When a multibillion-dollar conglomerate attempts to effect a business sea change around a simple story line, it's refreshing if corporate results actually begin to reflect the narrative arc. Below is a table detailing General Electric Company's (GE 1.25%) recently reported fourth-quarter 2014 revenue by segment:
| Segment | Q4 2014 | Q4 2013 | % change |
|---|---|---|---|
| Power & Water | $9,388 | $7,686 | 22.14% |
| Oil & Gas | $5,010 | $5,306 | -5.58% |
| Energy Management | $1,978 | $2,012 | -1.69% |
| Aviation | $6,424 | $6,170 | 4.12% |
| Healthcare | $5,133 | $5,117 | 0.31% |
| Transportation | $1,577 | $1,460 | 8.01% |
| Appliances & Lighting | $2,310 | $2,196 | 5.19% |
| Total Industrial Segments Revenues | $31,820 | $29,947 | 6.25% |
| GE Capital | $11,512 | $11,077 | 3.93% |
All dollar figures in millions. Data from GE 8K filing, Jan. 23, 2015.
As my colleague and all-around GE guru Isaac Pino had predicted as a possibility before the earnings report, the oil and gas segment proved a drag on the top line, as the spectacular drop in the price of crude oil has dampened demand for the drilling equipment sold and services rendered by this segment.
Yet the 22% increase in Power and Water revenue fits nicely within GE's communicated desire to transform itself into an infrastructure company. Given the demand in developing economies for new infrastructure, and the need for developed countries to maintain and repair their transportation systems, energy grids, and the like, GE executives see decades of potential growth ahead.
To this end, GE is selling off revenue streams that don't support the infrastructure initiative, including its celebrated appliances business, and investing in ones that will further its position. Let's examine the company's rebalancing act and the resulting implications for the rest of this year.
Shrinking the balance sheet: Look beyond Synchrony Financial
Long-time observers of GE can watch the infrastructure strategy carried out in slow motion as the company deleverages and diminishes its finance arm, GE Capital Corporation, or GECC.
Last year GECC successfully completed a partial spinoff of Synchrony Financial (NYSE: SYF), the company's North American retail finance business. GE still owns roughly 85% of Synchrony, but intends to make a complete exit this year by distributing the remainder of Synchrony's equity to GE shareholders in return for GE stock.
As the company often remarks, it's trying to "shrink the balance sheet" of GE Capital. While the Synchrony spinoff marks a significant step in this direction, outright borrowing reduction is also of utmost priority. During 2014, GE Capital's net repayments on debt outpaced net borrowings by $21.6 billion.
In short, GE Capital is cooling its loan originations -- and decreasing its receivables balances -- as it homes in on its target of supplying no more than 25% of GE's total consolidated earnings by 2016. Trimming this division will continue to be a primary focus for GE's management in 2015.
Levering up on industrial growth, and the virtues of purchasing at a discount
Gas turbine. Source: gereports.com.
While GE reins in its lending activities, it's not hesitating to borrow for industrial expansion across the segments listed in the table above. The company increased total industrial borrowings by nearly $3 billion, or 22%, during 2014, from $13.4 billion to $16.3 billion.
GE's switching out of debt between its two major divisions stems from reasoning that monies borrowed and invested in infrastructure projects (and aviation) will exceed the returns of the finance arm, and indeed of the entire business.
While one can keep score on the shrinking of the finance division as we did above, it's a little more complex to gauge in the near term whether GE is properly investing its industrial borrowings or not.
We can obtain some insight by evaluating the company's "enterprise multiple," in which enteprise value, or EV, is divided by EBITDA.
Enterprise Value is defined broadly as the market capitalization of a corporation, plus outstanding debt, less cash and cash equivalents. EV is a way to view a company through an owner's eyes, as the measure considers debt in addition to equity, and subtracts cash.
Consider an investment in a running business. If you purchased the equity of a business and assumed its liabilities, your total investment would be the price you paid plus the debt you signed on to, less the cash in the company's bank accounts.
By dividing enterprise value by EBITDA, and arriving at the enterprise multiple, investors can get a sense of how a total enterprise is valued relative to earnings.
As the chart below demonstrates, GE's Enterprise Multiple outstrips that of a wide selection of competitors. This is due to the proportionately larger debt held on its books by GE Capital:
GE EV to EBITDA (TTM) data by YCharts.
As GE seeks to change its capital structure over time, it can choose to invest in businesses with a lower enterprise multiple: companies valued at less on the open market relative to their earnings than is GE.
GE certainly exercised such choice in its acquisition of most of French energy and transport giant Alstom SA, a deal that will close this year at a transaction amount of roughly $17.5 billion. Let's add Alstom to the previous comparison:
GE EV to EBITDA (TTM) data by YCharts.
Viewed from the perspective of the enterprise multiple, GE is using its dollars wisely, acquiring Alstom at a discount to the market value of its own current capital structure.
Future infrastructure growth: Buying expertise
Yet an attractive valuation might be the lesser of principles guiding GE's investment in Alstom and upcoming acquisitions. General Electric understands that to be positioned as a global infrastructure giant, it needs to invest in people, presence, and capabilities in virtually every conceivable geographical market.
John Rice, CEO of GE Global Growth and Operations, spoke convincingly to this point at the Goldman Sachs Industrials Conference in November:
[Y]ou've got to have local teams with credibility, who can help you make local decisions. You have to have a presence, beyond the local leadership team. You have to be in new markets. We opened up an office earlier this year in Papua New Guinea. I didn't think when I started my career in GE, in 1978, that I would be in Papua New Guinea in 2014, opening up an office, but we have several hundred million dollars worth of business opportunities there.
Even for a company the size of GE, maintaining offices, teams, and operations in so many countries -- some of them as far-flung as Papua New Guinea -- isn't a trivial expense. Buying expertise and depth in target markets can be a shrewd use of resources. Accordingly, during the company's investor outlook conference in December, CEO Jeff Immelt remarked that Alstom had a superior operation in India, an important growth market, and greatly expanded GE's capabilities in China, the Middle East, North Africa, and Turkey.
2015: Not a huge payoff, but getting closer
Long-patient General Electric investors may want to keep their expectations tepid for 2015. Management has already signaled that this year will be devoted to closing out both the Synchrony and Alstom transactions. Within the next 12 to 24 months, however, we should see a company with higher industrial returns, and also one that hits its much publicized goal of a 75% to 25% earnings split between industrial segments and GECC. At some point during this time period, the markets may finally begin to appreciate GE's narrative.
