2019年11月21日 星期四

20191105 Mstar Uber

Uber Beat Top- and Bottom-Line Expectations; IPO Lockup Expiration Is an Overhang; Stock Undervalued
Ali Mogharabi
Senior Equity Analyst
Analyst Note | by Ali Mogharabi Updated Nov 05, 2019

Riders, trips, and their frequency grew strongly during the third quarter, providing support for our network effect-sourced narrow moat rating for Uber. Plus, improvement in take rates accommodated solid growth in gross bookings. The network effect moat source is also allowing Uber to more easily control costs which led to further improvement in adjusted EBITDA losses. All of this resulted in the company posting third-quarter results above the top- and bottom-line S&P Capital IQ consensus expectations. Uber expects to generate full-year adjusted EBITDA in 2021 as the rides segment expanded its adjusted EBITDA margin for the second consecutive quarter. Management also guided for sequential revenue growth acceleration in the fourth quarter. With continuing improvement in take rates, we upped our 2019 revenue projection. However, we still expect losses in Uber Eats, along with more aggressive investments in ATG, to delay Uber's first full-year adjusted EBITDA until 2022, one year later than the firm's goal.

While third-quarter numbers surprised to the upside, the stock is down 5% in after-hours, which we think may be due to the expected Nov. 6 IPO lockup expiration which could push the stock down much further. We continue to believe that investment in narrow-moat Uber requires patience. We are maintaining our $58 fair value estimate and continue to view the stock which is trading at a 0.51 price/fair value estimate as attractive.

Business Strategy and Outlook | by Ali Mogharabi Updated May 10, 2019

Founded in 2009 and headquartered in San Francisco, Uber Technologies has become the largest on-demand ride-sharing provider in the world (outside of China). It has matched riders with drivers completing trips over billions of miles and, at the end of 2018, Uber had 91 million users who used the firm's ride-sharing or food delivery services at least once a month. In light of Uber's network effect between riders and drivers, as well as its accumulation of valuable user data, we believe the firm warrants a narrow moat rating.

Uber helps people get from point A to point B by taking ride requests and matching them with drivers available in the area. The firm refers to this as personal mobility, which also includes micromobility, or shorter-distance transportation via electronic bikes and scooters. Uber generates gross booking revenue from this service, which is equivalent to the total amount that riders pay. From that, Uber takes the remaining after the driver takes his or her share. Ride-sharing gross booking grew 32% in 2018, while revenue increased 33% with a slightly higher average take rate, although we estimate the take rate will decline in the long-run.

We believe Uber has 30% global market share and will be the leader in our estimated $411 billion total addressable ride-sharing market (excluding China) by 2023. The firm faces stiff competition from players such as Lyft (mainly in the U.S.) and Didi, a business in which Uber has a 20% holding after the sale of its operations in China to Didi in 2016. While Uber no longer operates in China, it does compete with Didi in other regions around the world. The firm also has a stake (27.5%) in Grab, another former competitor in the Southeast Asian market. Globally, the market remains fragmented, and Uber competes with many local ride-sharing platforms and taxis.

Uber Eats, the firm's food delivery service, will be one of the main revenue growth drivers for the firm as it will benefit from cross-selling to its large ride-sharing user base. Further utilization of Uber's overall on-demand platform can also help the firm progress toward profitability, in our view.

Economic Moat | by Ali Mogharabi Updated May 10, 2019

In our view, Uber Technologies' core business, the ride-sharing platform, benefits from network effects and valuable intangible assets in the form of user data. We think these sustainable competitive advantages will help Uber to become profitable and generate excess returns on invested capital. For this reason, we assign Uber a narrow moat rating.

Uber's network effects benefit drivers and riders, creating a continuous virtuous cycle. Drivers and riders make up the supply and demand in ride-sharing, respectively. As a first mover in this market, where requests for rides from anywhere could be made in real time via a simple-to-use mobile app, Uber began to attract riders mainly via word-of-mouth. Growth in demand and further word-of-mouth marketing attracted more drivers, or, in other words, increased the supply of Uber vehicles. In turn, as the number of drivers increased, the timeliness and reliability of the service improved, which drove the number of users or riders higher, which in turn attracted more drivers, all of which indicates a network effect. Uber was able to accelerate this network effect by focusing on smaller areas, such as San Francisco, before expanding into more cities. A comparable tech leader that profits from network effects is Facebook, which started at Harvard before expanding to all colleges and then opened up globally.

We find evidence of Uber's network effect in New York City, where the number of daily rides provided by Uber in NYC grew at an average of 37% per year from 2015 to 2017. In addition, more drivers headed to provide service for Uber. As reported by the NYC Taxi and Limousine Commission, the city's count of yellow cabs declined to 13,587 in 2016 (from 13,635 in 2014, which was an increase from 13,437 in 2013). We think the decline accelerated in 2017 and will continue during the next three to five years, while we see Uber cars in New York City increasing. A New York Times article published in early 2017 said there were more than 46,000 Uber-enabled vehicles in New York City in 2016, which increased to over 50,000 the year after, according to the New York City's Taxi & Limousine Commission (TLC).

We must note that growth in demand is driven not only by more users, but also likely by more rides or trips per user. Globally, Uber's monthly average platform consumers, or MAPC, and number of trips support this and our network effect assumption. During the last three years, total MPACs and trips, along with trip per MPAC have been growing.

Plus, increasing supply is based on more drivers and further capacity utilization of each driver and the vehicle. Network effects, by definition, not only allow new network participants to benefit, but also existing ones. Thus, the riders on the platform benefit as more drivers are added, and existing drivers benefit from more riders, making the driver's utilization even more efficient. A figure that we believe supports this and demonstrates the increase in vehicle capacity utilization is growth in average number of rides dispatched per unique Uber vehicle, which has been increasing gradually from 2015 through 2018.

While Uber has benefited nicely from network effects in recent years, we don't believe it benefits from customer switching costs. In our view, the ride-sharing industry lacks barriers to entry or exit for customers and drivers. Both customers and drivers can easily switch to Lyft, while customers have other transportation options like taxis and public transit. In general, just as firms with network effects benefit from the positive flywheel effect when a network expands, they also run the risk of a negative flywheel if customers, drivers, or both start to depart, especially if the network lacks meaningful switching costs. Networks in tech are strong when faring well but can unwind quickly (think MySpace).

In early 2017, Uber faced much criticism for appearing to support an immigration order signed by President Donald Trump and attempting to profit from protests related to that event in New York City, both of which led to the #deleteUber campaign launched on Twitter and eventually tainted the Uber brand and reputation. Then CEO Kalanick was appointed to Trump's economic advisory council, to which some employees at Uber objected. The lack of exit barriers and switching costs for riders and drivers was on display during this period, as other ride-sharing providers, such as Lyft, made headway in New York City and experienced faster growth in trips as riders easily downloaded apps for other services.

While we may have witnessed a slight pause in Uber's network effect in 2017, we think the firm's return to faster growth in trips serviced supports our assumption that the platform still benefits from the moat source characteristic. After February 2017, growth in Uber trips reaccelerated and hit the triple-digit rate again in April. At the same time, Lyft's growth slowed a bit. In addition, Uber continues to dominate the New York City ride-sharing market, with a 2018 average daily trips run rate more than 5 times that of Lyft, based on data provided by the TLC. In 2017, Uber received 4 times more ride requests than Lyft. However, there remains a risk that what currently appears to be a strong network effect for Uber could reverse.

In our view, Uber's ride-sharing network effect can also help the firm tap into other markets and generate additional revenue streams. An example is the meal takeout and delivery market, in which Uber has gained traction with its Uber Eats service. According to data from Second Measure, as stated by Recode, Uber Eats has grabbed share from Grubhub and has more than a fifth of the U.S. market. In Uber's S-1, the firm mentioned a lower take rate, which implies that Uber Eats is willing to compete on price in the short term.

Regarding the network effect, the same can be said about Uber extending its reach into the bike-sharing and freight brokerage markets. Perhaps a good comparison for adjacent network effects, where one strong network enables a firm to expand elsewhere, is Microsoft: Its dominant network around Windows allowed it to leverage its strength into the productivity software market with Microsoft Office. Similarly, Uber's strength in ride-sharing might be leverageable elsewhere.

As Uber benefits from its network effect, we think it gains access to valuable intangible assets in the form of user data, which we suspect helps the firm improve its services and increase its vehicles' capacity utilization. In turn, Uber's service may become more effective as it further monetizes its riders via real-time supply and demand-driven pricing. Uber may also use this extensive data and knowledge to tap into other markets.

Uber gathers data about riders and drivers. As the firm compiles data from the rider app about the locations users request rides to and from and at what times of day, Uber can get a clearer picture of its users' tendencies. When combined with the user-generated driver ratings, we think such information helps Uber improve the timeliness of matching riders with drivers. Such overall enhancement in service could help the firm strengthen its network effect by increasing users and ride requests per user, which helps Uber gather additional data, possibly further increasing the overall value of the data. Simply put, data can also be considered an indirect network effect moat source. Google's search engine is an example of the benefits from indirect network effects associated with data, as more searches lead to better algorithms, better results, and in turn, more searches. Similarly, more rides with Uber may lead to better algorithms and supply/demand balance, thus reducing wait times for riders and idle capacity for drivers, leading to more ride requests.

Fair Value and Profit Drivers | by Ali Mogharabi Updated Aug 09, 2019

Our fair value estimate for Uber is $58 per share. Our fair value estimate represents enterprise value/net sales multiples of 8, 6, and 5 in 2019, 2020, and 2021, respectively. On an EV/gross billings basis, our valuation represents net revenue multiples of 1.7, 1.3, and 1.1. We project that Uber's net revenue over the next five years could grow at a 21% CAGR, in line with gross bookings growth rate we assume for Uber's $730 billion total addressable market.

We expect strong net revenue growth for Uber at a 19% 10-year CAGR through 2028, resulting in net revenue of $63 billion (representing $309 billion gross revenue or bookings), up from $11.3 billion (equivalent to $50 billion gross revenue) in 2018.

We expect net revenue to grow faster than portions of Uber's cost of revenue, including hosting, transaction processing, and insurance costs, which will result in gross margin expansion. We also project that Uber will benefit from operating leverage in the years ahead. With the network effect economic moat source, we think Uber might be able to increase revenue at a faster pace than selling, general, and administrative costs, especially in the sales and marketing lines, while also spending relatively less on operations and support costs. However, we anticipate that R&D will remain elevated as Uber is likely to invest in new ventures, resulting in only slight declines in R&D as a percentage of net revenue. Within our 10-year discounted cash flow model, we assume the firm will begin generating operating income in 2024 and we expect operating margin expansion over 20% by 2028.

Risk and Uncertainty | by Ali Mogharabi Updated May 10, 2019

We assign Uber a very high fair value estimate uncertainty rating. First, Uber faces intense competition in the U.S. from Lyft which has gained market share. In addition, it remains possible that Lyft out-innovates Uber in order to emerge as a winner-take-all (or most) ride sharing provider. Plus, there are certain concerns about whether Uber's network effect can remain an economic moat source if the firm is forced to incur additional costs imposed through regulations at the municipal, state, and/or federal levels. For example, Uber may be forced to conduct more thorough background checks on all driver applicants, such as adding costlier fingerprinting to the driver application process everywhere in the U.S., although the firm already conducts an annual background check on all its drivers.

Other regulatory concerns include whether Uber will have to pay a minimum amount to each driver per trip. While the firm may have to concede and implement such policies, it will also likely take an overall higher percentage from the gross revenue generated per ride, as its price is likely to remain competitive with Lyft's. We note that both dominating firms, Lyft and Uber, are likely to demand higher take rates.

Last, there also lies the risk of larger technology companies such as Alphabet's Waymo, or car companies such as General Motors' Cruise, more aggressively pursuing the growing ride-sharing market.

Stewardship | by Ali Mogharabi Updated May 10, 2019

We view Uber's stewardship of shareholder capital as Standard. While Uber's legal issues under former CEO Travis Kalanick (who will own 6.7% of Uber shares after the IPO) gave Uber a tainted reputation (involving everything from data breaches swept under the rug to a culture of sexual misconduct and accusations of not addressing internal racial discrimination issues) we believe Uber will see better days under Dara Khosrowshahi, the firm's current CEO. Khosrowshahi also has a seat on Uber's board of directors.

Since joining Uber in September 2017, Khosrowshahi has launched what appear to have been successful campaigns to repair the firm's image. In addition, he completed an investment deal with Softbank, settled legal disputes with Waymo, and most recently agreed to purchase the leading ridesharing service provider in the Middle East, Careem. Prior to Uber, Khosrowshahi was the CEO of Expedia for nearly 12 years. Khosrowshahi continues to serve on the board of directors of Expedia. Prior to Expedia, he was also the CFO of IAC/InterActiveCorp. Khosrowshahi brought Nelson Chai onboard in September 2018 as Uber's CFO. Chai's experience includes having served as the CEO of The Warranty Group, President and Chairman of CIT Bank NA, and CFO of NYSE Euronext and before that the NYSE Group.

From a strategic standpoint, we think the firm has taken the right steps to remain a participant in nearly every ride-sharing market in the world. While it operates in regions such as the Americas and most of Europe, it faced difficulties competing with local players in other areas including Russia, China, and Southeast Asia. The firm turned and sold those operations to the market leaders and now it has material ownership in Russia's Yandex Taxi (38%), China's Didi, and Grab in Southeast Asia (23%). For this reason, we foresee Uber benefiting from overall global growth in ride-sharing directly and indirectly. While the deal will not close until early 2020, Uber also increased its presence in the Middle East and Africa by acquiring Careem.

We note that Uber has also taken steps to become the one-stop-shop for transportation as it has added micromobility options such as bike sharing (via the acquisition of Jump in 2018) to its app, which we think may further strengthen the firm's network effect moat source.

While the firm battled and settled with Alphabet's Waymo regarding autonomous vehicle technology, we agree with its continuing investment in self-driving technology within the firm's advanced technology group, or ATG. While we expect further progression toward fully autonomous vehicles may help increase Uber's take rate, it will probably keep drivers even in autonomous vehicles over the long run for safety reasons. ATG has received investments from various parties, including Toyota, which bodes well for both as the two may more quickly and smoothly commercialize autonomous vehicle technology and cars. Similar to Lyft, we believe Uber's platform will become attractive to autonomous vehicle makers as it provides additional opportunities for technology and/or vehicle monetization.

On the food delivery front, Uber Eats is gaining market share, especially in the U.S. battling firms like Grubhub and DoorDash, as it may be benefiting from cross-selling to its large ride-sharing user base. In addition, Uber has continued to aggressively invest in and price its service to attract more restaurants and expand the food delivery business. Such strategy could lead to establishing another network effect moat sourced business within the firm.

Mstar: TSLA 20191024

Tesla Shows More Free Cash Flow Generation With Surprise Profit for Q3
David Whiston
Sector Strategist
Analyst Note | by David Whiston Updated Oct 24, 2019

Tesla reported third-quarter results with a surprise profit that blew away consensus. Adjusted diluted EPS of $1.86 easily beat consensus of a $0.42 loss and Tesla had a GAAP profit of $0.78 per share. GAAP free cash flow of $371 million declined from the prior year quarter's figure of $881 million but the company finished the quarter with a comfortable cash figure of $5.3 billion. Revenue declined year over year by 7.6% to roughly meet consensus of $6.33 billion. Total deliveries rose 16% year over year to 97,186 and by 1.9% sequentially. Model 3 should lead growth for the next several quarters until the Model Y crossover is at decent production volumes. The sedan's deliveries grew sequentially by 2.7% but rose by about 42% year over year, while Model S and X combined deliveries fell 36.9% year over year. The company is "highly confident" its 2019 total vehicle deliveries will exceed 360,000 and we agree but the top end of prior delivery guidance of 400,000 was not mentioned. The stock rose 20% after hours on Oct. 23 due to the EPS beat and Tesla saying the Model Y will now start production next summer instead of in late 2020.

Although the S & X are higher priced than the Model 3 and Model Y, we agree with CEO Elon Musk that the 3 and the Y are the future of Tesla as these vehicles will bring the volume it needs to get more scale. Given Americans' love of crossovers, it is the largest U.S. vehicle segment at over 40% of new vehicle sales, and other vehicles coming such as a pickup truck in a few years, we are substantially raising our vehicle delivery projections through 2028 which causes our fair value estimate to rise 41% to $326. We remain concerned about Tesla's debt load so if free cash flow becomes insufficient to service debt, we may raise our weighted average cost of capital. All else constant, that move would lower our fair value estimate to as low as $206. Tesla is a volatile name and fair value estimate changes may be frequent as its story changes.

Business Strategy and Outlook | by David Whiston Updated Oct 24, 2019

Tesla has a chance to be the dominant electric vehicle firm and is a leader in autonomous vehicle technology, but we do not see it having mass-market volume for at least another decade. Tesla's product plans for now do not mean an electric vehicle for every consumer who wants one, because the prices are too high. The Model X crossover released in late 2015 starts at about $85,000, but will average much higher with options. The Model S sedan's starting price is about $80,000. The Model 3 sedan starts at $39,490 and rolls out gradually through 2019 in other variants in foreign markets. Prices are before any tax credits, and the U.S. federal tax credit stops at the start of 2020.

Tesla is building its gigafactory--a lithium-ion battery plant under construction in Nevada--to help it produce at least 500,000 vehicles at its sole assembly plant in Fremont, California. CEO Elon Musk said in 2018 that total output in 2020 could be as much as 1 million vehicles, but that will not all be in California. A Shanghai plant opens in late 2019 and be wholly owned by Tesla. We are skeptical of the 1 million number, given Tesla sold about 245,000 vehicles globally in 2018. Even if demand exists for these vehicles, this quantity is small relative to total global auto production, which should reach 100 million units in the next few years. Thus, we think global mass adoption of pure electric vehicles is still a way off.

In the meantime, Tesla will have growing pains, possibly recessions to fight through before reaching mass-market volume, and increased its debt levels by acquiring SolarCity to become a vertically integrated sustainable energy company. It is important to keep the hype about Tesla in perspective relative to the firm's limited production capacity. Tesla's mission is to make EVs increasingly more affordable, which means more assembly plants must come on line to achieve annual unit delivery volume in the millions. This expansion will cost billions a year in capital spending and research and development and will be necessary even during downturns in the economic cycle. Tesla also has more vehicles to launch, such as a pickup truck, that will demand lots of capital.

Economic Moat | by David Whiston Updated Oct 24, 2019

We do not see a moat yet because Tesla is still relatively early in its life cycle and has a high degree of execution risk as it adds new models and new capacity. This dynamic creates huge uncertainty as to whether the firm will succeed in making great product at an affordable price and whether enough consumers will make the switch from internal combustion engine and hybrid vehicles. There is evidence suggesting that Tesla will succeed, but if not, Tesla will remain an automaker for the wealthy. In a January 2014 Automotive News interview, Musk said in regard to Tesla making it: "I think we will, but this is not a bold assertion we unequivocally will. There is a possibility we may not."

Tesla's growth runway looks lucrative, but this growth also requires constant substantial reinvestment in platforms, the gigafactory--for which Tesla is only spending about 40% of the total cost of about $5 billion, while suppliers pay the rest--and annual assembly capacity, since the eventual output limit of Fremont is uncertain, as is the cadence of Tesla opening new plants overseas. During this growth phase, there will almost certainly be a recession or two. In times of economic uncertainty, it is difficult to say what Tesla's sales volume will be or what access, if any, the firm will have to capital markets. Tesla wants between 10 and 12 gigafactories in the long term.

We model return on invested capital below weighted average cost of capital through 2020 in light of high capital expenditure requirements and more invested capital after the SolarCity acquisition. We also see risk of major value destruction should EV adoption flop or occur much more slowly than any of our three 10-year forecast periods assume, or if the company cannot meet its volume targets. For that reason, we wait for now to award Tesla a moat, but we see a positive moat trend as a result of the strengthening of the firm's brand and its cost structure.

Although we stress the uncertainty in investing in Tesla today, the company's competitive position is better than some may expect from a tech startup that makes automobiles. Looking at our five moat sources, we see a case for brand (intangibles) and cost advantage as sources of a moat in the future. Some may argue for efficient scale, claiming that Tesla is the dominant pure EV firm. Although Tesla's long range gives it a huge advantage over pure EVs on the market (370-mile EPA range for the long-range Model S versus 259 miles for the Chevrolet Bolt, 226 miles for the Nissan Leaf, and 234 miles for the Jaguar I-PACE), we consider Tesla's competition to be the entire auto industry rather than just EVs. There are far too many automakers globally for us to claim Tesla's market is effectively served by a small number of players.

Musk's own words do not support efficient scale. He wrote in a June 12, 2014, blog post announcing that Tesla would not sue companies that use its patented technology in good faith: "Given that annual new-vehicle production is approaching 100 million per year and the global fleet is approximately 2 billion cars, it is impossible for Tesla to build electric cars fast enough to address the carbon crisis. By the same token, it means the market is enormous. Our true competition is not the small trickle of non-Tesla electric cars being produced, but rather the enormous flood of gasoline cars pouring out of the world's factories every day."

Fair Value and Profit Drivers | by David Whiston Updated Oct 24, 2019

We are raising our fair value estimate to $326 from $231 per share. The change is from modeling much higher deliveries through 2028 to account for a sooner than previously guided launch of the Model Y crossover and our expectation of more consistent free cash flow generation going forward, though we think some quarters will burn cash during launches of new vehicles. We now model total deliveries over our 10-year forecast period of about 12.5 million from 9.4 million previously. We remain concerned about Tesla's debt load so if free cash flow becomes insufficient to service debt, we may raise our weighted average cost of capital. All else constant, that move would lower our fair value estimate to as low as $206. Tesla is a volatile name and fair value estimate changes may be frequent as its story changes. We add back about $3.9 billion of nonrecourse debt to our valuation. The midcycle operating margin remains 9% and includes stock option compensation expense.

We model 2019 vehicle deliveries of 370,000, 2020 deliveries of about 566,000, and nearly 950,000 in 2021. We model capital expenditures of $3.3 billion in 2020. When modeling Tesla in our discounted cash flow model, we keep an open mind regarding the disruptive potential of Tesla on the auto and utilities industry as well as focusing on what the company can achieve in 10 years. For a young company like Tesla, we think long-term potential is the more important question and value driver than how many Model 3s get delivered in a quarter, but tremendous uncertainty surrounds the story.

Management's long-term guidance since its 2010 initial public offering is for an operating margin in the low teens to midteens. The guidance is also non-GAAP, so it excludes stock option expense, whereas we include stock option expense in EBIT to capture the cost of diluting shareholders. Tesla's guidance is also much higher than typical mid-single- to low-double-digit automaker EBIT margins, but the firm has upside margin potential if it can reduce its battery costs and have a high-margin storage and autonomous ride-hailing business. We model $1.9 billion of energy revenue in 2019, with that figure growing to about $6 billion by 2028. This revenue is about 4% of our fair value estimate.

Risk and Uncertainty | by David Whiston Updated Oct 24, 2019

Investing in Tesla comes with tremendous uncertainties due to the future of electric vehicles and energy storage. If a recession hits, investors may not want to hold the stock of a firm whose story will not play out until next decade, or Tesla could fail to raise capital when it needs it. Until an electric vehicle far cheaper than the Model 3 goes on sale in mass volume, there is no way to know for sure if consumers in large volume are willing to switch to an EV and deal with range anxiety and longer charging times compared with using a gas station. Tesla is fighting a state-by-state battle to keep its stores factory-owned rather than franchised, which raises legal risk for Tesla and could one day stall growth. Other automakers are entering the BEV space. If the company's growth ever stalls or reverses, we would expect a severe decline in the stock price because current expectations for Tesla are immense, in our opinion. With a young, growing company, there is always more risk of diluting shareholders or taking on too much debt to fund growth. Tesla also has customer concentration risk, with the U.S. and China constituting about 78% of 2018 GAAP revenue, up from 56% in 2015.

We see immense key-man risk for the stock, as Tesla's fate is closely linked to Musk's actions. Should he leave the company or the SEC bans him from running Tesla, we would not be surprised to see the stock fall dramatically. Also, Musk has 13.4 million Tesla shares as collateral for personal debt. Selling this block of shares quickly may cause a rapid fall in Tesla's stock price. Tesla will soon have formidable EV competition from German premium brands it does not have today. It's uncertain if Tesla vehicle owners will also want solar panels and batteries in sufficient volume to justify buying SolarCity. Given the many uncertainties regarding investing in Tesla today, including our concerns on its debt load, our fair value uncertainty rating will remain very high for a long time.

Stewardship | by David Whiston Updated Oct 24, 2019

We award Tesla a Standard stewardship rating. Musk is barred from holding the chairman role for three years following a 2018 settlement with the SEC on civil securities fraud charges. Tesla must also appoint two new independent directors. In December 2018, Tesla appointed Oracle founder Larry Ellison and Walgreens HR boss Kathleen Wilson-Thompson to the board to fulfill the settlement. Ellison is a fierce Elon cheerleader, so we doubt he will give Musk any headaches. In November 2018, Tesla named Robyn Denholm chairman. She has been on Tesla's board since 2014 and has experience both in autos with Toyota Australia in finance and in technology as CFO and COO of Juniper Networks and CFO of Telstra and time at Sun Microsystems. We like that she resigned as Telstra's CFO to focus full time on Tesla. We do not expect major changes in Tesla day to day and still think it is the Elon Musk show. Denholm's top priority in our view will be to keep Musk content and ensure he doesn't say anything to violate his SEC settlement.

We considered downgrading our rating after the all-stock offer to acquire SolarCity closed because the offer came about one month after Tesla raised equity and at the time there was no disclosure of a possible acquisition. The deal to acquire a firm led by two of Elon Musk's cousins (who have since left Tesla) after SolarCity's stock had fallen by 75% since early 2014 is not what we like to see. We left our rating in place, however, because there is a valid strategic rationale for acquiring SolarCity, which is to make Tesla a vertically integrated sustainable energy company.

Musk, 48, is synonymous with Tesla, and the stock could suffer should he resign. We doubt he will resign soon, however, because shareholders approved a new 10-year performance award in January 2018. The plan has aggressive market cap targets for Tesla's stock of up to $650 billion that are paired with 16 milestones focused on revenue and adjusted EBITDA targets. The revenue targets are as large as $175 billion and the adjusted EBITDA targets, which exclude stock-based compensation expense, are for as much as $14 billion. Up to 16 operational milestones may be paired with the market cap milestones for shares to vest. The market cap milestones start at $100 billion and go up in $50 billion increments afterward. As the board certifies each milestone, Musk receives one of 12 tranches of stock options. Each tranche is for about 1.69 million shares (about 1% of Tesla's outstanding shares) and has a strike price of $350.02. Musk must hold any shares he exercises for five years (which we like a lot), and there is no acceleration of vesting for a change in control.

It is also important that the plan gives clarity to Elon's status as CEO. We do not think he wants to be CEO forever, but he has said he will remain involved with Tesla for the rest of his life. This new award has vesting eligibility as long as Musk is CEO or stops being CEO to become executive chairman plus chief product officer. Musk has many interests beyond Tesla, so we expect he will not be CEO for the length of this award plan. Tesla has estimated in the past that should Musk receive all the shares, he would own 28.3% of Tesla. The plan is designed so that as Tesla issues more shares, the maximum value of the compensation, which Tesla estimates at about $55.8 billion, goes down. We see this plan as very rewarding for shareholders, should Tesla reach a $650 billion market cap. It's a plan that encourages massive growth in shareholder value over a long period and is done in a way that is easy to track with metrics reported in SEC filings. It also does not give Musk incentive to sell the company. Musk beneficially owns about 22% of the stock.

Musk is on the board along with his brother, Kimbal and many longtime connections of Elon's. In 2019, Tesla proposed to reduce its classes of directors to two from three, which would mean two-year terms instead of three years but the proposal failed because too many nonvotes led to no supermajority of outstanding shares for the affirmative votes. This proposal was a step in the right direction but we see the current board of nine members, which includes his brother, still friendly to Musk. We'd like to see the entire board up for election every year and more members with fewer ties to Musk.

Musk has arguably too much responsibility serving as Tesla and SpaceX CEO, plus running the Boring Company and artificial intelligence plans, which raises the risk of him being pulled in too many directions. Directors and officers own over 20% of Tesla's stock, so Elon's interests are aligned with Tesla's shareholders, but other shareholders are essentially along for the ride. Tesla has various related-party transactions with SpaceX or The Boring Company for aircraft, battery components, and other equipment, but we see no alarming transactions in the proxy statements.

Mstar: Spotify 20191029

Spotify's Q3 Surprises on the Upside, but ARPUs Continue to Decline; Shares Fairly Valued
Ali Mogharabi
Senior Equity Analyst
Analyst Note | by Ali Mogharabi Updated Oct 29, 2019

We still have our doubts about whether no-moat Spotify can create an economic network effect moat source. While Spotify's premium subscriber base continues to grow, which drove the third-quarter top line above S&P Capital IQ's consensus expectations, monetization per subscriber also continues to decline. On the podcast front, it appears that additional content is helping reduce churn and increase engagement. The quarter was also profitable because of slightly higher gross margin, cost control on R&D and sales and marketing, plus lower social charges related to stock-based compensation. However, we continue to think that labels will limit premium revenue gross margin expansion, and the firm likely will continue to attract listeners through lower prices or more sales and marketing as it competes with big names such as Apple and Amazon.

While management's fourth-quarter guidance implied full-year revenue higher than consensus expectations, it was in line with our initial projection. We made only slight adjustments to our estimates and are maintaining our $130 per share fair value estimate for Spotify. The stock is up 14% in reaction to the strong third quarter and is now trading slightly above our fair value estimate. We recommend waiting for a pullback before investing in this name.

Spotify reported total revenue of EUR 1.7 billion, up 28% from last year, driven by premium subscriber count, which increased 30% year over year to 113 million. The firm's total monthly active users of 248 million (up 30%) also included ad-supported users of 141 million, which were up 29%. While churn improved 19 basis points from last year, according to management, average revenue generated per user remained weak. ARPU of premium subscribers was down 4% from the previous quarter and 1% from last year to $4.67, as Spotify continues to market aggressively by offering the service at lower prices.

Business Strategy and Outlook | by Ali Mogharabi Updated Feb 07, 2019

Swedish-based Spotify is the world's leading music streaming service provider. We foresee the fast-growing digital streaming space as becoming the primary distribution platform of choice within the ever-changing music industry. We believe Spotify can benefit from various network effects that will help the firm increase its users and amass valuable intangible assets associated with user data and listening preferences. However, it faces intense competition and has a (mostly) variable cost structure that may limit Spotify's future operating leverage and profitability. Thus, we do not have sufficient confidence that it will generate excess returns on capital over the next 10 years.

In our view, while Spotify is ahead of the pack in the growing music streaming market, it faces stiff competition from behemoths such as Apple, Google, and Amazon. Unlike Spotify, these firms don't rely solely on streaming music to drive profitability and can potentially run at break-even, or even as loss leaders, while monetizing users via other products and services. It might also be harder for Spotify to steal share from these competitors over time, as Apple Music users are probably entrenched with other Apple products, Amazon Music with Echo, and so on. Thus, they might be relatively more loyal to these music platforms than the users an operating-system-agnostic platform like Spotify can capture.

Competition aside, we think Spotify may be at the mercy of the record labels in the music industry, as it will need access to content to continue attracting more listeners. While the distribution side of the industry (Spotify, YouTube, Apple, terrestrial and digital radio, and so on) is fragmented, over 80% of licensing is controlled by the big three major record labels: Universal Music Group, Sony, and Warner Music Group. As these licensors gather royalties from Spotify and its peers, they maintain pricing leverage as content remains king.

Economic Moat | by Ali Mogharabi Updated Feb 07, 2019

We consider Spotify a no-moat company. While we foresee several potential moat sources for Spotify, we don't have tremendous confidence that any of these characteristics will enable the company to generate excess returns on invested capital today. Ultimately, we do think the firm can effectively monetize its listeners and the content it provides. In fact, based on user and ad revenue growth, we model a 20% total revenue compound annual growth rate for the firm through 2021. However, given doubts about how much of Spotify's revenue will go to the bottom line, we do not expect the firm to generate excess returns on capital.

We believe Spotify may benefit from three different types of network effect associated with its streaming music platform, although none of these guarantee excess returns on capital, by our estimation.

First, the firm benefits from a platform network effect. The firm has aggressively expanded its content library, which allowed it to attract users to the platform. In turn, Spotify's strong user growth has attracted more artists from both major labels and independent ones. We think this flywheel effect will continue as more users attract more artists and labels, which attract even more users, and so on.

Second, we think Spotify benefits from an indirect network effect associated with playlists and curation. As more users listen to more music, Spotify can improve its algorithms and provide all users with better playlists that more closely match their listening preferences. As Spotify's algorithms improve, the company can better retain its existing users while also potentially attracting more users to its service. To a lesser extent, Spotify's users have even developed a bit of a direct network effect, where users share playlists with one another and, in turn, attract more users to Spotify, even without a corresponding increase in artist or label content.

Third, we believe that Spotify also benefits from a network effect between users and advertisers. As the firm gains more listeners, leading to more hours of content consumed, we think it can attract more advertisers, generating more ad dollars. The ad revenue allows Spotify's service to remain free for users, as users implicitly agree to listen to ads in exchange for the free service. This network effect has a cap, though, as Spotify obviously can't serve its users nothing but ads. In turn, this limits Spotify's ad inventory, which also limits the growth of the advertiser network effect to the growth of the user base, assuming Spotify is currently maxing out how much ad time can be played per user.

In addition to these network effects, Spotify may also benefit from intangible assets associated with user data. Spotify's collection of user demographics and music preferences is likely a treasure trove of information that is attractive to advertisers, both within the music industry and from outside parties. Premium subscribers do not receive ads, but the firm's last reported base of 92 million free subscribers will receive targeted ads. As free users listen to more music and Spotify collects more data, it is likely to attract more advertising buyers. The firm also can use the data to learn more about fans of various artists, help them attract and invite fans to their live events, sell artists' labeled merchandise, and more. In our view, these additional services can further attract artists to the platform.

However, none of these favorable characteristics will translate to tremendous certainty about future bottom-line growth, in our view. This uncertainty is based mainly on the fact that part of the firm's cost of revenue, the content acquisition cost, remains variable, likely limiting Spotify's gross margin expansion. Regardless of revenue earned from premium subscribers or advertising, Spotify must pay record labels and publishers a royalty for the content streamed to its users. Without any ownership of the more than 35 million tracks currently in its library, Spotify, along with other music streaming providers, will remain significantly dependent on record labels, which it will continue to pay for content consumption.

Spotify has guided for a long-term gross margin of 30%-35%, and in our view, the revenue type that can drive most gross margin expansion is advertising revenue. The firm may prosper from either a rise in freemium users and, in turn, the number of advertisements shown, or from average revenue per user, by selling more ad inventory per user and/or extracting higher ad prices. Like many websites and apps, Spotify will need to strike the fine balance between serving ads to its users in order to offer a free service, and serving too many ads and thus driving users away. Spotify's balance is somewhat unusual in that an ad not only creates revenue for the firm, but it also lowers costs, as it leads to fewer songs being played and, in turn, modestly lower royalties to be paid. That said, if Spotify serves too many ads, reducing royalties owed and driving gross margin expansion as a result, it may turn away users. Also, Spotify's royalty costs are different from terrestrial radio, as Spotify pays both labels and publishers/songwriters, whereas terrestrial radio broadcasters only pay publishers.

Another aspect of the potential gross margin expansion could come from the premium side. However, it is based on the assumption that premium ARPUs are more likely to approach the firm's standard subscription price per month. As the firm's user base strengthens, Spotify could lower its discount offers slightly, particularly for potential premium subscribers. Such a strategy could narrow the gap between the firm's premium ARPUs and the standard $9.99 monthly rate that it charges its premium subscribers.

The other potential route to operating leverage for Spotify is if it can reduce operating expenses, either in R&D or in declining customer acquisition costs. However, it faces competition from much larger companies such as Apple, Amazon, and Google, which will be willing to aggressively acquire listeners by spending more on marketing and/or offering their services at a discount for a longer period. Further, it is likely that none of these firms are running their streaming music businesses as high-margin profitability drivers; rather, they are aiming to keep users within their respective ecosystems and monetize via other methods. Thus, we think these companies could more easily retain listeners, given their larger overall ecosystems of offerings, so we believe a sizable reduction in Spotify's customer acquisition costs will be difficult.

Spotify is in the early stages of building an ecosystem where the firm is aiming not only to offer a variety of content including podcast and video, but also to remain ubiquitous and make all its content available everywhere, including on various apps, in cars, and on hardware provided by competitors such as Apple, Google, and Amazon. In addition, the firm is focusing on creators, as it can help them learn more about their fans, more effectively plan the location and timing of their events, sell a variety of artist merchandise, and overall become more easily and quickly recognizable. While we applaud these strategies, they do not differ much from what some of Spotify's competitors, including Pandora with around 78 million monthly active users, are doing.

Fair Value and Profit Drivers | by Ali Mogharabi Updated Oct 29, 2019

Our fair value estimate is $130 per share, which implies a 2019 enterprise value/sales multiple of 3. We project strong top-line growth for Spotify at a 10-year CAGR of 17%. We project that Spotify will become profitable in 2021 and will improve its current negative margin to an operating margin of over 11% by 2027.

Revenue growth will be driven by growth in the firm's overall users for both premium and ad-supported services, along with continuing growth in online ad spending. We have modeled an 11% 10-year CAGR for premium and ad-supported users through 2028, with a consistent ratio of paying and freemium users over our forecast period. Looking at just the next five years, we expect those users to grow at 17% per year. As the firm's user base strengthens, we expect fewer discount offerings, particularly to potential premium subscribers. For this reason, we expect premium ARPU to increase at a 3% 10-year CAGR to $6.74 by 2028, from $4.81 in 2018. With an increase in ad inventory sales, plus growth in freemium users, ad-supported ARPU can grow at an average annual rate of 17% to $2 through 2028, up from $0.42 in 2018.

We also anticipate gross margin accretion over time, from 26% in 2018 to 32% in 2028. Part of the firm's cost of revenue, the royalties paid to labels, remains variable, as this accounts for a percentage of revenue and we do not expect it to decline or vary much over the years. Regardless of revenue earned from premium subscribers or advertising, Spotify must pay record labels and publishers a royalty for the content streamed to its users. Part of the gross margin expansion that we have modeled does come from the premium side. However, it assumes that premium ARPUs are more likely to approach the firm's standard subscription price per month. We also think ad revenue growth can drive gross margin expansion.

Our fair value uncertainty rating for Spotify is very high, in light of potential near-term volatility associated with Spotify's direct share listing (rather than a traditional IPO), as well as uncertainty around the company's future growth rates and profitability profile.

Risk and Uncertainty | by Ali Mogharabi Updated Feb 07, 2019

We believe the greatest risk for Spotify is competition, as large firms like Apple, Google, and Amazon may undertake more aggressive strategies to grow listeners. Another significant risk is associated with royalties owed to large record labels. These labels may have the power to raise the royalties that Spotify owes on songs, especially if Spotify starts to become too powerful or popular. Plus, while Spotify may be able to reach distribution agreements directly with artists, doing so may put the firm at a further disadvantage when negotiating with record labels. Another risk may stem from any potential downturn in online advertising, which could weigh on revenue growth.

Last, as we have witnessed historically, the entire music industry faces the risk of disruptive distribution technologies, such as the shifts from cassette tapes to CDs and, more importantly, in the late 1990s with technological innovation for music download and file sharing, which led to rampant piracy and crushed many well-established music business models.

Stewardship | by Ali Mogharabi Updated Feb 07, 2019

We assign a stewardship rating of Standard to Spotify's management team. While the firm has been around for only 12 years and officially launched its service 10 years ago, we commend the team for navigating Spotify through various negotiation phases with record labels while at the same time expanding its user base. In addition, we think the experience of CFO Barry McCarthy is very valuable. McCarthy is a veteran of the media and entertainment business and was Netflix's CFO for over 10 years until 2015. He was also a board member of one of Spotify's competitors, Pandora, for around two years. McCarthy joined Spotify's board in 2014 and held the position until he was named CFO in July 2015. He is also in charge of Spotify's ad-supported business, which bodes well for growth of that segment.

Daniel Ek is the cofounder, CEO, and chairman of Spotify. He has an extensive background in both technology and online advertising. Ek, along with Martin Lorentzon, founded Spotify in 2006. Lorentzon is currently a board member of Spotify. Similar to Ek, he has experience in online marketing as he founded TradeDoubler, an online ad firm that acquired one of Ek's earlier startups, Advertigo, in 2006. Ek and Lorentzon have 37% and 43.5% voting power.

Mstar : GE 20191106

The Ink From GE Bears Will Soon Dry
Joshua Aguilar
Equity Analyst
Business Strategy and Outlook | by Joshua Aguilar Updated Nov 06, 2019

Our GE thesis is an all-out bet on industry veteran Larry Culp. We believe he is the best person to lead the long-term turnaround of General Electric. Given his outsider's pedigree, we expect he will continue his dispassionate analysis of GE's businesses and take decisive action to stop the cash burn at GE Power, address GE Capital's lingering liabilities, and position GE's remaining industrial businesses to operate from a position of strength. For proof, we point to Culp's astute decision to sell the highly desirable GE Biopharma business for $21.4 billion in cash and pension liabilities, while retaining the remaining portions of healthcare. We also believe Culp is increasingly comfortable with GE's financial situation, as shown by the team he is methodically assembling.

The GE turnaround story begins with the notoriously fickle and long-cycled power market. A successful multiyear turnaround of the industrial conglomerate won't be easy. While there are stark differences between Culp's role at Danaher, we believe green shoots of change are evident in the gas power order book.

Power continues to face both competitive and substitute threats. Renewables like wind power offer diminished environmental impacts at comparably attractive prices. The industry suffers from overcapacity, and poor capital allocation decisions forced GE to take a $22 billion write-down, exhausting nearly all of the segment's goodwill balance. GE Capital, furthermore, remains an overhang on the stock, particularly related to its insurance liabilities, as well as required additional capital contributions from industrial GE. We estimate these contributions amount to a run-rate of just over $2.6 billion from 2020 to 2023, after an additional $2.5 billion contribution in the latter half of 2019. Compounding these issues are GE's recent credit downgrades, which raise GE's borrowing costs on over $100 billion of interest-bearing liabilities.

Ultimately, we expect Culp will position GE's operating business for long-term success by aggressively cutting costs, implementing the proposed separation of BKR, exploring further asset sales, and driving operational improvements and working capital management.

Economic Moat | by Joshua Aguilar Updated Nov 06, 2019

General Electric was once heralded as "America's most admired company." While we agree there is a lot to admire about the company, we no longer believe it merits a wide economic moat and are downgrading its moat rating to narrow. Morningstar's definition of a wide-moat company is clear; a wide moat exists when we have a high degree of confidence a company can achieve normalized excess returns over at least the next 10 years, and more likely than not over the next 20 years. As it stands today, we no longer have that confidence in GE.

Labeling GE a wide moat oversimplifies three critical issues: secular pressures facing power and renewable energy; the firm's capital position as it pares assets; and lingering liabilities related to GE Capital. While the firm's aviation and healthcare segments certainly have moats, we think it will be challenging for GE to isolate the less desirable portions of its portfolio and lift its ROIC profile without adverse consequences. GE has about $105 billion in borrowings, and by our count, underfunded pension and other postretirement liabilities of just over $21 billion. When GE disposes of assets, these obligations must attach somewhere, and the firm can't attach them to chronically underperforming cash burning businesses like GE Power. Some of these will attach to disposed assets, as in the case of about $400 million Danaher is assuming with the purchase of GE Biopharma. GE will use the cash from asset dispositions to pay down its interest-bearing liabilities and satisfy credit ratings agencies threatening additional downgrades. Even so, the firm is also losing one of its higher growing healthcare assets in GE Biopharma going forward.

Aviation undoubtedly meets the definition of a wide-moat business and is GE's crown jewel. The segment benefits from intangible assets, switching costs, and scale-driven cost advantage. GE essentially competes in a duopoly in both the wide-body (twin-aisle) and narrow-body (single-aisle) space against Rolls-Royce and United Technologies, respectively. Including GE's 50% interest in its joint venture with CFM, we estimate that GE commands well over 40% of the combined narrow-body and wide-body engine markets, as measured by new deliveries. The aviation segment, furthermore, operates on a razor-and-blade model. A GE engine is present in two of every three commercial departures, and the firm's installed base between GE and its joint ventures reaches 37,000 engines. In the formative years after a new engine launch (about one third of the overall cost of a new plane), GE will typically implement an estimated 70% discount on its new narrow-body engines from their listed prices. Over time these discounts erode. A typical jet engine will then first require service in about year seven of operation at which time an engine program may pass break-even and become a recurring and enviable profit stream for GE (in the LEAP engine's case, management anticipates NPV breakeven in 2021). These bespoke service contracts typically extend 25 years into the future. We believe intangible assets are particularly critical for engine deliveries–the razor in the razor-and-blade model. The technical knowledge needed to design and manufacture a jet engine is GE's main source of intangible assets. This technical know-how is supported by the firm's research and development budget, of which about one third is principally funded by the U.S. government. Other intangible assets include the firm's patents, a long track record of success, and its customer relationships with both Boeing (primarily) and Airbus. A track record of success can have a disproportionate impact in delivery wins. For example, according to Bloomberg, in 2017, about 46% of Airbus' A320neo jets powered by competitor Pratt & Whitney's GTF engine (counterpart of CFM's LEAP 1-A) were out of service for a least one week in August of 2017 (compared with 9% for GE). These delays allowed GE to outpace Pratt in 2017 new A320 jet engine orders by 10-to-1, and further allowed GE to increase its market share for such orders to 60% (a 5% increase over historical norms).

Relatedly, switching costs are strongly associated with aftermarket sales – the blade in the razor-and-blade model. GE's switching costs are a result of the firm's engines and associated equipment's strong integration into customers' airframes and landing systems. In the United States, aircraft engine inspections are both mandated and regulated by the Federal Aviation Administration, and unplanned downtime related to concerns over an engine's efficacy can wreak havoc for airlines, both in terms of time and expense. This high cost of failure ultimately increases customer loyalty. By our count, nearly 61% of GE's commercial aviation revenue stems from its services, which we believe represents strong evidence of customer reliance on GE as the original equipment manufacturer. Moreover, GE's pursuit of rate-per-flight hour service agreements, whereby OEMs like GE receive service payments based on flight hours, both boosts returns and solidifies switching costs. With flight hour services agreements, GE receives payments over the life of a contract. Additionally, because OEMs assume the maintenance risk, firms like GE, Pratt, and Rolls Royce are incentivized to increase on-wing time. According to Aviation Week in late 2016, the LEAP's predecessor, the CFM56-7B demonstrates an industry-leading 99.96% percent engine dispatch reliability rate, which equates to only one delay or cancellation every 2,500 departures. Furthermore, that engine can stay on-wing for as many 20,000 cycles (typically 18,000). Cost advantage from scale is also evident in GE Aviation's margins, which exceeds Pratt's by about 12.5 percentage points, or in the R&D it can leverage not just across its power segment with its gas turbine units, but also previous-generation jet engine models.

Healthcare is currently GE's second-best business and one we think also merits a wide-moat rating, even with the absence of GE Biopharma within GE Healthcare's Life Sciences division.

Medical imaging, which constitutes about two thirds of GE healthcare's revenue base, is a notoriously opaque industry and increasingly commoditized, but one where we think GE also benefits from intangible assets, cost advantage from scale, and switching costs. GE's medical imaging installed base is large at over 1 million units. From our conversations with industry experts, GE and its competitors consolidated the industry, acquiring competitive threats like well-regarded x-ray machine maker Picker in the 1980s. Two major players have dominant share in the market, including GE and Siemens (within the 20%-plus range). Practically speaking, moreover, our experts inform us that GE and Siemens are the only two vendors actively considered by large hospital networks (with notable exceptions like Hologic's mammography machines). Doctors may go as far as choosing their residencies based on the reputation of these machines, particularly CT scans, both in terms of quality and service reliability. Indeed, most large U.S. hospitals will have a reputation of being either a "GE hospital" or a "Siemens hospital." Our belief is that this reputation obviates some of the pricing pressures that may naturally occur in more rural markets, where price is far more important given availability of resources. Given the critical functions these machines perform, their high cost of failure, and a doctor's familiarity of use, hospitals loathe switching providers for a less expensive alternative. These switching costs are reinforced by GE healthcare's massive footprint, which allows the firm to expeditiously service any faulty equipment and avoid any disruption to patient care.

Another advantage of having acquired makers of different machines is that both GE and Siemens attempt to sell hospital procurement departments an entire suite of machines. GE's economies of scale afford it the privilege of hiring a large salesforce of specialists for each types of units, including MRIs, X-rays, CT scans, ultrasounds, and mammography machines. Moreover, while it is our understanding hospitals will often pool procurement resources to increase bargaining power when negotiating with medical imaging providers, GE mostly continues to directly negotiate with each hospital. We suspect it retains its bargaining power by not disclosing pricing and requiring hospitals to sign non-disclosure agreements regarding any pricing information, keeping confidential what was once common knowledge in the industry two decades ago. Finally, GE's digital software is well-integrated with machines, which also reinforces these switching costs. Physicians less often read x-rays from hard copy film, but instead rely on GE technology to read these images digitally in a single image repository, often in a different location from where a machine may be located. While a third-party software vendor could in theory operate with GE machines, our understanding is that this solution is far less than optimal.

After aviation and healthcare, however, GE's competitive position fares far worse, with many of its other business lines facing secular pressure. GE power, the firm's other large segment (largest by revenue, number three by segment profit) faces three long-term issues: 1) overcapacity in the industry; 2) pricing pressures; and 3) a shifting energy mix in its end markets toward renewables (as well as operational issues). Grouping together its power and renewable energy segments, we think of this super-segment as a no-moat business. While power operates in a three-way oligopolistic market (along with Siemens and Mitsubishi) , GE's renewable energy competes in a fractured industry with other wind turbine manufacturers (onshore and offshore wind revenues represent about 95% of renewable energy's portfolio). Moreover, while GE power touts its 7,000-plus gas turbine installed base, and the fact that it currently powers more than 30% of the world's power, the segment has at times fallen to number three of global gas turbine orders by energy capacity in 2018. This is behind narrow-moat rated Siemens and the joint-venture between no-moat rated Mitsubishi and Hitachi within our coverage, and significant share losses mean this segment is even more competitive than we previously had appreciated.

Furthermore, GE was late to realize the inevitable transition from fossil fuels to renewables, which is predicted to compete with fossil fuels subsidy-free from a levelized cost of electricity standpoint. Wind turbines don't require the same maintenance needs as gas machines, which is where GE has traditionally made money on its long-term service contracts. We think these cost dynamics threaten to obviate the competitive benefits GE derives from its massive installed base in gas turbines, particularly as renewables also offer a far more attractive and minimal carbon footprint. According to the Financial Times, while natural gas narrowly beat wind power for new generation capacity in 2016, worldwide GE sales of large gas turbines dropped appreciably over a nine-year cycle (from 134 in 2009 to 102 in 2017). Using data from statista, market expectations, including the U.S. Department of Energy, materially under-forecast, by 383%, the energy usage and production of wind generation over a ten-year period. Under Jeff Immelt, GE failed to appreciate these risks, and we suspected its ill-time purchase of thermal energy provider and grid company Alstom will continue to weigh down the segment's ROICs, including goodwill, for years to come due to this overcapacity. Power is forced to continue restructuring efforts to counteract this dynamic as demand for new gas orders is now expected to be as low as 25 to at most 30 gigawatts in 2019 compared with 40 to 45 GW articulated at the start of 2017. As if that were not enough, however, GE renewable energy suffers from many of the same competitive dynamics that plague GE power, including even greater price competition to gain market share, and cheaper alternatives from other forms of energy, like solar, and depends heavily on production tax credits. As such, we don't believe it's a business with durable competitive advantage.

For oil and gas, in which GE continues to own a 50%-plus interest in through Baker Hughes (and plans to for the next two to three years), we also don't believe it has a moat. The GE-Baker Hughes merger created large goodwill balances, and in our view, the kind of transformative impact necessary to generate economic profits on this inflated invested capital base is not a reasonable base-case scenario. Moreover, neither Baker Hughes or GE was able to previously forge an oilfield-services portfolio on par with the quality of industry leaders Schlumberger or Halliburton, even as they were fairly acquisitive in the decade prior to the merger. Similar to the entirety of GE, we think portions of oil and gas, like the turbomachinery and digital solutions subsegments are moaty, but we conclude that economic profit generated in these lines of business will be more than offset by economic losses in oilfield services and oilfield equipment. In oilfield services, which is essentially equivalent to pre-merger Baker Hughes, we believe oil and gas will continue to remain a step behind competitively. Pre-merger Baker Hughes saw market share decline in many key product lines as competitors like Halliburton focused on U.S. shale, allowing them to overtake Baker Hughes in completion equipment, while Schlumberger took the lead in drill bits with its Smith acquisition. In oilfield equipment, and specifically subsea processing and boosting, which potentially reduces deep-water development costs by slashing project infrastructure requirements, oil and gas failed to win the lion's share of limited subsea processing projects launched thus far. We think this has been a key contributor to oil and gas trailing Cameron's operating margins in recent years.

Finally, GE Capital has been an albatross around the company's returns, and in our view, is not only a no-moat business, but ultimately has been a liability for the company. The exception would be GE Capital Aviation Services, or GECAS, which has been the one bright spot for the segment. According to Bloomberg, with more than 1,300 leased aircraft, GECAS retains number-two market share behind AerCap in terms of estimated market value of its owned and managed fleets. In financial services, however, what matters is asset quality, which can hamper profitability during a recession. On this metric, GECAS has fared well, with reported segment profits declining only 14% from 2008 to 2009 (GECAS typically earns just over $1 billion per year). Even so, this is a competitive business without any natural barriers to entry, and Chinese lenders are willing to underprice competitors like GECAS and AerCap. Other portions of GE Capital, moreover, have not fared nearly as well. Most notably is its long-term care insurance business. While GE has not originated any new policies since 2006, the Kansas Insurance Authority is requiring the firm to contribute an additional over $9 billion to its insurance reserves over the next six years after already contributing $3.5 billion in 2018 (after a $1.9 billion injection in 2019). These problems are exacerbated in a low interest rate environment as investment income can fall below projected returns. On the expense side, GE is also encountering claims that were underwritten with poor assumptions, including the life span of policyholders, or the cost of healthcare.

Bottom line, we expect that GE Capital will continue to incur charges as it restructures and in 2019, as well as from the impact of GAAP insurance accounting rules. In the short term, we believe this will mask the earning power of the firm's moatier assets. That said, we conclude that by year five in our model, GE's returns will substantially improve from recent historical experience.

Fair Value and Profit Drivers | by Joshua Aguilar Updated Nov 06, 2019

After reviewing GE's third-quarter results, we maintain our fair value estimate of $11.70. We think the latest results are another data point in support of our long-term thesis: GE has valuable assets and CEO Larry Culp will be successful in orchestrating a long-term turnaround of the firm. Our fair value estimate is also now nearly in line with our SOTP value of $12.30. We also raise our diluted adjusted EPS to 62 cents per share, about a penny ahead of CapIQ consensus, or about a nickel higher than our prior estimate. We also model slightly positive 2019 free cash flow growth toward the lower end of guidance. The stock now nearly trades in line with both our fair value estimate and our SOTP value.

Our revised fair value estimate implies a forward P/E of 19 times our adjusted 2019 total GE EPS estimate. However, these earnings net out restructurings (among other adjustments), which are likely to continue for several years, as well as impairment charges. We continue to implement the impact from the Wabtec merger, the sale of GE Biopharma to Danaher, and the separation of GE's remaining 36.8% interest in Baker Hughes.

In our view, the important contributors to GE's industrial portfolio are GE Aviation and GE Healthcare. In Aviation, we think robust revenue passenger kilometer growth will drive demand, which we believe is front-end-loaded for midsingle digits over the next two decades. Finally, we use our share assumptions and our commercial engine market forecast to derive our explicit GE engine sales projections. For GE Aviation overall, we believe sales will grow at a 6.7% CAGR over our explicit forecast.

As for GE Healthcare, GE's other moaty line of business, we currently assume key market drivers include both increasing demand for healthcare services from emerging economies outside of the U.S., as well as increasing healthcare expenditure from an aging U.S. population. We also think the imaging market between the top two players in Siemens and GE, will remain relatively intact. As such, we assume GE can relatively maintain share on the strength of new product introductions and its installed base.

As for segment profits, we still assume a recovery in power margins to 9% by 2023, but assume pricing pressures translate to a new normal, both for power and renewable energy. For total segment profit margins, we think GE will reach about a 13% bogey at the end of our explicit forecast, but prior to any corporate items and eliminations.

Risk and Uncertainty | by Joshua Aguilar Updated Nov 06, 2019

We think the chief risks for GE are: GE's significant cash burn in some of its operating businesses, including GE Power (which burned through negative $2.3 billion in 2018 after segment restatements); liabilities at GE Capital, particularly from its legacy insurance operations; additional capital contributions from GE required to support GE Capital's operations amid asset sales; the SEC investigation related to GE's accounting for long-term service agreements; execution risk when implementing the separation of some of GE's assets; and shareholder lawsuits.

We're also increasingly concerned about rising claim experience in long-term care insurance, which rose nearly 19% through portions of 2018. While these were offset by raising discount rate assumptions (from 5.7% to over 6.0%), we don't believe it's prudent to raise a rate just to remain in line with peers, particularly as we find these assumptions aggressive and highly subjective. An example of GE aggressive assumptions include the $55,000 amount per policy versus the more than $90,000 it costs for a one year stay in a private nursing home room.

Stewardship | by Joshua Aguilar Updated Aug 02, 2019

We assign GE's management a Poor stewardship rating, primarily based on previous management's record of value destruction under prior CEO Jeff Immelt and GE's opaque accounting. We are reserving judgment on current management before any ratings upgrade. While prior CEO John Flannery and current CFO Jamie Miller laudably took noticeable steps to improve earnings quality, GE continues to overly rely on adjusted non-GAAP figures, which are prone to greater manipulation after multiple adjustments and simply confuse investors. That said, we are strong supporters of Larry Culp's leadership given his long and proven track record of success and execution, exception reputation for candor and transparency, and ability to effectively communicate his strategic vision to the market.

In a complete surprise as to timing, but not as to selection, Culp was appointed Chairman and CEO of the company on Oct. 1, 2018. Culp was previously the CEO and President of Danaher Corporation from 2000 to 2014. Under his stewardship, Danaher's stock rose about 465% against the S&P 500's approximately 105% gain. Culp was responsible for helping evolve the Danaher Business System, taught strategy at Harvard Business School, and served in a variety of advisor roles at prestigious firms. Although we prefer that the two roles remain separate, we like the choice of Culp given his pedigree operating an industrial-healthcare conglomerate. We assumed he was the logical choice to succeed Flannery when he was named Lead Director. Replacing Culp as Lead Director is Thomas W. Horton, who served as Chairman and CEO of American Airlines from 2011 to 2013.

In October 2017, Jamie Miller was appointed CFO. Miller rose quickly through the ranks, having joined GE only in 2008. We like her background and believe this role is a better fit than some of her roles since she first joined GE (like CIO, where she had no discernable background in her resume in technology). Prior to joining GE, Miller was a partner at PwC and served as controller of WellPoint (now since renamed Anthem). Since joining GE she has served in a variety of roles, including chief accounting officer and CEO of GE Transportation. We were impressed with how quickly she learned key aspects of the business, which was highlighted during a special call on Nov. 13, 2017. Only two weeks into the CFO job she had a clear, demonstrable command of some of the key issues facing GE, as well as several key metrics. That said, we were concerned she oversold her visibility into GE Capital's liabilities during the length of tenure. On July 31, (during the second-quarter 2019 earnings release), GE announced that Miller will leave GE once a replacement candidate is identified. We speculate that Culp will call on his former CFO at Danaher, Dan Comas, to serve as Miller's replacement.

We applaud Culp for taking decisive action, particularly in obtaining selling GE's Biopharma business to his former firm Danaher for a very favorable price. We believe he will successfully execute GE's current plan to rationalize the firm's global footprint, rightsize headcount, institute lean initiatives, and position its operating businesses for long-term success. As Culp has indicated, GE is in the very early innings of a recovery. Nevertheless, we trust Culp's very capable operating acumen and his ability to bring both lean discipline to GE, while focusing on the voice of the customer. While we admire Culp for his proven track record, we continue to monitor GE's progress before upgrading our stewardship rating.