Followers of General Electric (NYSE: GE) have probably noted the widely reported speculation over a possible tie-up between the power operations of Siemens (NASDAQOTH: SIEGY) and Mitsubishi Heavy Industries. Given that they are the second- and third-largest players in a gas turbine market dominated by the three companies, it's not hard to see why any kind of deal could cause concern for GE investors. However, there's also a good case for the argument that it could be a winning scenario for GE. Here's why.
Falling end demand
The starting point is that the gas turbine market is seeing falling end-market demand. As you can see below, large gas turbine industry orders (here defined as producing output above 30 megawatts) have been in significant decline in the last five years, and the pressure is on the industry to cut capacity.
Data source: General Electric presentations.
So the industry needs consolidation and capacity reductions -- something Siemens and GE are aggressively working on -- in order for margins to improve in the future. Simply put, there's too much capacity in the industry, and a deal between Mitsubishi and Siemens would surely be based on sharing costs and/or reducing combined capacity.
That could be good news for the industry at large and especially for GE, not least because it could ease pricing pressure in the industry -- a point I'll come back to in a moment.
Of course, cutting capacity and reducing costs has substantial impacts in the near term, and industries with overcapacity often experience a period of cutthroat pricing in which combatants fight to win orders in order to utilize their existing capacity. In fact, going back as far as 2015, Siemens' management was talking about overcapacity and every gas turbine order being "a competitive event." That pricing competitiveness was only going to get worse as end-market demand continued to decline more than GE's management expected.
GE investors shouldn't worry too much about a Siemens/Mitsubishi deal on power. Image source: Getty Images.
The downturn in the market certainly caught GE by surprise, and although former CEO Jeff Immelt is often criticized for the 2015 ill-fated acquisition of Alstom's power and grid businesses, it's worth noting that Siemens and Mitsubishi joined forces in order to bid for Alstom's businesses as well. In other words, all the leading management figures in the gas turbine industry were caught short by the decline in end markets.
Where Immelt, his successor John Flannery, and current CFO Jamie Miller deserve criticism is for the failure to react to events quickly enough, either operationally or through adjusting guidance. The latter is something current GE CEO Larry Culp alluded to when he said that GE "held on too long to a too robust revenue outlook for the year" when discussing power in an interview in November.
Ultimately, the impact can be seen in the profitability of GE and Siemens power segment earnings and margin in 2018. For reference, Siemens power and gas segment revenue declined 19% in 2018, with GE power revenue down 22%.
|Power segment|| |
Siemens Power and Gas
377 million euros
1,571 million euros
Data source: Company presentations.
What's gone wrong
It gets worse, not least because it's far from clear whether this is a long-term structural issue. In a nutshell, the falling cost of electricity storage and renewable energy has significantly increased the viability of using renewable energy rather than conventional gas turbines to generate electricity. Falling storage costs make storing energy from intermittent sources, such as renewable energy, more viable.
Of course, GE is also a leading player in renewable energy and storage, but that part of its business isn't significant enough to move the needle on overall earnings. For example, the power segment overall generated 2.5 times the revenue of the renewable-energy segment in 2018. Moreover, the renewable-energy segment has its own margin issues to deal with.
Frankly, it's still hard for anyone to accurately predict where the gas turbine market will be heading, just as it was hard for Siemens, Mitsubishi, and GE management to predict it in 2015.
What we know about 2019
However, what we do know is that capacity must be reduced for pricing and margins to improve in the industry. Culp has already told investors GE power "reduced headcount by 10,000 or 15% in the business, consolidated our footprint by 30% and took out $900 million of base cost exiting at a $1 billion lower run rate" in 2018. And cost cutting at power is an ongoing process.
Siemens is also cutting costs, and if the rumor that it's seeking some kind of a deal with Mitsubishi on gas turbines -- in whatever form it might take -- is true, investors can expect more industry capacity reduction. That would be good news for GE.
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