General Electrics is undergoing major structural changes in search of a better business model
Conotoxia Comments 22.02.2023 14:29
General Electrics (GE) – a well-known global conglomerate founded by Thomas Edison in 1892 for Edison's incandescent lamps and related products – has expanded over the years through mergers, acquisitions and natural growth. Now it is adapting to a new, more focused business world by splitting into three independent companies.
In search of a better business model, GE has decided to split the company into 3 separate entities: GE Healthcare, GE Aerospace and GE Vernova.
Breaking up a conglomerate into individual companies can have several benefits, including improved management focus, increased transparency, improved valuation and better capital structure.
GE Aerospace division has a well-established and profitable revenue stream. It is currently benefiting from the commercial airline industry's recovery from Covid-19 as well as the US government's emphasis on strengthening the defence sector.
GE Healthcare - the first division to split from the rest of General Electrics - has taken on a significant amount of the company's debt, leaving the conglomerate in a stronger financial position.
GE Vernova - although it may have considerable potential in the future, currently it seems to be struggling financially due to increased costs of R&D and production.
One of the original 12 Dow constituents has been credited with numerous innovations throughout its rich history, including the first turbine supercharger, engine jet, and gas turbine engines. It was one of the key computer companies in establishing the digital world as we know it today, and two of its employees have been awarded Nobel Prizes for their work within the company.
GE stock price has fallen heavily since its peak of 363 USD during the dot-com bubble. The stock seems to have found ground around the 50 USD level during the pandemic and, since then, has reacted positively to the company's structural changes and overall market growth.
The company is undergoing major structural changes in search of a better business model, including splitting its businesses into independent companies. Before the split, GE had four main segments: Healthcare, Aerospace, Power and Renewables. The first division to separate from the rest of the company was Healthcare - it began operating as an independent company as GE Healthcare in January 2023. The next split is planned for Power and Renewables, which will form a company called GE Vernova. The original company will change its name to GE Aerospace and continue to operate in this segment.
Based on FY2022 revenue streams, GE Aerospace is the largest division of the company - 35%. GE Healthcare accounted for 25% of revenues, Renewables for 18% and Power for 22% (together accounting for 40%).
Source: GE financial statements
Conglomerates – not the business model of the 21st century
The expansion of GE and many other well-known conglomerates took place at a time when diversification of a business portfolio was seen as an effective way to mitigate risk - when one industry was in a downturn, another might be thriving. Meanwhile, the number of corporate spin-offs over the past decade may suggest that "bigger is better" may not be the current strategy. Breaking up a conglomerate into separate companies can offer several benefits, including improved focus, greater transparency, better resource allocation, improved valuation, better capital structure and increased agility.
If we look at recent spin-offs in the healthcare sector, numerous companies, such as Alcon, Envista Holdings, SeaSpine Holdings, and Siemens Healthineers, have managed to separate from their core businesses.
GE can serve as a prime example of the benefits of a break-up, where the value of the individual parts of the company is greater than that of the company as a whole. GE's three main businesses - aerospace, healthcare and power - are very different in nature and therefore have little to gain from being combined. In fact, GE's financial reports suggest that the opposite might be true. The Corporate Items and Eliminations section shows that the company spends a lot of money at the corporate level. For instance, in 2015, the company's earnings from ongoing operations were 1.7 billion USD, while the Corporate Items and Eliminations section totalled 5.1 billion USD. Although these expenses might not be entirely eliminated, creating three separate businesses could save significant money in the long run.
Following the separation, each company may be able to focus solely on its core business. Moreover, specialists, analysts and investors could now include each company in their coverage, increasing each company's presence in different investment universes. Although it may not seem like a good reason at first, investor relations, especially with institutional investors, play a crucial role in the success of listed companies.
As the division of the company's business lines is underway, retail investors can also select the business line that corresponds best to their investment strategy, objectives, and views about the most successful sectors in the future.
GE Aerospace – the segment that may have the biggest potential
The separation of GE into separate businesses may allow each business to have a clearer focus on its own market position and growth strategy, leading to improved market competitiveness and a clearer focus on its financial performance, leading to improved overall financial performance for each business in the future. Each of the three companies could benefit from the factors discussed, although GE Aerospace may have the greatest potential of the three to outperform as a separate entity.
Firstly, let us review the latest earnings numbers for each division as reported for Q4 2022. The aerospace division had the strongest profit margin for the period. The aerospace division's year-on-year growth may be attributed to the industry's recovery from the pandemic. However, there may be a potential for additional growth as some parts of the world, such as China, are not yet fully recovered.
Source: GE financial reports
The company predicts continued growth in its aviation engine business. It expects the division's 2023 revenue to jump year-on-year in the "mid-to-high teens" per cent range, with 2023 profits coming in between 5.3 billion USD and 5.7 billion USD.
As demand for air travel grows, especially in emerging markets, GE Aerospace could be one of the biggest beneficiaries in the future. According to the International Air Transport Association, global air passenger traffic is expected to double by 2037. As individual airlines and even aeroplane manufacturers, such as Boeing and Airbus, may be significantly affected by economic downturns or such unexpected events as Covid-19, GE Aerospace may also be negatively affected by lower demand. However, GE Aerospace has a strong customer base as it manufactures engines and provides maintenance services to both Boeing and Airbus, which in turn supply aircraft to most major airlines, including United Airlines, Emirates, Delta Airlines and many others.
Even during an economic downturn affecting the commercial aviation industry, GE Aerospace could maintain a stable revenue stream due to its participation in the US government's efforts to bolster the defence sector. As the government emphasises strengthening national security, GE Aerospace stands to benefit from increased demand for defence-related products and services, which could help offset any potential decline in commercial aviation revenue. In addition to already cooperating with Boeing, which is known to receive US government contracts for defence aircraft, GE, on its own, is also receiving contracts from such US government agencies as the Department of Justice, NASA, and Department of Homeland. At the end of 2022, GE Aerospace received a grant of up to 203 million USD to work on new jet engine technologies from the Air Force Life Management Center.
GE Healthcare had accumulated a large debt burden over the years due to R&D spending and a rather aggressive approach to increasing its market share. Fortunately for the other two segments, this debt has been transferred to the newly formed company and will not weigh on the balance sheet of the remaining business.
The net debt of the newly established company is 8.4 billion USD, which grows to 15 billion USD in case outstanding pension obligations are taken into account. For a company with a market capitalisation of 27 billion USD, 15 billion USD of debt may be a challenge, especially in a rising interest rate environment.
Interestingly, in preparation for the spin-off, GE HealthCare took on debt that was used to buy back 7.23 billion USD worth of debt of the parent company leading to significantly improved capital structure and lowered interest payments for GE (soon-to-be GE Aerospace). Indeed, this put additional pressure on the capital structure of GE HealthCare.
Despite its immense potential, the GE Renewables segment may have the most unclear future among the four segments. With revenues lower than a year before and the only division with a net loss, the Renewables segment drives lower the financials of the rest of the company.
Source: GE financial report 4Q 2022
GE Renewables may benefit from the growing demand for renewable energy as more countries adopt renewable energy targets and customers increasingly demand cleaner sources of energy. However, this division faces challenges related to high production costs, limited geographic presence, and potential changes in political and regulatory environments.
The production costs of renewable energy technologies are still relatively high compared to traditional energy sources, which could make it more difficult for GE Renewables to compete in certain markets. Furthermore, the many incentives governments offer for adopting renewable energy technologies may become smaller as these technologies become increasingly popular.
Santa Zvaigzne-Sproge, CFA, Head of Investment Advice Department at Conotoxia Ltd. (Conotoxia investment service)
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