In December 2017, Bill Nygren (Trades, Portfolio) and Win Murray of the Oakmark Funds sat down for an interview with GuruFocus. One of the topics discussed was General Electric (GE, Financial), which Oakmark started buying a few months earlier. Here’s Murray with an update on GE:
“We were wrong in our initial assessment of General Electric. We believed that its new CFO Jeff Bornstein would help change the company’s history of poor capital allocation, as evidenced by transactions he initiated, such as the GE Capital exit, the Alstom purchase, and the Synchrony (SYF, Financial) spin. We also believed the company’s cost structure had not been run as efficiently as it could’ve been and that margins would expand over time.
As it turns out, GE’s culture of 'growth, growth, growth', with a focus on reported EPS, was inappropriately applied to the company’s Power division. GE Power built capacity and inventory for orders that never came and sold OEM equipment at poor contract terms, while booking GAAP profits through adjustments to prior-period long-term service agreement accounting. GE Power’s sustainable operating income turned out to be vastly lower than what had been reported. The stock has been a significant underperformer, and many executives (including the CEO, CFO, two Vice Chairmen, and the head of GE Power) no longer work for the company.
This is far from the first investment mistake we’ve made at Oakmark… What’s important is handling the mistakes properly, once identified. Using GE as an example, when fundamentals looked as though they were moving in the wrong direction, one of our analysts wrote a full Devil’s Advocate memo on the company, which was distributed to the whole department and then discussed at our domestic investment meeting. The GE analyst and the Devil had to come to agreement about what numbers were acceptable to use in the model. In addition, portfolio managers met with management, including new CEO John Flannery, in Boston and again in New York.
It’s important not to anchor to the prior thesis and original assumptions, but instead to take a fresh look at the company at current prices. We believe that GE has some outstanding businesses with long-lived service income, which should (when properly run) trade at least at parity with other high-quality industrials. We also believe that Flannery is a very capable CEO who will ultimately run the company more effectively than it’s been run in decades. The turnaround won’t occur overnight, but the current price appears to be factoring in significant challenges, and we believe the stock remains attractive.”
Since that interview, GE's stock has continued to crater: it’s down more than 20% year to date. I’ve done work on GE and tend to agree with the team at Oakmark: I think this may be an opportunity for investors to pick up some great businesses at a reasonable valuation.
But I’m not 100% sold on that conclusion. For full disclosure, I made a small investment at prices well above current levels. I have not added to the position as the stock has moved lower. For now, I don’t I have the level of confidence in the company that I would need to keep adding (that became abundantly clear after reading the most recent 10-K filing).
My hope is this will be the first in a series of articles about GE (that may take some time as my attention is drawn to other opportunities created by market volatility). I’m going to look at the individual segments to determine whether the business valuation makes sense; currently, the market cap is around $110 billion. This article will focus on one of GE’s strongest businesses: aviation.
GE’s aviation business designs and produces commercial and military aircraft engines, as well as aftermarket services for those engines. Aviation also designs, produces and services integrated digital components, electric power and mechanical aircraft systems. The largest piece of the business is commercial engines and commercial engine services, which accounts for 75% of segment revenues.
Notable engines in GE’s commercial portfolio include GEnx (65% win rate on the 787 and sole sourced on the 747-8) and LEAP (roughly 60% win rate on the A320neo and sole sourced on the 737 MAX and C919). The LEAP engine, a product of GE’s joint venture with Safran (XPAR:SAF, Financial), is the successor to the best-selling engine in the history of commercial aviation (the CFM56). The LEAP entered into service on the A320neo and the 737 MAX in 2016 and 2017 respectively.
Here’s segment revenues and operating income (before corporate costs) over the past five years:
As you can see, the financials have trended higher in Aviation. Over the past five years, revenues increased at a 7% compound annual growth rate. Operating income increased much faster (12% CAGR), with segment operating margins expanding 550 basis points. The margin profile has been helped by mix shift toward higher margin services, which accounted for roughly 60% of segment revenues in 2017 (compared to a shade under 50% in 2014). Services revenues in the aviation business have increased by a double-digit percentage each of the past three years.
Because Aviation’s profit margins are significantly higher than the other business segments at GE, the segment accounts for 45% of the company’s industrial profits (compared to 25% of revenues). As a result of outsized growth, Aviation’s share of profits at the company has climbed meaningfully over the years (the recent collapse of power segment profitability has played a role as well).
As GE management detailed at the 2017 Investor Event, the company holds a strong position in commercial engines. GE engines powered nearly 70% of the roughly 37 million commercial departures around the world in 2017 (includes joint venture engines). This has been the case for some time: an article published in “The Economist” in 2007 (“Odd Couple”) suggests GE and its joint ventures held a similar share of the market a decade ago.
On top of significant market share, GE’s installed base of roughly 35,000 commercial engines is growing. Safran estimates the CFM fleet in service will increase by more than 4% annually over the next decade. In addition, the fleet is young: 45% of GE’s installed base has yet to see its first shop visit (usually eight to 10 years after entry into service, or EIS); another 18% of the installed base has had one shop visit. To quantify what this means for the business, GE expects shop visits for the portfolio to grow at a 5% to 6% CAGR over the next few years (to roughly 5,500 visits in 2020). This will be driven by the CFM56, which Safran estimates will see max shop visit activity around 2025, as well as early shop visits for LEAP engines.
The large and growing installed base provides a long runway for maintenance, component repair and overhaul services: Safran expects LEAP original equipment production will probably go beyond 2035, with aftermarket revenues beyond 2060. As GE’s installed base continues to grow, we’re talking about decades of commercial services business attributable to LEAP (the services backlog for GE Aviation has increased by roughly 130%, to $137 billion, since 2010).
Guidance at GE’s 2017 investor event called for 7% to 10% revenue and operating income growth for Aviation in 2018 (orders and the backlog both increased double digits in 2017). Because of the impact of accounting changes, revised segment EBIT will start from a base that’s roughly $800 million less than what GE reported in 2017 (call it $5.8 billion).
If GE hits the midpoint of those targets (and after accounting for the impact of the new revenue recognition standards), that implies roughly $30.5 billion in revenues and roughly $6.3 billion in operating profits. At a 21% tax rate, that’s roughly $5 billion in after-tax profits (to be clear, that’s without attributing any interest expense or allocation of corporate costs to aviation). Over the next decade, I think there’s a good chance segment level profitability reaches $10 billion.
The current results include the upfront costs associated with the LEAP ramp. CFM will go from 459 LEAP engines delivered in 2017 to a target production volume of more than 2,000 engines in 2020 (LEAP is expected to plateau at these levels – about 30% higher than the CFM56).
Throughout this process, there will be pressure on the income statement. In each of the past two years, GE has called out “unfavorable business mix driven by negative LEAP margin impact” in the segment results. Executives at Safran estimate LEAP will only reach breakeven on original equipment production around 2020. Clearly the losses booked today do not capture the lifetime value (future MRO revenues) attributable to adding another engine to the installed base.
In summary, I think this is a high-quality business with attractive returns on invested capital. In addition, it has a strong competitive position in end markets with structural tailwinds and long product cycles. CEO John Flannery recently said he would stack up Aviation “against any business on the planet”. While I might not go that far, I wound say this is a really good business.
If GE Aviation was on its own, I bet Mr. Market would be willing to pay at least 20 times earnings (and that’s before considering the short-term pressure on profitability from the CFM56 - LEAP transition). For what it’s worth, Safran currently trades at a comparable earnings multiple (and I think you could make the case that GE Aviation is in a better position than Safran).
If you accept my arguments, GE’s aviation business is currently worth roughly $100 billion.
This conclusion only holds if the accounting accurately captures the underlying economics of the business. I feel the need to explicitly state that because I have my doubts. For example, I have a tough time understanding why GE’s margins have climbed higher through the LEAP ramp; the margin profile at Pratt & Whitney over the past five years makes a lot more sense. In addition, the 2018 guidance from GE Aviation only calls for 80% free cash flow conversion despite the meaningful step down in segment profitability from the accounting change. While that’s not too surprising considering where we’re at on the LEAP launch, I'm not comfortable simply accepting such a larger free cash flow gap – especially when you’re dealing with a company that may have pushed the envelope in the past. In summary, my inability to estimate the timing and magnitude of cash flows over the life an engine is still an issue (and there isn’t much in GE’s 224-page annual report that helped either).
Needless to say, that aspect of this exercise has been frustrating. But the "glass half full" perspective is this is keeping most potential investors away. The combination of complexity and a big drop in the stock price has undoubtedly led to widespread selling (that's when clients start asking questions). Sometimes, that's where opportunity resides. Time will tell if GE is one of those opportunities.
Disclosure: Long GE.Ă‚
