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Why General Electric Company's Industrial Services Can Help It Prosper

By Columns Fool.com

When investors think about buying stock in General Electric Company (GE) they usually think about the company's high-profile industrial products, and then its finance arm, GE Capital. However, revenue generated from industrial services represents the biggest growth opportunity for the company. Essentially, industrial services revenue is generated when the company services the base of installed products sold to customers.

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The company is better known for its industrial products, but it is servicing them that really counts in terms of the bottom line. Let's look in more detail at how important services revenue is, and at its future growth prospects

General Electric's industrial services
The latest 10-K filing shows services revenue of $46 billion and operating income margin of 32%, implying income from product services of around $14.7 billion in 2014. Clearly, the bulk of industrial profits is coming from product services, because total industrial segment profit was $17.8 billion in 2014.

Industrial services matter to General Electric's profitability, and growing services profit is also a plus for its valuation. Services revenue has a tendency to decline less in an economic downturn compared toequipment orders -- a quality that reduces the cyclicality of earnings, and should encourage investors to pay a higher earnings multiple for the stock.

Looking ahead, there are three reasons to believe the company can boost itsindustrial service revenue.

The industrial Internet
First, the company's move into what management calls the "Industrial Internet" is likely to increase service revenue in the future. In a nutshell, the Industrial Internet is a combination of Big Data analytics with the Internet of Things.While it sounds complicated, it's really just about embedding computing devices into products (Internet of Things) and then analyzing and interacting with the data they produce (Big Data analytics).

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Ultimately, it allows for greater interactive engagement with the client, which should result in additional recurring revenue (including services) for General Electric For example, embedded devices could monitor and then communicate when equipment needs servicing

At the company's Services & Industrial Internet Investor Meeting in October, CEO Jeff Immelt said: "One of the big paydays of analytics, I think, in services is going to be higher margins, better productivity; better analytics is going to drive a lower cost structure. So one part of innovation is the new products; the other part is really driving cost and productivity in a very accelerated way."

Industrial equipment sales remain strong
Second, investors should watch the industrial equipment order book. It might seem strange to focus on equipment orders when we're primarily concerned with service revenue, but growth in the latter tends to follow growth in the former, since products sold now will need to be serviced later.

I've broken out industrial equipment order growth for the three key cyclical segments:


Source: General Electric Company presentations.

Aviation order growth remains strong, with fourth-quarter 2014 equipment orders up 8% and service orders up 25%.

The reported 12% quarterly decline in power and water industrial equipment orders is an obvious concern, but Immelt said during the earnings call in Januarythatwith the exclusion of a large Algerian deal in 2013, overall fourth-quarter orders were up 13%. In addition, the integration of the energy operations purchases from French company Alstomwill add to service growth in the future. Power and water service revenue rose 3% for the full year.

The primary worryis with future service revenue from its oil and gas operations. The segment's equipment orders declined 15% in the fourth quarter and 8% for the full year, suggesting the 4% growth in service revenue for 2014 could be hard to replicate.

Service orders backlog
The third indicator of future service revenue growth is the service orders backlog, which has an 8.7% compound annual growth rate in the last three years. The current $189 billion services backlog represents more than four times the $46.4 billion in service revenue reported in 2014. You can think of the services backlog figure as representing future services revenue -- if current backlog is growing, then future services revenue will grow too.


Source: General Electric Company presentations. All figures in billions of U.S. dollars.

Where next for General Electric Company's industrial services?
General Electric has a good opportunity to increase its services revenue in future. That's good news for the company, as industrial services are responsible for the bulk of its industrial segment profit. Its Industrial Internet initiatives should strengthen ongoing relationships with customers.

Meanwhile, its services backlog is strong, and the trend of its overall equipment orders (up 5% in 2014) supports future growth. Throw in the potential for the Alstom deal to increase future industrial services demand, and there is much to look forward to with General Electric.

The article Why General Electric Company's Industrial Services Can Help It Prosper originally appeared on Fool.com.

Lee Samaha has no position in any stocks mentioned. Author is aware that GE has been a serial underperformer in the last decade, but thinks investing is about where a stock is going, not where it came from. By all means, beat up on Immelt if the stock underperforms from here, but give the guy a bit more time to restructure GE first.
The Motley Fool owns shares of General Electric Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.