Sometimes, General Electric's (NYSE:GE) power and renewable energy businesses are seen as millstones around the neck of the company. However, they could also be seen as a value investing opportunity. Here's how and why investors shouldn't be too quick to dismiss the potential in both segments.
The value case
Value investors come in all shapes and sizes, but one type of value investor likes to look at a business and compare its earnings and/or free cash flow margin to its peers and invest on the basis that the troubled company has an opportunity to raise its margin vs. its peers. That's precisely the argument that investors could make about GE's power and renewable energy businesses right now because both segments are behind their peers in terms of margin.
That point will be returned to in a moment, but in order to build a case for improvement, it's a good idea to look into what went wrong and why GE's businesses have been underperforming peers like Vestas (OTC:VWDRY), Siemens Gamesa (OTC:GCTAF) in renewable energy, and Siemens (OTC:SIEGY) in power.
General Electric's legacy
To understand why, you have to go back to the tenure of former CEO Jeffrey Immelt. One of his big ideas was to make GE a so-called digital-industrial company by accelerating the implementation of digital technologies as part of its solutions. At the heart of it lay a software company, GE Digital, which would work to implement the industrial internet of things (IIoT) into all of GE's hardware and services.
With GE's IIoT solutions leading the marketplace and adding value for customers, the next logical step was to try and scale by buying businesses that didn't have digital solutions and then add GE's digital capability to them. In addition, GE could try to build scale by aggressively competing for contracts in order to implement its digital solutions.
It appears that GE took both options. It signed a slew of ill-fated deals in the oil and gas sector. These included a $7.4 billion contribution to help combine with Baker Hughes (NYSE: BKR) in 2016, the purchase of Alstom's power businesses that was bought for around $10.6 billion in 2015, and the company's acquisition of wind turbine blade manufacturer LM Wind Power for $1.65 billion in 2017.
While GE's management was busy loading up on debt in order to make acquisitions, its power and renewable energy businesses were increasingly inking less profitable contracts. As such, the businesses together managed to report a segment loss of $516 million in 2018 and a loss of $280 million in 2019.
It gets worse. On a combined basis, the two segments were responsible for a $2.5 billion cash outflow in 2019.
How General Electric can improve performance
To be fair, not all of GE's woes can be blamed on its previous management. For example, it's very difficult to predict the direction of oil prices and gas turbine demand. Unfortunately, both collapsed just as GE was getting ready to try and profit from its strategy of building scale to apply digital capability to the new businesses and contracts.
No matter, the end outcome was the same, and both segments have seen profit margins collapse in recent years as the new management struggles to turn the business around while encumbered with legacy contracts.
That said, there's definitely an opportunity for improvement. For example, in renewable energy, both Vestas and Siemens Gamesa produced high-single-digit adjusted operating profit margins in 2019. Vestas' operating profit margin before special items was 8.3% in 2019, and Siemens Gamesa's adjusted operating profit margin was 7.1%. Those are targets that GE Renewable Energy is aiming for.
Meanwhile, Siemens' gas and power segment margin was 3.8% in 2019. Here again, there's an opportunity for GE to play catch up. Moving up from GE Power's 2.1% margin in 2019 to Siemens' gas and power margin of 3.8% may not seem much, but it would lead to a 180% increase in profit in the segment.
Moreover, there's evidence that GE is making progress in improving the performance of both segments. As you can see above, GE Power's margin improved in 2019, and GE CEO Larry Culp has talked about 2020 as the year when the renewable energy segment would start to turn around.
Obviously, the COVID-19 pandemic has negatively impacted matters. However, in the second-quarter earnings presentation, management outlined how negative impacts were "partially offset by Onshore Wind price and lower project execution losses." This is a sign that GE is starting to improve underlying performance in the segment.
Clearly, the key to GE's medium-term future remains at GE Aviation, but it would be a mistake to write off the power and renewable energy segments as lost causes. In fact, management has an opportunity to grow earnings simply by better execution and taking on fewer less-profitable contracts, as the company did before.