Yesterday morning, both General Electric’s (GE) and Baker Hughes GE (BHGE) released fourth quarter earnings announcements and hosted conference calls. (You can find the GE presentation materials on GE’s Investor Relations site and the BHGE presentation materials on the BHGE Investor Relations site.)
After last week’s announcement regarding GE’s insurance and reinsurance operations (summarized in this Framework note), the earnings announcement was mostly anti-climactic, but there was important information to be gleaned from both calls.
We review the key points from both calls and provide commentary regarding the announcements and our analytical process in this article. We have also opened up a new Framework Forum thread to discuss our research on General Electric.
General Electric Announcement – Key Points
- The business of manufacturing and selling power generation equipment is at historic lows.
- The company is taking steps to operate more efficiently but, as I discuss in the Framework 102 course, a severe drop in revenues always trumps an increase in efficiency.
- Aviation and Healthcare results are strong. The Aviation business results have been helped by a successful introduction and widespread commercial acceptance of new Leap engines.
- The company is guiding for a worst-case free cash outflow of $1 billion in 2018 and being free cash flow neutral ($0) in the best case. This number differs from Free Cash Flow to Owners (FCFO) because it does not include acquisitions or, more importantly to GE at this point, disposals.
Baker Hughes GE Announcements – Key Points
- Short-cycle business — mainly services supporting new onshore oil and gas production — has received a predictable boost from the rise in oil prices.
- Long-cycle business — mainly equipment supporting exploration and offshore mining — is still very weak.
- Baker Hughes capability to drill in complex formations (e.g., Permian Basin), which is enabled by sensors and digitized process control — a strength of GE’s IoT offering — is allowing it to win new business and capture market share.
Comments
The very quick and dramatic downfall of GE has brought about some realizations and has forced me to reevaluate my own analytical process.
The drop-off in the Power business is generational — an industry analyst specializing in the Power Generation industry, McCoy’s Research — predicts that sales of power generation equipment, measured in Gigawatts of capacity, will reach lows in 2018 not seen since 2002. In statistical terms, this equates to something like a two- or three-standard deviation event.
When I do valuations, I purposely try to think in one-standard deviation terms. For an initial valuation, I want to derive the most-likely valuation range for that company in the most likely situation. This bias makes sense for an initial valuation. No one would ever invest if their worst-case scenario involved a rogue asteroid destroying all life on earth. However, as one increases one’s ownership stake and the time that one is an owner, I believe that the analytical focus must change from a statistical perspective (e.g., thinking about revenue growth, profitability, and investments from a “normalized” view) to a detailed perspective based in and understanding of actual dynamics in the marketplace.
This seems like a common-sense approach, but in fact, the mantra oft repeated by Buffett acolytes is “Just buy a good company and hold it forever” — essentially in direct contradiction to the “Start general, get specific” approach detailed above.
Related to this realization is a renewed and reinforced dislike for an approach that values quantity of ideas over quality of understanding. One of the reasons that we have started talking about re-engineering Framework’s subscription structure is my realization that a typical “newsletter” approach forces the writer (me in this case) to offer a constant stream of different investment ideas. A constant stream of investment ideas means that either there are many people working to understand companies in depth or that you’ve got one or a few people with only a cursory understanding of a lot of companies.
My last realization deals with the sensitivities of complex systems. My mental model going into 2017 was that GE was producing equipment and providing services needed as the world’s population enriched themselves and aged. GE was busy paring down its portfolio, creating a smaller stream of profits, but, in the process, was using the cash generated when it sold assets to buy back equity. In other words, the company was choosing to shrink its capital base at the same time that it was shrinking its asset base.
This is a sensible view and I think it still holds. However, the historically significant weakness in its largest segment (Power) and typical cyclical weakness in another important segment (Oil & Gas) meant that cash was not available to buy back shares. Because share buybacks stopped, the dividend payment was doubly untenable — the cash flow supporting it had weakened and the equity base was too large.
Long story short, GE’s fair value is certainly lower than my published fair value for the company, but how much lower, and what the range is, is still impossible for me to say. Once the full annual statements are published, I will reassess and republish a valuation and, if appropriate, an investment structuring recommendation.
Recent movements in the price of a stock are mostly, if not wholly, based on what I call X-System processes. It is hard for me to imagine a level of pessimism toward a company much higher than it is for GE today, barring the existence of large-scale fraud (e.g., Enron). If this is true, it suggests there may be an investing opportunity in GE now, but to say so without the analysis to support an investment would be to completely abandon a commitment to C-System (i.e., rational) processes.