Service contracts are an important part of the industrial revenue stream. After all, you can only sell a big hunk of metal once. But you can sell the servicing of said hunk of metal year in and year out until it's time to upgrade to a new model.
General Electric (NYSE:GE) knows this full well. In fact, it has been deriving more and more of its revenue from service contracts, including software and logistical support contracts, over the past several years.
But now GE isn't just servicing its own equipment: It's servicing its competitors' as well. And that should make rivals such as Siemens (NASDAQOTH:SIEGY) very nervous.
The razor and the blade
The sales approach at work here is the "razor and blade" model. A manufacturer sells an item (the razor) for a very small profit and a component part (the blade) for a much higher price and profit. The video game industry uses this technique quite often: Consoles are sold at a relatively low price, or even at a loss, while the games themselves cost much more.
For GE, the razor is its industrial equipment, while the blade is the service package it sells to support that equipment. And while the industrial equipment may bring in more revenue, it's the services that bring in the profits, because it costs a lot less to service equipment than to build it from scratch.
GE doesn't break out its profit margins on equipment sales vs. services in its reporting. But in 2014, CEO Jeff Immelt revealed in a presentation that GE's industrial services had about a 30% profit margin. That's much higher than the company's overall operating margins, which were only 14.2% in 2014.
Indeed, the percentage of revenue a segment derives from services correlates to its profitability:
The vast majority of GE's services contracts are naturally for equipment it built. After all, who better to service a machine than its manufacturer? But with its recent Alstom Power acquisition, GE has acquired additional capacity to service other manufacturers' equipment. And GE reports that it's "quickly expanding" these efforts, which is hardly surprising, given their profitability.
The most recent case in point is GE's winning of a contract to overhaul a Siemens steam turbine at Mondie Swiecie's paper mill in Poland. "GE's proposal was selected based on the technical solution, price, and short delivery time," said Tomasz Katewicz, Mondie Swiecie's production director.
"These projects underscore our expanded capabilities as a total solutions provider for operators around the world -- no matter if their turbines and other components were originally supplied by GE, Alstom, or another original equipment manufacturer," said Paul McElhinney, president and CEO of GE's Power Services business.
If GE is indeed able to offer pricing and turnaround times that allow it to steal competitors' service business on a regular basis, that's a very good thing for GE -- and a very bad thing for competitors such as Siemens.
How much is enough?
Despite being far more profitable, GE's revenue from industrial services lags behind its equipment manufacturing revenue. In 2015, for example, industrial services revenue was $47.9 billion, compared with $60.9 billion in industrial equipment.
And while GE would no doubt like to ramp up its services revenue, the backlog for services projects is already massive -- and growing. The company's backlog in services was an already-large $185 billion in 2013, but by 2015 it had ballooned to $226 billion, dwarfing the company's equipment backlog -- a comparatively tame $89 billion in 2015. GE should hope that the company's new capacity from its Alstom acquisition will help it manage its backlog -- otherwise, turnaround times might balloon to the point that the company is no longer able to actively pursue service contracts on other manufacturers' equipment.
The Foolish bottom line
GE is a profitable company, particularly now that it has divested itself of many of its financial holdings and has agreed to sell its low-margin appliances business. But its biggest profits come from its industrial services. By expanding its capacity to accept these high-margin contracts, GE will help its bottom line -- and hurt any competitors from whom it steals business.
While it remains to be seen exactly how much business GE can get in this manner, this can only be good news for the company. GE is a buy.