Tuesday, August 6, 2013

Why General Electric is Outperforming

If you think that investing is simple, then just take a look at industrial giant General Electric’s (NYSE: GE) latest results. The industrial sector has been weaker this year, but GE reported a surprisingly good set of results. Furthermore, rivals such as Switzerland’s ABB and Germany’s Siemens, have subsequently given disappointing results and guidance. So what's going on with GE? How has it managed to achieve such good results?

The three reasons why the results were good

GE actually reported a 4% decline in revenues, and its earnings from continuing operations before taxes were down 11%. It may seem peculiar to describe such results as being "good," but here are three reasons why the description fits.

First, the industrial side actually increased segment profits by 2%. The negative contribution came from the financial services side, where GE Capital’s segmental profits declined 9%. The decline at GE Capital was in line with the company's strategy to reduce its portfolio size and focus instead on its core GE business. The days are long gone from when GE was regarded as a financial services company with an industrial division attached to it. In fact, the industrial division now generates double the income of the GE Capital.

Here is a chart (sourced from company accounts) of GE’s segmental income in the quarter:

Five of the six industrial segments increased profits, so the underlying performance is better than it appears at first.

Orders are up

The second reason is that its industrial orders were better in the quarter. Overall orders were up 4%, with U.S. orders up a whopping 20%, and its European orders were up 2%, having been down 17% in the previous quarter. Indeed, industrial bellwether Alcoa (NYSE: AA) highlighted similar dynamics in its latest conference call.  Alcoa implied that North America was strengthening, Europe was weak-but-stabilizing, and its outlook for China remained the same. Meanwhile, GE claimed on the conference call that its emerging-market performance “remained resilient.”

A breakdown of GE’s order growth in the quarter, with all data sourced from company accounts:

Power & water has been the problematic segment this year, particularly within Europe. Indeed, European power & water orders were down 40% in the quarter. Excluding Europe, power & water orders were actually up 6%.

Furthermore, GE claimed that 70% of the segment's shipments would occur in the second half of the year, which should lead to strong margin expansion in the second half. This is good news, because the segment is GE’s biggest industrial profit center.

Relative strength in GE’s key markets

Finally, GE is relatively well-exposed to the growth areas in the industrial sector in 2013. The relative strength in the aerospace and automotive sectors has been a recurring theme of investing in the industrial sector this year.

Indeed, Alcoa noted a similar trend in its recent results. Alcoa investors should note that, on its conference call, GE discussed its gas turbine orders, and said that “the overall market is not going to be quite as strong as we had initially expected.”  In contrast, Alcoa left its forecast for industrial gas turbines unchanged.

GE also has heavy profit exposure to other sectors that are outperforming, such as oil & gas, and transportation. The most surprising result probably came from its health-care segment.

Healthcare giant Johnson & Johnson (NYSE: JNJ) has a large medical device and diagnostics division (40% of sales) that achieved tepid growth of only 0.5% (excluding acquisitions) in the last quarter. Moreover, Johnson & Johnson described the U.S. hospital capital expenditure market as being in a recession for the last 10 to 12 quarters.

GE’s healthcare sales told a similar story. Its strong expansion in growth markets (revenues up 10%) managed to offset weakness in developed markets (where revenue declined 4%), resulting in flat revenue for the quarter.

Where next for General Electric?

In conclusion, revenue growth will be hard to generate in 2013 due to a weak global economy, but GE has enough exposure to the end markets that are doing relatively better. Conditions could hardly get much worse for its European power & water operations, and going forward, GE will start to lap some easier comparables.

The underlying performance on the industrial side is relatively good for the sector, and GE represents one of the better ways to play the industrial sector this year. It's well worth looking at.