Industrial Focus Drives Growth for GE

 General Electric (GE) reported fourth-quarter operating earnings of $0.53 per share, reflecting 20% earnings growth versus the prior year. Organic revenue improved 5% in the quarter, with order growth continuing the positive trend from the third quarter. The company continues to deliver solid operating margin performance, with industrial margins improving 1 percentage point year over year to 18.3%. The quarter's performance was slightly ahead of our expectations but not enough to amount to a material change in our $27 fair value estimate. Our Wide Economic Moat Rating is intact.

Considering that the oil and gas segment is still less than 20% of industrial revenue, we were a bit surprised by the strong contribution to earnings growth in the quarter. Industrials were also aided by strong earnings growth and margin expansion in power and water as well as the aviation business. As of the end of the fourth quarter, the firm's backlog stands at $244 billion, which is more than double annual sales. Just under 75% of the current backlog is related to long-term service contracts, which adds to near-term visibility.

We expect 2014 to be a bit of a transition year at the corporate level for GE. While the industrial operations should contribute meaningfully to earnings growth, we expect GE Capital to detract from that growth. The primary driver of the weakness will be the partial sale of GE Capital's North America retail finance business. While the company will receive cash proceeds from the sale, GE plans to reinvest that capital in the retail finance business to shore up its balance sheet in preparation to be a stand-alone business. We do expect the cash to come back to shareholders, but that is more likely going to be a 2015-16 event and is subject to a successful full spin-off of the North American retail finance business. We welcome the 16% dividend increase to an annualized rate of $0.88 per share, returning cash in a shareholder-friendly way.

Power Infrastructure Will Lead Growth
General Electric positions itself to be a leader in all markets in which it competes. After shedding underperforming businesses during the past few years, the firm has energy infrastructure square in its sights. We believe GE will emerge as a leader in the power infrastructure market, which will be the backbone for the firm's growth.

GE makes its mark by combining businesses with strong synergies and opportunities for information-sharing across business lines. Add to this GE's ability to invest large amounts of money in expanding businesses, and barriers to enter a new market are significantly lower. With its proven ability to drive improvement in operating efficiencies, the firm is able to generate healthy returns on invested capital in many of its markets.

The portfolio of businesses continues to be correlated with industrialization and the needs of growing economies. GE has changed its focus as the world has shifted; it now has a heavy focus on clean-energy products, such as wind and gas turbines. The strength of GE's competitive advantage is most notable in wind turbines, where the company was able to unseat longtime incumbent Vestas with its superior manufacturing execution and better customer satisfaction. Though the wind energy business is currently under margin pressure driven by oversupply, we continue to see GE emerging as one of the dominant players. Underscoring the benefits of a diversified business model, GE has remained agnostic to the fuel source for new power generation, with exposure to gas turbines and steam generation as well as renewable sources.

Since the collapse of the credit markets in 2008, GE has rebuilt its captive finance arm, improving capitalization and general business profitability, while working to pare noncore assets. Areas of focus will remain middle-market commercial and industrial loans, equipment leasing, and aircraft leasing. In each, GE is now competing with a stronger capital base and less competition. With near-term headwinds easing, investors should benefit from a better-capitalized bank with higher asset quality over the long run.

Service Business, Economies of Scope Contribute to Wide Moat
General Electric's wide economic moat stems from three factors that provide a solid foundation for sustainable profitability: strong service support for its installed base, a shift in the portfolio toward more moatworthy assets, and strong economies of scope that are very difficult to replicate quickly.

GE's core energy, health-care, and aviation businesses each benefit heavily from the company's intense effort on increasing service revenue for every piece of equipment that it sells. Although this is nothing new, GE's approach is more aggressive than that of industry peers, and its execution is impressive. In the case of gas turbines, each unit has a set service routine that is embedded in the engineering specifications. If a customer chooses to ignore the service schedule, repairing any malfunction down the road is at the buyer's expense. Downtime and unexpected maintenance expenses result from not using GE's service plan, and customers typically prefer to avoid such consequences. The service component is a big deal because contracts last a long time (more than a decade for energy equipment and five years for health-care equipment) and typically boast operating margins in excess of 25%, whereas equipment sales produce operating margins lower than 10%. High margins on the service side of a deal give GE flexibility on equipment pricing.

GE Capital once was one of the moat pillars for GE. Its valuable AAA credit rating gave it a lower cost of borrowing, producing higher net interest margins on its book of business. The credit rating was lowered in spring 2009, wiping away that benefit. We don't think GE Capital is a wide-moat business, but aspects of it strengthen GE's industrial moats. GE Capital can help finance purchases of GE's jet engines, medical scanners, and power equipment, which we think helps GE capture additional sales opportunities. GE Capital's expansion into different types of loans exposed it to unnecessary risks, which we think it had no fundamental advantage in underwriting. The financial crisis forced the company to rethink and cut the bank down to its bare essentials. Although this will lower the bank's margin contribution down the road, we believe this paring more closely links GECS to GE's other businesses, and this is positive, in our opinion.

Unlike other diversified manufacturers that have few synergies among business units, GE's businesses support one another, lowering operating costs compared with operating as stand-alone entities. This is notable in research and development. New information learned when trying to reduce the weight of a jet engine fan blade can quickly be applied to a gas turbine engine. Spreading R&D costs across a larger base of interested parties means that GE can pursue projects that may be unprofitable for pure-play firms. These economies of scope extend throughout the organization, from leadership development to new market expansion. Even though these softer factors are tough to quantify, we think replicating these advantages is sufficiently difficult, and this gives us confidence that GE has an ability to generate sustainable economic profits.

Diverse Markets Offset Cyclical Earnings
We assign a medium fair value uncertainty rating to General Electric, as cyclical earnings volatility is mitigated by diverse product and geographical end markets. GE's industrial businesses are susceptible to economic downturns and are particularly sensitive to changes in infrastructure spending. The health-care business is sensitive to changes in government health-care reimbursement rates. GE Capital Services originates and underwrites loans for its own portfolio, as opposed to securitizing these loans in the open market, reducing potential exposure to liquidity risk. It is, however, exposed to the creditworthiness of its counterparties and may experience steeper write-downs as delinquencies rise. The firm's credit rating gives it access to lower-cost financing, and losing it could hurt profitability and make growth more difficult to achieve. The company's long-term growth profile is closely linked to global GDP growth, and our discounted cash flow analysis is also sensitive to changes in GE's operating margins.

Management Bench Is Strong and Deep
GE is known for the strength and depth of its executive team, which has a long history of creating value for shareholders. As testament to its depth, several former executives have gone on to lead other large companies. CEO Jeff Immelt took the reins from the legendary Jack Welch just days before 9/11, and his tenure to date has been characterized by a stronger balance sheet, significant acquisition spending, and the divestiture of most of the firm's insurance and plastics businesses. Immelt's management style is more collaborative and less transient than his predecessor's. It also keeps managers in jobs longer to take advantage of their expertise. Overall, we're satisfied with GE's corporate-governance practices but would prefer to see Immelt's variable compensation more closely linked to return on invested capital, as that metric provides a better proxy for corporate stewardship than operating cash flow. Our favorable view of the company's stewardship has been tempered by the financial crisis and the company's need to dilute shareholders in the fall of 2008 to support GE Capital.