GE Offers High-Quality Earnings in a Slow-Growth World

Despite sluggish organic revenue growth, industrial operating margins (excluding Alstom) managed to remain flat year over year at 14.2%, reflecting ongoing progress in GE’s cost-cutting initiatives as well as some benefits from pricing outpacing inflation. These factors helped improve gross margins by 110 basis points since the prior period, which offset some of the negative impact of product mix in the quarter. As GE continues to work excess costs out of its legacy industrial businesses as well as newly acquired Alstom, we expect stronger operating leverage as volume improves across the portfolio.

Although organic revenue growth has trended slightly negative through the first half of 2016, the healthy but back-half-loaded backlog in power and aviation, combined with growing momentum in healthcare, still makes it possible for GE to reach its 2%-4% organic industrial revenue growth target for 2016. Even if GE misses this target because of ongoing volatility in the global macroeconomic environment, we still believe that its balanced portfolio is positioned quite well for the long run. In our view, ongoing Alstom integration, a growing digital business, and increasing focus on aftermarket services offer GE shareholders a long runway for high-quality industrial earnings in a slow-growth industrial world.

Intangible Assets, Cost Advantage, and Switching Costs Add Up to Wide Moat GE's recent portfolio repositioning placed the company's competitive advantages front and center, in our view. The company's massive installed base of industrial equipment is the physical representation of a wide economic moat that poses formidable barriers to entry. Each of GE's industrial segments benefits from a strong foundation that is difficult for competitors to replicate at scale. Furthermore, GE's network of physical assets has evolved into a software-supported ecosystem capable of capturing useful operational data. In our view, GE demonstrates three main competitive advantages that allow it to sustainably generate economic profit despite the asset intensity of the industrial portfolio: intangible assets, cost advantage, and switching costs.

We believe intangible assets in the form of patents, long-lived customer relationships, and a strong brand all support GE’s wide economic moat. With research and development at the heart of GE’s industrial core, it would take vast amounts of capital and, more important, time to match the value of GE’s R&D organization. Patents, technology, and capitalized software represent about $7 billion worth of assets on the balance sheet, with average estimated economic lives of nearly 25 years, 21 years, and 5 years, respectively. However, we consider engineering expertise and organizational memory--the difficult-to-quantify human element that extracts the real value from these assets--to be an equally important component of GE’s R&D advantage. From a customer relationship standpoint, we believe that long, reliable histories lead to secure futures. Few companies can report decades of performance data in particular product categories, supporting a distinct advantage when bidding for new contracts to supply equipment for mission-critical systems. Furthermore, service contracts play a major role in lengthening GE’s customer relationships. Finally, GE remains one of the best-known brands in the industry, built through more than 100 years of operating history.

A global footprint allows GE to source materials and services for internal use at scale, demonstrating an advantage over new entrants hoping to unseat the company’s market leadership in an already established product category. While we’re likely to find many examples of scale advantages throughout GE’s operations, we believe economies of scope do even more to lower operating costs across the enterprise. With R&D an embedded part of GE’s overall corporate culture, spreading R&D costs across multiple divisions allows the company to pursue projects that might be uneconomical for smaller firms. GE’s Global Research Centers serve as centralized hubs, working to understand how proprietary technology in one segment can provide solutions for another. For example, one subsea drilling platform in GE’s oil and gas segment may use turbines from the power and water segment, distribution networks from energy management, and imaging technology created in the healthcare segment. The ability to source from within, rather than relying on outside vendors for materials, parts, specialized products, or expertise, supports a cost advantage and, increasingly, a time-to-market advantage.

In our view, a growing services backlog, which has long eclipsed the total value of the product backlog, is the greatest evidence of GE’s high switching costs. In certain sectors, such as aviation, specified products become entrenched in particular platforms. Redesigning an incredibly complex system in order to accommodate a competitor’s product doesn’t happen often, given the immense expense the customer would have to bear. This gives rise to robust service revenue, which ultimately protects the customer’s capital investment over time. Service contracts secure regularly scheduled maintenance, upgrades, and repairs, ensuring reliable operation of mission-critical equipment. As examples, catastrophic failure in an aircraft engine or a malfunctioning MRI can cost lives as well as profits, motivating customers to enter into service agreements that span 10-20 years, depending on the length of the asset’s useful life. While third-party maintenance offers an alternative for customers looking to save on operating costs, we believe original-equipment manufacturers know their equipment much better, can source parts more easily, and oftentimes have a working knowledge of the customer’s particular systems. These factors provide the customer with greater assurance that the high cost of asset failure will be avoided, ultimately cementing long relationships with GE.