When Jack Welch left General Electric at the dawn of the 21st century, he was revered as among the greatest business executives ever. Revenues during his twenty-year reign increased by 385% and investors in the company saw a 20% compound return on their money.
Fast-forward seventeen years later to today and General Electric is a company seen in disarray by many. New CEO John Flannery has been forced to slash guidance and announce asset sales. A complete break-up of the company is even being discussed. What has gone so terribly wrong? And if a break-up is seen as the best outcome for General Electric, is there even any benefit in having a conglomerate business model any longer?
In and Out
Conglomerates have come into and out of favor with investors over time. Their popularity peaked during the 1960s when companies like ITT seemed to be taking over the world, enticing investors with frenetic deal activity and juicing earnings by acquiring companies with debt at low-interest rates or stock that traded at a higher multiple than the acquired company. The form came under pressure when interest rates began to rise and stock market values plummeted in the 1970s.
Something else began to take shape in the 1970s: the rise of strategy consulting. Boston Consulting Group made their initial reputation by devising tools to help conglomerates manage business portfolios. Ultimately, the consensus in the business world and on Wall Street was that companies should focus on specific core competencies and not own businesses spread between multiple industries.
The Welch Model
Bucking that trend was Jack Welch’s General Electric. Welch laid down a few principles that guided General Electric’s strategy throughout his tenure. At its core, General Electric was a manager of a portfolio of businesses and Welch only wanted to own ones at which GE had a leadership position – either first or second in the industry. Starting from a strong industry position, though, adds no value to shareholders in the business who could own a portfolio of companies that are dominant in their markets. To make sense as a model, a business owned by a conglomerate must be more valuable than if it was independent.
Welch confronted this need for added-value in two primary ways. First, he instituted practices that he hoped would make General Electric home to the greatest management talent in the world. He also believed implicitly that great leadership was often interchangeable at different divisions of the company. Hence, an executive like Bob Wright ran the appliance division and worked in GE Finance before being tapped to run NBC. Hoping to harness great talent, Welch instituted programs like “rank and yank,” where the top 10% of managers were fired each year. (It was a program particularly admired by Jeffrey Skilling at Enron.)
Running somewhat parallel to management talent was a deep knowledge of process engineering. Deploying tools like Six Sigma throughout the company, at a time it was not as widely used, could allow GE to have an infrastructure to guide the day to day operations of a unit in a superior way to others in that industry.
Finally, GE excelled at taking its own advantages and using them to outperform in other industries where those advantages can be meaningful to performance. No better example of this exists than GE Capital.
GE’s financing division was originally formed during the Great Depression to finance industrial purchases from its other divisions. Welch saw more opportunity in Finance and an opportunity to use GE’s AAA credit rating to earn more profits for the company. Welch acquired Employers Reinsurance and investment bank Kidder, Peabody in a bid to expand the financial arm even further and as time progressed GE Capital became one of the largest banks in the world. In 1985, it was earning 1/6th of GE’s overall profits, but the time of the financial crisis that had grown to almost 60%.
What went wrong?
It would be inaccurate to trace all of GE’s present problems to being a conglomerate. In truth, if a single problem has plagued the company, it has been extremely short-term thinking.
Having a large finance division within the company meant that during the late 1990s it could rely on selling financial assets whenever it needed to meet quarterly earnings estimates. By the time Jeff Immelt took control of the company in 2001, the raison d’etre of General Electric was becoming harder to find. It owned a prized media asset in NBC, but owned little content directly in a world where content ownership was becoming more and more critical and the seemingly inexorable rise of finance around the world was pushing GE Capital into becoming more and more critical to the overall profit picture of the company. In 1985 financial businesses at GE earned $391 million, or about 17% of overall profits. In 1995 those same businesses generated $2.3 billion of profit – equal to 35% of GE’s total. And by 2007, on the eve of the financial crisis, financial businesses at GE earned $12.2 billion, a full 55% of the total earnings of General Electric.
Not everything about GE’s entry into finance was nonsensical. It put the company’s prized AAA credit rating to good use and extended its skill in transactional businesses. But, as time passed, GE began relying more and more on the fact that GE Capital was not regulated to the same extent as the traditional banking industry.
Being under-regulated can save a company direct costs in having to deal directly with regulators and maintain excess compliance staff. But, the real benefit is that it can accumulate risks for itself that a regulator may frown upon. In periods where the global economy seems to present a benign risk environment that can create enormous profits. GE’s financial businesses grew to include units that leased equipment, made consumer loans to Poles and Guatemalans, and lent money to the retail customers of Home Depot and Gap.
Following the financial crisis, it was impossible for this regulatory dichotomy to continue and Jeff Immelt made the decision to begin unwinding GE Capital. Importantly, though, he dithered in making this decision. Most of the unwinding of GE Capital did not occur until 2015 and 2016. Once it did, the re-allocation of those assets happened swiftly and, at times, unwisely. Alstom was purchased for $17 billion, the Baker Hughes deal required $7.5 billion in cash, and, in 2016 alone, $21 billion was spent on share repurchases.
Compounding capital allocation problems, the Power division has reported horrendous results after executives misjudged demand and were left with inventories that were completely misaligned to sales.
Is there Still a Place for GE?
Calls by some investors to break up the company suggests that they believe that the conglomerate model is dead and that the units of GE would be worth more independently than together. It is unlikely in the near term that a break up would happen, but mostly because GE has large pension obligations of more than $30 billion and legacy liabilities from GE Capital. Nevertheless, it is still possible for General Electric to add value to its businesses and have coherent reason to exist as a conglomerate. Doing so requires it to think further into the future, rather than the thinking that led it to over expand the financial businesses and rush to invest the assets for fear of being seen as overcapitalized.
GE needs a glue binding its divisions together, a recipe for cohesion and “1+1=3” thinking. Its focus on applying software to industrial problems, what it calls “digital industrial,” is promising and is one link between its disparate businesses. GE also is clearly still a leader in knowing how to run large, industrial businesses.
Many of its problems are also cyclical rather than structural and several of businesses are performing quite well. While Flannery, the current CEO, will need to continue to undo the opaqueness of the overall company and run-off legacy liabilities (including shoring up pension funds), GE looks like it can continue to prosper in coming years.
The trick will be to see if Flannery can create the kind of cohesion and vision that will allow that prosperity to be sustainable.