GE: Lessons From the Rise and Fall

Sector

IndustrialsManufacturingAviation

Background

Josh Aguilar is a senior equity analyst at Morningstar. We cover GE's business strategy, how it lost the right to be an industrial conglomerate, and the role GE Capital played in its rise.

Cover

Date

September 14, 2022

Episode Number

74

Key Learnings & Lessons for Investors

1. Value of Leadership and Management: Jack Welch's era at GE exemplifies the impact of leadership on a company's valuation and growth. Named the Manager of the Century by Fortune, Welch's management was seen as one of GE's structural competitive advantages.
2. Diversification vs. Core Competency: Over the years, GE diversified into various businesses - from NBC to Investment Bank, Kidder Peabody, plastics, appliances, and many more. While diversification can reduce risk, spreading too thin or moving away from core competencies can also lead to management complexities and inefficiencies.
3. Dangers of Over-reliance on Financial Engineering: Using financial entities, like GE Capital, to consistently beat earnings led to long-term adverse effects, especially if these earnings are used to mask weak performances in other business segments. For instance, Welch's method of keeping "a nickel in your pocket of earnings per share" led to questionable earnings quality.
4. Risks of Misjudging Market Trends and Poor Capital Allocation: Immelt's series of decisions, from the purchase of Alstom to investing in oil-related interests and the sale of NBC, resulted in significant value destruction. These decisions, often driven by overly optimistic projections, highlight the importance of rigorous due diligence, understanding market dynamics, and the dangers of hubris in leadership. For investors, it underlines the significance of scrutinizing management decisions and ensuring they align with long-term value creation.
5. Understanding Business Models & Market Dynamics: GE's aviation business exemplifies the 'razor and blade' model. They sell engines (e.g., LEAP engine) at a loss, recouping the investment and making profits from parts and service revenue over many years. Recognizing such business models and understanding the market dynamics (e.g., the LEAP engine being a primary or sole choice for specific aircraft) can help in predicting a company's long-term profitability.
6. Importance of Capital Allocation & Structural Advantage: GE's struggles as a conglomerate highlighted the significance of efficient capital allocation. Warren Buffett's view, as mentioned, is that conglomerates' value proposition rests on tax-free movement of capital, but it only holds if the conglomerate can allocate capital better than the market can. Investors should critically evaluate a company's ability to allocate capital and assess whether its structure offers any inherent advantage in the market.

Key Takeaways & Business Model

1. Historic Transformation of General Electric (GE): GE, once the world's largest company with a market cap nearing $600 billion in 2000, has undergone massive transformation and decline over the years. From its historic innovations like the incandescent light bulb to being the most valuable company under CEO Jack Welch, its current status contrasts starkly.
2. Drastic Financial Decline: In 2000, GE reported sales of nearly $130 billion with a free cash flow of close to $13 billion. In contrast, in the recent past, GE reported just over $74 billion in revenue and didn't even clear $2 billion in free cash flow. The company also used to pay out dividends of over $5.4 billion, which dwindled to a mere 535 million in 2021.
3. Culture and Capital Allocation: GE's decline was largely attributed to cultural issues and capital misallocation, especially under the leadership of Welch and Immelt.
4. Heavy Reliance on GE Capital: At its peak, GE Capital constituted nearly 60% of GE's earnings, enabling the company to consistently beat earnings expectations. This reliance masked the true operational performance of the conglomerate's other businesses.
5. GE's Current Focus: GE has streamlined its focus on three main businesses: aviation, healthcare, and energy (further divided into power, renewables, and digital grid). All these sectors aim to establish a vast installed base of equipment to derive high-margin parts and service revenue. The aviation sector stands out as a prominent pillar, especially as GE plans to spin off its healthcare and energy businesses in the coming years.
6. GE's Conglomerate Strategy Shift: GE has decided to deviate from its conglomerate structure. The conglomerate approach is effective only if the parent company can allocate capital more efficiently than the market, which GE has struggled with over time, as indicated by its long-term stock price trend. The intent of breaking up is to enable GE to focus more on each business unit's distinct investment profiles and align its stock value with its peers.

Transcript