest 16x 2017 estimates and one of the lowest relative multiples versus the S&P 500 in the last ten years. For investors you have an opportunity to purchase one of the premier industrial companies in the world as the company emerges from its heavy capital spending cycle into a cash generating service and technology leader – did I mention the 3.50% dividend you receive while you wait?
I hope you enjoy Bill’s comments:
What do you think the market is missing about General Electric [GE]?
WM: We like to look for management catalysts in companies that we think have a stale perception in the marketplace, and this fits that profile precisely.
We have always admired GE’s businesses – we really like businesses where you sell a big piece of OEM equipment at a low margin and then collect a 40-year stream of high-margin service revenues that the customer is essentially locked into. GE has a lot of those businesses.
The problem we had with GE is that the culture of capital allocation developed under Jack Welch and continuing under Jeff Immelt was one that bought high-multiple businesses and sold low-multiple businesses in a way that destroyed shareholder value. They bought expensive healthcare, Amersham, when oil and gas was really cheap. Then they bought expensive oil and gas – Lufkin Industries, Vetco Gray, Dresser, and others – when healthcare was really cheap. They expanded financial services at the worst possible time. They sold NBC at the bottom of its ratings cycle at a very low multiple of cash flow. It was one thing after another that made us put a big discount on cash flows because of how they were being reinvested.
When Jeff Bornstein took over as GE’s Chief Financial Officer in mid-2013 you can draw a line when capital stewardship changed. They bought Alstom’s power-equipment business for a single-digit multiple of cash flows. They sold Synchrony Financial in a tax-efficient spinout and effectively used the proceeds to buy back shares. They sold the appliance business for a high multiple. They combined the oil and gas business with Baker Hughes at the bottom of an oil cycle in an asset-light way. They dismantled GE Capital swiftly and at a good multiple of book value. All very impressive and executed as a contrarian value investor would.
In another significant move, Bornstein drove a change in how GE’s top 6,000 or so executives are paid. The new incentive system put in place at the beginning of 2016 was a complete revamp of a 1950s-era plan that was almost union-shop in construction, based more on seniority and your bonus last year than how you actually performed. The new plan pays out based on a scorecard of factors under managers’ direct control and tracked in real time, and it’s far more possible to get paid a lot or a little than under the old system. That’s a big change we expect to have a very positive impact over time.
How well positioned do you consider GE’s key operating divisions?
WM: Aviation is a powerhouse that has been taking global market share and is currently rolling out its biggest product launch ever – the LEAP jet engine developed with France’s Safran – which is showing great uptake. The medical-equipment business is well positioned in its core ultrasound and imaging markets and has good growth potential in developing markets and with an expanded product line for the development of biologic drugs.
In power, while the broad segment may not grow quickly, there is significant upside for GE through cost synergies and cross-selling after the Alstom purchase. The last big piece is oil and gas. The Baker Hughes transaction filled holes in both companies’ portfolios with little overlap and now the merged company has access to GE’s balance sheet. Many national oil companies are resource-rich but cash poor and to develop their fields they would like to partner with an oil-field service company that can help finance the exploration and development. As the oil market recovers, the new Baker Hughes has the potential to gain share as a result.
Some analysts, citing a lower conversion of earnings into cash flow, have questioned GE’s earnings quality. Is that a concern?
WM: We don’t believe so. The company has been preparing for big product launches and has by design been less efficient with working capital in order to ensure smooth rollouts. We think that’s fully explainable by where they are in the launch cycles and that the cash flows they’re going to produce from those launches are well worth any short-term mismatch between GAAP earnings and cash flow.
Postscript: Since the publication of this interview, GE has announced that CEO Jeff Immelt will retire on August 1st, to be replaced by John Flannery, currently CEO of GE Healthcare. Jeff Bornstein will remain CFO and will also be promoted to the role of Vice Chairman. We believe these announcements are very positive. We’ve met with Flannery multiple times, and believe his cerebral return-focused leadership will serve the company well. GE remains a very attractive investment, in our view, and is well-positioned for substantial earnings and FCF growth. Flannery is being set up for success exactly opposite of the way Jack Welch left Immelt set up for failure.
William C. Nygren, CFA