When we hear about or talk about the American conglomerate General Electric (GE 1.81%), we tend to think of its manufacturing roots, its engineering culture, or its large banking or energy businesses. But we rarely talk about the product it was built around back in the late 19th century: electricity.
After 122 years, does GE still have an interest in making its namesake product?
This is a perfectly valid question, yet it might surprise you just how important electricity is to GE today. Electrical power generation often gets lumped into GE's broader energy portfolio, but it's a dynamic -- and massive -- business on its own. And for investors staking a claim on GE's future profits, it might be the most important GE business to understand.
Yes, but GE's not a utility...
One of the reasons we don't often associate GE with electricity -- though we should -- is that we tend to think of utility companies when we think of electrical power. And why not? For me, at least, those are the companies I write a check to on a monthly basis -- not General Electric.
So, let's be clear about what we're talking about here. GE's interest is not in utilities, but its products serve as the engines that often power the utility companies' plants. At a basic level, electricity is created from a fuel source like oil, gas, wind, or coal. GE gets involved right at the core of that conversion process.
For example, GE's natural gas turbines are just complex tools that turn mechanical energy into electrical energy. These products, in turn, could be considered the heart of the power plant, whereas the electricity is the blood that runs through it.
Source: Flickr/PSNH.
For GE, this is a good business to be in, even if it represents only a sliver of the large, complicated industry that's responsible for distributing power from a natural resource to my desktop computer. True to its roots, GE has remained focused on the areas where its engineering talent provides a competitive advantage, and that's especially the case when it comes to its power and water division.
...and power is not a commodity
It might seem counterintuitive that a company could be making hearty profits in a commodity-driven business, but it's important to understand that GE has targeted the lucrative areas in the electricity value chain. Again, natural gas turbines are a prime example.
Natural gas turbines are highly complex machines that burn a cleaner substance than coal -- a historical mainstay in electrical power generation -- at an efficient rate without requiring large tracts of land. They're more reliable than wind and solar, can start up quickly, and also happen to last for 30 to 50 years. This is an impressive lifespan, especially when you consider the fact that these machines burn natural gas at temperatures that exceed 2,000 degrees Fahrenheit. For perspective, that's hotter than the melting point of the metal in parts of the machines, but GE has employed material coatings that can remain rigid and resilient at that temperature.
Still, these machines -- like any machine -- will need some maintenance, a tune-up, or even a rigorous analysis to optimize their use over time. And that's precisely where GE can flex its pricing muscle.
Customers who purchase a gas turbine from GE tend to buy a service plan -- what we've come to know as an "extended warranty" -- along with it. They don't want to risk downtime at their plant, they know GE has the expertise to service the equipment, and they don't want to bear the burden of a major repair because they failed to change the oil regularly.
A profile view of a GE natural gas turbine. Source: General Electric Company.
As a result, this relationship can improve the performance of and extend the life of the machine, which is a win for GE since it gains an ongoing revenue stream with healthier margins than the initial equipment. If you look at services within GE, the typical operating margin hovers near 30%, whereas GE states in its annual report that equipment margins are below 10%. It's a classic razor-and-blade business model, and one that I've pointed out will be immensely important to GE's future profit growth.
The key takeaway for investors
It's easy to think electricity is yesterday's technology and not an area where a company like GE would want to place its bets in the years to come. After all, our appliances and devices are getting more efficient, and customers are finding more ways to offset their electrical bills with solar panels and energy-saving homes.
But the landscape is much different beyond the developed world: Not only is demand rising rapidly in emerging markets, but the infrastructure's barely getting built, decades behind a place like the U.S. The International Energy Agency estimates that more than 90% of net energy demand growth through 2035 will arise from these up-and-coming economies.
For GE's $25 billion power and water business, that market is squarely in its crosshairs. Not only does GE still make electricity, but it's found a way to make it lucrative as well. For investors, that's a growing business worth buying into.
