A shrivelled leviathan. What investors can learn from the once mighty, and now fallen.
“Only about 1 in 4 transformations succeed in the short and long run, and the success rate has been trending downward” Boston Consulting Group (BCG)
With odds like this it should come as no surprise as to why Insync is reluctant to invest in turnarounds. General Electric is a prime example. This may also partially explain why ‘value style’ investing is not doing as well at this stage of the market as previously, as many companies undertaking significant turnarounds also usually trade on low P/E’s.
For GE, despite trading on 10.8x PE, holding some very attractive businesses and hiring a great CEO (again) this Iconic US manufacturing powerhouse continues to struggle to grow. Its share price continues to languish resulting in its ejection from the Dow Jones index after 111 years. Its share price is currently around $9USD versus its high of $60USD in 2000.
Disruption risk as you will see, looms large in significant parts of GE’s businesses hitting profitability hard. Returns on invested capital is very low. 3 CEOs in 2 years reflects the magnitude of the multiple challenges it faces.
GE earned a reputation as one of the world’s best managed companies particularly with regards to ‘optimising’ businesses. Take an existing way of doing things with an existing product to its absolute best! Remember SIX Sigma? Its former legendary CEO, Jack Welch, (named Manager of the Century by Fortune magazine), along with its highly competent executives were much sort after to run other companies as a result. In our present fast changing and highly disrupted world there is now a fundamental trade-off facing businesses between innovation (critical in building and sustaining a competitive advantage), and optimisation. We believe that this inability to transform to the former continues to be a big part of GE’s problems today.
60% of the 3,600 world’s largest companies are experiencing disruption. (Accenture).
Disruption impacts a manufacturer’s ability to deliver products, manage the supply chain, and serve customers in the traditional manner, that sets the base for delivering the right financial outcomes for investors. Deloitte’s has identified the following factors driving disruption in manufacturing.
Customised demand: Changes in consumer demand greater customisation and personalisation
Products: ‘Smart’ manufacturing and connectivity is increasing. From “dumb” to “smart.”
Economics of production: Advanced manufacturing methods are changing the economics
Economics of the value chain: Intelligence and insights enabled by digital manufacturing are revolutionising the economics of the value chain
Being big or great provides no protection
It’s clear from this list that a culture of Optimisation will not address all these factors. The challenges facing even the largest and most successful of yesterday’s world are struggling to respond to the impact of the rapid pace of disruption. Business models are being upended overnight. Even the most experienced CEOs are finding this incredibly daunting. .
Buying more ‘buggy whip’ manufacturing as the Model T drove onto the streets. Back to GE for an example within one of its major divisions – gas powered generators. For the past 10 years it was not only busy focusing on getting better and better at building gas powered generators, but also on consolidating their position globally in electricity generation. It acquired the French company’s power division of Alstom in 2015 for US$10.6bn.
Seemingly it made sense. GE's power unit in 2014-- its largest in revenue terms, was doing comparatively well. A 19.4% profit margin was one of the company’s highest, and sales were expanding, up 11% in 2014. They didn’t foresee renewable energy making such a huge advance and improve its science so quickly (accelerating disruption). An inflection point for renewables on the upside resulted in extinguishing demand for gas powered turbines.
GE failed to evolve its power businesses, instead focusing on optimisation and market dominance. It was disrupted as a result. The Alstom acquisition is under performing with GE rapidly cutting costs to "right size" its investment. The disruption risk was missed by most professional investors. Analysts at the time calling the move "brilliant" and GE's "best deal in a century."
In the old stable world where standard business cycles occurred with little disruptive threats, the opportunity to successfully turnaround this business would be considered good and probable, especially so considering GE’s pedigree and leadership. However, we are no longer operating in cycles the way we have for the last hundred plus years. A very unstable operating environment is today’s reality.
No one can accuse ousted GE CEO Jeff Immelt of not caring about innovation. In fact, he made innovation the core of his brand at the 127-year-old giant. As the world becomes more digitised, its generating more information surrounding products and services and speeding up processes. Large and small industrial companies are now competing more like the software industry. Short product life-cycles ensue. Rapid decision-making a must.
Fastworks not fast vision. GE has responded to accelerating disruption- eventually, by using a technique called “FastWorks.” The approach was to develop new products that came out of “Agile” software development, with “sprints” (quick deliverables) and fast learning. GE believed that rapid learning cycles with customers will reduce the risk that you build something you can’t sell. The question is, why did “Fastworks” not see the forthcoming challenges in their power division?
Arguably GE’s last major great invention was the MRI back in the early 1980's. Clearly, this is not due to a lack of technical prowess, as it continued to improve the present lines of business, but probably more a case of a lack of exploration. Hard to do when optimisation is driving your culture.
MRI Launch 1983
As standalone businesses they would potentially be part of our quality universe.
GE is a highly diversified, global industrial company. Its businesses are organised broadly under seven segments: Power, Renewable Energy, Lighting, Oil & Gas, Aviation, Healthcare, Transportation, and GE Capital. The company's products and services include power generation equipment, aircraft engines, locomotives, medical equipment, and compressors. Over half of the business is tied to service and aftermarket support. There is no doubt that the aviation and medical equipment businesses are excellent world class businesses.
GE has a complexity problem. That was a plus 10 plus years ago as investors also trusted management. Now, GE no longer gets the benefit of the doubt. Its share price reflects this.
Headwinds for GE, not Tailwinds that Insync investors enjoy:
Low levels of profitability. GE’ s trailing 12 month return on invested capital (ROIC) is 4%. Insync’s portfolio averages 48+%. This is also below its cost of capital. Companies must earn an ROIC greater than ‘Weighted average cost of capital’ (WACC) to generate positive economic earnings and create value for shareholders. A low ROIC has been a consistent feature of GE’s history and suggests poor capital allocation decisions. Its ROIC decline accelerated rapidly from 2013.
Balance Sheet Risk. ‘Net debt to ebitda’ is 3.7x, but net debt to free cash flow is 8.0x. Companies with large debt loads typically need near-constant access to new capital raising and GE is no exception. With $8 billion of bonds due in 2019 and a whopping $25 billion in 2020 and 2021. What is worrying is that the company looking at selling a ‘Family Silver’ business - Life sciences, to help reduce the significant debt burden.
Liability Risk. GE insurance was termed 'risky' by Fitch. Insurers make the bulk of their money from premiums charged to policyholders and investing those premiums before paying out claims. Forecasting the future payout for long-term-care policies is crucial. Science and data are involved but it also requires guesswork around the future price of health care. Fitch said its analysis found GE still have not set aside enough money to cover losses expected on long-term care policies. These are unusually risky because the costs are volatile and vulnerable to interest rate changes.
We trust this examination provides insight into how we use ‘disruption’ not to just pick the winners, but also avoid the losers. The losers may not seem so due to their historical standing and size at first glance.
Whilst GE may well end up being the 1 in 4 turnarounds (after at least 3 attempts so far), the odds are against it. Clearly GE does not meet any of our key investment criteria. What GE’s do you have hidden in your portfolio?
There are more attractive opportunities that are more likely to compound returns for our investors with less risk. Insync, is always focused on finding those companies with high ROIC, strong long tailwinds (Megatrends) and are positioned for, and understand, the accelerating disruption we are all facing. Being Future focused!
There are companies that will continue to deliver outsized results in this environment even during recession and falling financial markets. Insync’s process of selecting stocks wherever they reside that meet our strict criteria also continues to deliver. Invest with us. All our team are both shareholders and investors in the funds alongside you.
Disclaimer: EQT Responsible Entity Services Limited (“EQT”) (ABN 94 101 103 011), AFSL 223271, is the Responsible Entity for the Insync Global Quality Equity Fund and the Insync Global Capital Aware Fund. EQT is a subsidiary of EQT Holdings Limited (ABN 22 607 797 615), a publicly listed company on the Australian Securities Exchange (ASX: EQT). This information has been prepared by Insync Funds Management Pty Ltd (ABN 29 125 092 677, AFSL 322891) (“Insync”), to provide you with general information only. In preparing this information, we did not consider the investment objectives, financial situation or particular needs of any particular person. It is not intended to take the place of professional advice and you should not act on specific issues in reliance on this information. Neither Insync, EQT nor any of its related parties, their employees or directors, provide and warranty of accuracy or reliability in relation to such information or accepts any liability to any person who relies on it. Past performance should not be taken as an indicator of future performance. You should obtain a copy of the Product Disclosure Statement before deciding about whether to invest in this product.