The financial media these days has two stories when it comes to General Electric (NYSE:GE): the one that says GE is downplaying its banking business and the one that shows how GE is returning to its roots by "making stuff" again.
While both storylines are important to GE investors, a separate transformation taking shape inside the world's seventh-largest company will steal the spotlight in the years to come. The seeds of GE's next big breakthrough were planted nearly two decades ago, but they're just now taking root as manufacturing enters a technology- and data-fueled era.
Read on to learn the untold story of GE's most lucrative business and discover why it's so important for shareholders to understand.
The one that (almost) got away
The origin of this story dates back to the early 1990s. Jack Welch, also known as "Neutron Jack," was GE's CEO, and he was busy making his mark on corporate America.
Quadrupling GE's market value in roughly 14 years made Welch a superstar in the eyes of everyone from the media to stockholders. To business students around the country, he was the Michael Jordan of their future profession.
Like Jordan, Welch was a fierce competitor, and his unorthodox, assertive style of management took his team to the top: GE became the largest company in the world.
By the mid-1990s, however, this titan of industry faced a dilemma within GE's walls.
His success to date had rested on strategies that boosted manufacturing efficiency, heightened competition among his managers, and focused strictly on markets in which GE could steamroll the competition. Each had its pros and cons, but the latter strategy specifically began to show signs of obsolescence in the mid-1990s.
This strategy had become known as the "No. 1 or No. 2" policy at GE. It meant General Electric aimed to dominate the industries in which it operated, or else it would abandon the cause. Anything less than first or second place in market share was simply unacceptable.
As GE grew in size, this all-or-nothing style of thinking caused some serious problems. First off, the incentives were misaligned for GE's managers. Its own leaders became hyperfocused on maintaining their market position in a given industry instead of thinking about how to expand into a new one. Expansion would mean growing their addressable market, of course, which could bump GE's rank down a notch or two.
There was absolutely no incentive to grow outside of the box, per se, even if it made sense from a product or customer perspective. To use an analogy, it's as if a traditional motorcycle manufacturer refused to enter the growing market for off-road dirt bikes because this would grow the arena in which it competed and would mean relinquishing its "No. 1 or No. 2" position. While this might sound ridiculous, it was a prime example of how GE's bureaucracy was creating perverse incentives.
And, in the worst-case scenarios, GE managers were given leeway to define their own markets. When this happened, they would often manipulate (read: shrink) their "industry size" in an attempt to look like they had a dominant market presence. Since GE's underperformers could be shown the door at any moment, this move was a self-preservation no-brainer. But it was highly counterproductive for the company.
At the end of the day, the overriding focus on being first or second prevented managers from tackling new, promising opportunities in which GE might be the underdog at the outset. And the services business was one of these markets.
A "punch in the nose"
At the time, the business of maintaining and servicing heavy industrial equipment was loaded with entrenched players dispersed across the globe. In fact, GE's potential competitors in this arena numbered in the thousands. One could compare the scenario to a major car manufacturer trying to nudge its way into an auto maintenance industry overpopulated with established, local mechanics.
Taking a backseat to entrenched players -- even if it was in the best interests of GE's customers -- was simply unacceptable. It also seemed like small potatoes for a company of GE's size.
But here was GE selling hundreds of proprietary products like gas turbines that would inevitably need regular maintenance and upgrades. Services might not have seemed glamorous, but it was an area in which GE had a unique and potentially durable advantage.
By 1995, Welch relented; ironically, it was his middle managers who convinced him that this market was too crucial to be overlooked. Welch did an about-face on his long-standing management mantra, and GE began to aggressively pursue services.
In 2000, Welch recalled how the light bulb went off and why he reversed course on services:
Rather than the increasingly limited market opportunity that had come from this number-one or number-two definition that had once served us so well, we now had our eyes widened to the vast opportunity that lay ahead for our product and service offerings. This simple but very big change, this punch in the nose, and our willingness to see it as "the better idea," was a major factor in our acceleration to double-digit revenue growth rates in the latter half of the '90s.
Welch's refusal to set foot in industries in which he couldn't dominate would be like Michael Jordan refusing to take some lower-percentage perimeter shots. It might make sense for a short stretch of time, but ultimately it underutilized the company's talent and limited its ability to attack areas where the competition could be outmaneuvered.
The rise of services
Welch called his realization a "punch in the nose," but he took it in stride. Within three years time, revenue from GE services reached $10 billion, and Welch was singing its praises in his annual letter to shareholders:
The opportunity for growth in product services is unlimited. We have the ability, using high-technology services, to make our customers' existing assets (e.g., power plants, locomotives, airplanes, factories, hospital equipment and the like) more productive, and by doing so reduce their capital outlays. This growing capability, much of it information technology-based, will enable us to increase our revenues from product services by more than 30% in 1998 -- to $13 billion.
What began as a maintenance-focused exercise was unfolding as a productivity-enhancing opportunity for GE customers. And that has continued behind the scenes for the last 15 years. Welch's successor, Jeff Immelt, has carried the torch.
Under Immelt's leadership, GE's services capabilities have evolved and multiplied. Today, GE can actually diagnose problems in the company's products in advance of a breakdown. For gas turbines and rail locomotives, it's like a "check engine" light flashing on in your car, but with a real-time response from one of GE's engineers connected via the industrial Internet.
The probability that a customer will actually have to visit the repair shop is greatly reduced -- a big win for around-the-clock energy, airline, or rail operations.
For GE, it's also a win. Long-term contractual service agreements deepen GE's relationship with major clients. They enable engineers to better understand how their products are being used in the field, which can, in turn, influence the design process.
It's also a highly lucrative business.
I've compared the equipment-and-services relationship to a razor-and-blade business model. This means the initial sale of GE equipment (the razor) is often accompanied by an even more profitable service relationship (the blade).
The following chart shows how much more profitable services are for General Electric relative to the operating margins of the company as a whole:
What's more, services are growing. Once again, this segment is outpacing the rest of GE's business, making up ground at a company that was hit hard by the financial crisis:
Finally, services are scaling across the business. This means it's starting to make a significant impact on the revenue and earnings of this massive conglomerate.
For instance, from 2011 to 2013, services accounted for 28% of revenue but 40% of earnings on average. Investors can expect services to be an even larger piece of the revenue and earnings pie going forward due to a huge pipeline of work.
Right now, the most important chart for GE investors is one of its $250 billion order backlog. Look at how GE's backlog has ballooned and transformed from services-light to services-heavy over the past 13 years:
What you need to know about the new GE
For investors, it's important to recognize GE for what it is today.
It's no longer a bank. In fact, GE expects to derive only 25% of operating earnings from lending by 2016. Lending, too, will be a services-driven business, with GE providing financial expertise -- as well as money -- to clients in a variety of industries.
It's no longer an old-school manufacturer, either. Gone are the days of trying to win based on having the absolute lowest costs in the business.
Today, it's all about enhancing products through services. How can customers reduce downtime? How can real-time data, robots, and connectivity make machines more efficient? Here's how Immelt put it in a recent presentation on services and GE's industrial Internet:
[T]his is the new battlefield. This is the new basis for competition. No matter who you invest in, if you are in the industrial space ... this is the game of the future.
After two decades in the making, the future has arrived in the form of high-tech services at GE. Although it has generally flown under the radar in the mainstream financial press, the story of services is one that long-term GE investors simply can't afford to ignore.
Isaac Pino, CPA, owns shares of General Electric Company. The Motley Fool owns shares of General Electric Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.