Unlike many of its Dow Jones Industrial Average (NYSE:DIA) brethren, General Electric (NYSE:GE) has not regained the market value it previously had prior to the financial collapse back in 2008.
Back on September 1, 2007, GE stock hit $41.40 per share. It is currently trading around $21.30 or nearly 50% from its peak.
Ultimately, CEO Jeffrey Immelt must bare the ultimate responsibility for this lackluster performance. Fairly or unfairly, GE Capital expanded aggressively and collapsed under his watch and he is responsible for guiding the proverbial ship through the storm. So it is with that in mind that I seek to analyze what I perceive to be GE's current strategy and recommend a new one to improve shareholder value.
What Businesses are in GE?
Looking at GE we see a massive, diversified, and profitable conglomerate with a lot of very good but very unrelated businesses. NBC, airplane engines, and commercial financing carry only so many opportunities for cost reduction and economies of scale.
Their businesses also include medical devices, power generation, and household appliances. Within the power generation segment they sell gas turbines, generators, Integrated Gasification Combined Cycle technology (IGCC systems convert coal and other hydrocarbons into synthetic gas), steam turbines, nuclear reactors, nuclear fuel and support services, and motors and control systems for oil and gas extraction and mining. In just that segment of the business they have an astonishing range of products. Any one of these products would serve as a large and viable business in and of itself, but GE has them all rolled up under its corporate umbrella.
Analyzing GE's Business is a Frickin' Nightmare
And therein lies the problem: Analyzing GE's business and where its going is an absolute nightmare. I could expound on any one of those products ad nauseum, but GE's current composition requires a simply massive amount of analysis to assess and understand the risks involved with ownership (I might add this is a criticism that can be levied on many companies in this day and age). That ripples out amongst investors whether they're institutional or individual.
Since the financial collapse, investors are far more risk averse and naturally so. Hence the rush into gold during the past two plus years. So looking at GE with all of its subsidiaries and a balance sheet that includes a very large financial component ($322 billion in receivables for GE Capital alone), its easy to see why investors have said "why bother" over the past decade. Add this to the fact that the company is exhibiting tepid revenue growth and the list of concerns to an investor is daunting.
One would tend to think that General Electric's diversification across both product lines and geography would have done a better job protecting it from the maelstrom of 2008. The problem with major financial crises is that correlations between assets tend to increase meaning that businesses with different exposures to the ebbs and flows of the business cycle suddenly all react negatively to it.
The implications of this for GE are that its decades long efforts to become a diversified company have been for naught because the primary argument for that diversification, safety during crises, has been proven to be nullified by severe liquidity events in the financial markets. What makes the conglomerate structure even more contradictory to the idea of diversification is that diversified assets are supposed to be independent of one another, but in a conglomerate like GE the combination ultimately serves to support each division; in effect all of the businesses become correlated even if they would not be if separate.
Another aspect of GE's recent governing strategy that I find worrisome is their recent emphasis on using government contracts and bailouts to bolster their business. By way of a loophole in the regulations underpinning the Federal Deposit Insurance Corporation, GE was able to rescue its borderline insolvent GE Capital division by using the Temporary Liquidity Guarantee Program and issue nearly $74 billion in debt. Without that guarantee it is unlikely GE Capital would have been able to continue to function given its current business model which, like so many financial institutions that stood on the precipice, was dependent on borrowing short and lending long.
Once the short-term markets tightened up, firms whose operations depended on such cheap financing faced severe liquidity issues. What this tells us is that GE Capital encumbers General Electric with so much financial risk that bankruptcy is a real danger to not just the subsidiary itself, but the entire firm during turbulent times. This has to be factored in to any analysis we do of General Electric.
Recently, the Wall Street Journal published an op-ed entitled "The Great Misallocators". The crux of the piece was that politically allocated capital is inherently less efficient than is privately allocated capital and as a result will lead to slower economic growth than the alternative. The Wall Street Journal epitomized the relationship between GE and the United States government with the following quote from Jeffrey Immelt: "The interaction between government and business will change forever. In a reset economy, the government will be a regulator; and also an industry policy champion, a financier, and a key partner."
Now obviously the government needs to make purchases from private companies to operate and for many of those purchases GE is an ideal supplier. But GE has been going to the Obama Administration hat in hand and pushing the administration's policies such as cap and trade and the expansion of wind generation so as to curry favor amongst federal appropriators. Given the historic inefficiency of state-owned enterprises as observed across multiple countries, I find such a cozy relationship very uncomfortable as an investor. There is an inherent conflict of interest when the government serves as both partner, financier, and regulator (see housing market). How such a relationship could rebound on GE is impossible to foresee and therefore, impossible to price. The government doesn't give federal contracts solely based on merit (much to the chagrin of most of the electorate).
For GE to want to ingratiate itself to such a murky market serves as an unwanted distraction from appealing to the consumer driven market it should be working to win over. Or worse, its a tacit admission that it can't win over that market anymore. Perhaps my paranoia at the conflicted relationship that may ensue between the U.S. government and GE is just that since currently, government contracts make up only a paltry 4% of revenues (though how you factor in the nearly $80 billion in government financing may push that number substantially higher). But I suspect Mr.Immelt has every intention of expanding GE's dealing with the government greatly and as with all investing our concern is with the future as much as it is with the here and now.
Using what I consider to be some very optimistic earnings estimates based on what analysts currently believe to be GE's forward earnings and assumptions including a return to somewhat normal volatility levels, I arrive at a valuation of $24 per share for General Electric or around a 13% premium to its current price. That is hardly the type of appreciation potential that would make me jump at investing in this company (and again I must warn the reader that this is based on very liberal assumptions). Now the company does seem to be making some strides in managing its balance sheet more prudently since the days when GE Capital drove the firm.
In 2008, making adjustments for goodwill and cash and equivalents, GE had a long-term debt to equity ratio of over 20x whereas that has now dropped to around 8x. So the firm has reduced the financial risk it encumbers shareholders with, but even that level of leverage is still far too high and as I have mentioned in previous pieces, results in a higher discount rate being applied to the valuation of the equity of the company.
What Should GE Do?
So what is GE to do? How can it regain its previous shareholder shine? I see a multitude of paths forward for this company. My personal preference is to divide the company into stand-alone businesses and distribute equity in the new firms to existing shareholders. There is tremendous unrealized shareholder value in this company, but most of it is being held down by the risk premium associated with the difficulty of analyzing the company and the fact that GE Capital is now considered a much more risky venture than it previously was. Complexity and leverage begets risk to shareholders and risk leads to discounted shares.
A very basic plan would be to divide the company into GE Capital, Energy Infrastructure, Technology Infrastructure, NBC Universal, and Consumer and Industrial and let them thrive on their own. The argument could be made to divide those divisions even further for instance airplane engines could easily be its own division. As could medical devices or home appliances.
Using similar assumptions to the previous scenario and valuing the components separately I arrive at a combined value of just over $28 per share or about a 32% premium to today's value. What the valuation shows is that GE Capital is the dog of the group. It is also dragging down the value of the entire firm because of the intrinsic risk associated with it and because implicitly, the other divisions of the firm could see their resources shunted to bolster GE Capital during another financial melee.
An alternative might be to redouble efforts to deleverage the company. Since GE Capital is the source of most of that debt it would make sense to shrink its balance sheet and finance only high quality borrowers. GE didn't start out as a finance company and it almost collapsed trying to be one - now seems like a good time to end that practice. GE's future isn't in lending. Its in medical services, energy infrastructure, and technological infrastructure.
With the collapse of the credit induced housing bubble firms are slowly getting back to investing capital in improving things that make people's day-to-day better. This is not to say GE Capital has no place in the firm, but its place should be similar to that of other finance arms in large industrial conglomerates: as a source of financing for the customers of its divisions that produce goods and services not as a lending arm in and of itself.
This post originally appeared at Wall St. Cheat Sheet.
Get the latest General Electric stock price here.
If somebody was to ask what industry Virgin operates in primarily, the first thought that comes to mind would inevitably vary between each of us. This is due to the Virgin Group partaking in what’s known as ‘unrelated diversification’ – the fifth strategy in Ansoff’s Matrix. Unrelated diversification involves entering an entirely new industry that lacks any important similarities with the firm’s existing industry or industries, and is often accomplished through a merger or acquisition.
In the case of Virgin, unrelated diversification has certainly been a successful strategy in terms of maximising profitability. Looking back to 1970s and the start of its operations as a record mail order company and record store soon after, given the rapidly changing nature of the music industry since, it is possible that the company would no longer exist if it hadn’t innovated in this way. With a total of 35 subsidiary companies within the Virgin Group globally, within the UK today’s breadwinners look very different to the 1970s, helping the Virgin Group to a total revenue of £15 billion in 2012:
The key to successful unrelated diversification is identifying an industry with strong profit potential, where the firm has internal competences that helps to gain a competitive advantage. Virgin Atlantic’s market entry in the 1980s in a good example of this at a time when great customer service was a rare quality in the airline industry, which was instead plagued by cancelled flights, delays and lost baggage. Virgin’s internal competence of providing an excellent customer experience throughout its existing family of companies offered an advantage that would be hard for competitor airlines to replicate – and therefore potential to charge a price premium.
However, the ‘unrelated diversification’ strategy is far from full proof and there are numerous examples in which it has failed for Virgin. Perhaps the most high profile case is the short rise and rapid fall of Virgin Cola in the mid-1990s – following an ambitious, yet unsuccessful plan to compete with Coca-Cola and Pepsi. Despite the ever-growing fizzy-drinks market, conditions were not conducive to Virgin’s entry due to the existing players’ ability to block access to widespread distribution and a backlash in advertising spend – which ultimately limited Virgin Cola to just a 3% market share on its home UK turf before exiting.
Looking beyond the risk of failure, I would also argue that unrelated diversification creates further risks in terms of losing brand strength, by blurring the delivery of a single strong message. Virgin used to have the image of being a rebellious brand that resonated strongly with its young audiences through music and records – a lifestyle in itself almost – but with Virgin Money and Virgin Trains, it doesn’t have that single message and association any more. Today, the host of sub-brands do not comfortably fit together in a way that Virgin can define itself as meaning something, which goes a long way towards explaining why Virgin isn’t a leader in any of its industries. In the airline, broadband and gym industries to name just a few, Virgin is simply another player and fails to innovate in the way that a leader generally does. Instead, Virgin tends to take an existing service or product and undercut prices or offers a slight variation on the business model.
Richard Branson summarises the Virgin Group’s modern strategy with the quote; “Business opportunities are like buses, there’s always another coming along”. Essentially, Virgin now examines existing industries to see if the group can offer something better than existing companies which may have become complacent – trains, insurance and banking for example.
Virgin has lost some of its magic and, consequently, the brand name survives on its credentials as a strong global business that creates efficiency and profitability where others fail, rather than something more powerful in people’s minds.
With this in mind, a case could be argued that Richard Branson is now attempting to revisit the past and recreate a more distinctive image, such as through the publicity generated around the launch of Virgin Galactic, which aims to launch the first commercial spaceflight. Although this industry is full of uncertainly and offers no commercial value as yet, it brings with it beneficial associations of innovation for the Virgin brand. The diverse nature of the Virgin Group’s business model means that trying to reinforce a niche differentiator of ‘rebellion’ no longer washes for such a broad target audience, so being considered the driving force in an infant industry that holds strong media interest can reach out to all existing audiences; demonstrating that the Virgin brand is always trying to push existing boundaries of possibility.
The next 10 years or so will be a crucial period for Virgin, and it will be interesting to see how it pans out. What will come to mind when somebody says Virgin to us in 2024? Let’s hope it’s much clearer and consistent than it is today.