Monday, September 3, 2012

General Electric Equity Research Analysis

A stock like General Electric $GE is always going to be seen as a proxy for global GDP growth and I can’t argue with the logic. However, global economies have many moving parts and I think there was good cause to believe that GE was exposed to some of the more favorable trends. The bad news is that while the recent results confirmed some positive end markets, on balance the figures were rather disappointing.

GE’s Favorable Trends

Global energy infrastructural spending remains ok and low prices in gas should be encouraging purchases of gas turbines as utilities switch to using it for power generation. Further, as turbines are used more (to take advantage of low gas prices) GE’s service revenues should be increasing too.  Aviation is a strong sector for GE and so far most of the companies in the sector have reported good results, albeit with a weak outlook for defense spending.

Turning to healthcare, this is clearly a more defensive sector and with low interest rates and increasing credit quality in the US, GE Capital has good opportunities to grow profits. While global growth is definitely slowing, GE looks well placed to weather them so it does look rather positive from an end-market perspective.

The problem is that GE’s positioning and sales mix within this segments looks a bit weaker after these results. Before going into detail on these issues, here is the relative importance of the divisions in terms of segmental profits for this quarter.

Maybe this is the Strongest Point?

Starting with the largest contributor to profits (GE Capital), things are unlikely to be as rosy going forward. The US is doing ok but GE capital has significant European exposure. Europe is a mixed bag but unlike many other companies that might predominantly sell to a particular market, GE has broad-based exposure. Italy was described as a "tough place" and places like Spain will create difficulties too. As we saw in 2008 with GE, it is not just an industrial company and loan losses and write-offs can quickly hurt the bottom line.

Energy infrastructure is doing fine with mid-teens growth in revenues and segmental profits and it confirms what Alcoa $AA said recently about its industrial turbines business. However, I would strike a note of caution. These businesses tend to be long-cycle so any slowdown will not be seen initially in a downturn. The market isn’t silly and will anticipate such events, so investors need to bear this in mind. Within the two components of the division, energy spending remains robust but it was noticeable that oil & gas equipment revenue was flat while service revenue rose 10%. This suggests that oil & gas spending is starting to moderate.

Aviation saw strong revenue growth in line with what companies like Textron $TXT and Alcoa said recently about commercial aviation. GE did see some strong areas here but overall aviation margins were down due to a negative relating to the sales mix, and segmental profits were down 4%.  I noted that AAR Corp $AIR recently affirmed how much of a drop off on military spending there would be in the future and GE is exposed here. The other thing that worries me is that aviation spending is cyclical. Orders will get canceled or delayed and order books that look full now do not so look so good in future when airlines start cutting back.

Probably the biggest disappointment was in healthcare. Revenues were flat and segmental profits went down 2%. Management blamed some "execution issues" in Latin America but the weakness seems global. Moreover companies do not usually take pricing when they are competing well in stable end markets. European revenues were down 8% and the US only recorded a 1% increase. On a brighter note, GE was positive about better performance in Q3.

What About China?

Whilst we know Europe is weak I think China is also a cause for concern, particularly with GE. It has a lot of long-cycle business in China that won’t be turning down initially, given a slowdown. This can create a misleading optic especially when a company’s numbers are being supported by a relatively stronger growing region. In other words, the earnings and order numbers may look great now but they will suffer in future if China’s growth continues to moderate.

Overall Outlook

GE management stated that four or five segments would be positive in the next quarter with energy being a particular strong point. My concern is that aviation and oil and gas are sectors that could disappoint in future. GE is not performing in the healthcare segment and GE Capital has significant European exposure. China is creating some positive optics but that situation could unravel the other way.

In conclusion, GE is a well run company and investors who are bullish on the global outlook would do a lot worse then pick some up. However, it also has challenges and if you are worried about the global situation then there is a strong case to be made for the argument that GE’s revenue base is giving over-exposure to cyclicality whilst its defensive divisions are not performing well enough.

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