Failure Mode: Welchification
American Reindustrialization Must Learn from GE’s Mistakes
Previously: The Roots of Progress Fellowship, Charting a Path for US Material Progress after the China Shock
Re-industrializing the US has been a hot topic since the pandemic. It’s certainly on top of Americans’ minds given the upcoming election. While industrial policy efforts are just starting to bear fruit, I am thinking about the ways this bet might fail. The US deindustrialized once, starting long before China’s ascent to global manufacturing superpower (manufacturing was already less than 25% of US GDP by 1990). This trend was celebrated at the time, and I suspect the root cause for deindustrialization has persisted: physical-world businesses moving atoms simply have different return profiles than digital-world businesses moving bits. Physical-world businesses have higher costs and no power law like Moore’s Law driving increasing performance and innovation.
Well into the second century since the Industrial Revolution, there are many books, articles, and case studies happy to tell future industrialists what to do and who to emulate—many of which are autobiographical and self-promoting. While Elon seems happy for others to write about him, Jack Welch was all too happy to tell you how great he was. From 1981 until 2001, Jack Welch was the icon of American manufacturing, pushing General Electric (GE) to become the most valuable company in the world. It was short lived, as the great financial crisis of 2008 exposed how his changes had hollowed out the company far more than investors had appreciated. During Welch’s era, GE would demonstrate tremendous material progress, enrich his investors and leadership team, become the envy of every other industrial company, and still set the company on a path to decline and breakup for one simple reason: financial engineering became more important than mechanical engineering. In his wake, leadership would keep his principles and strategies before gravity took hold and sent the company into decline. In April 2024, GE would split into three companies: GE would remain focused on aviation (the one, true GE), GE Vernova would focus on power generation and renewables, and GE Healthcare would focus on medical systems. In October 2024, their cumulative market cap was $316B, down over 20% from Jack Welch’s heyday.
What did Welch do?
For readers most familiar with modern tech companies, industrial companies like GE have many similarities. Both are fundamentally in the business of making things better, faster, and cheaper. The lifecycle for these companies is longer, though, because it takes longer for them to build factories and ship products. The factories serve as both their performance engine and a barrier for other competitors. The result is that feedback cycles are longer—it takes longer to know if a company is working well, it can be trickier to know if a company has achieved its full potential, but once decline becomes obvious, it is often very late to change things. Welch took over as CEO of GE almost 100 years into its history, found it sclerotic, and wanted to make some big changes focused on innovation, leadership, and shareholder performance, all ostensibly praiseworthy things.
1. GE under Welch delivered tremendous progress.
Welch demanded performance from his business units, and many delivered exceptional improvements to their products. GE was the first to introduce CT scanning machines, commercial MRI machines, and 4D ultrasound systems1. During Welch’s tenure, these products and others (like jet engines) increased GE’s revenue from $25 billion to $130 billion and GE’s market cap from $13 billion to over $400 billion2. In other words, GE was becoming the most valuable company in the world.
Mini-Case Study: GE drove significant progress in jet engines during Welch’s tenure.
To illustrate this progress, let’s take a short digression into how jet engines improved over this time, courtesy of my aerospace engineer spouse3. Unlike lightbulbs, appliances, and medical devices, commoditization has not come for the jet engine. Why is that? The main customers, airlines, care deeply about fuel efficiency as it is their biggest variable operating cost. As a result, all three major commercial aircraft propulsion manufacturers (GE, Pratt Whitney, Rolls Royce) have to continually innovate to improve this critical performance metric. The market dynamics of having three competitors who are all packed with talented engineers continually embracing the latest innovations across every component has led to eight decades of compounding innovation.
Both the airline industry and the automotive industry have been focused on improving fuel efficiency over time; however, unlike cars which have been electrifying with batteries, aircraft must be as light as possible to maximize passengers and cargo. That means jet engine design is a multivariate, multi-disciplinary optimization problem: minimizing specific fuel consumption (SFC) while maximizing thrust-to-weight ratio.
The impressive compounding performance is a result of innovations across materials (e.g. composite fan blades, single-crystal nickel superalloys for the turbine blades, ceramic matrix composite turbine stator vanes, thermal barrier coatings), aerodynamic design (i.e. better modeling & simulation tools as a result of Moore’s Law), and manufacturing (e.g. 3- to 5- to 7-axis CNC machines, investment castings, additive manufacturing). Below is one such example of the compounding improvements in compressors:
The E3 was the experimental predecessor to the GE-90 core. The increased stage blade loading is a result of higher rotor speeds, lower aspect ratios, higher solidity, 3D shape optimization, and pressure ratios approaching their practical maximums for a robust surge resistant design. Similar types of compounding innovations can be seen in the combustor and the turbine. In addition to increased performance, as a flying public we all benefit from the increasing reliability (safety) and time-on-wing (lower operating expense for airlines).
What is incredible about all this progress is that it still is insufficient to explain GE’s financial outperformance and eventual downfall. A core aspect of Welchification is that the products can get better while the products become less important to the business.
2. Welch incentivized his team with options, encouraging extreme risk-taking.
Climbing to the top of Mt. Capitalism required change in GE. Both Welch’s promoters and detractors indicate that the primary transformation was GE’s new and extreme emphasis on creating shareholder value. To focus his leadership team on shareholder value, Welch famously compensated his executives with options. Today, options compensation is typical for startups but less common for publicly traded companies. Roughly, both an option and a stock give you upside exposure to the company’s valuation increasing. However, an option is much cheaper than outright buying the stock and can give higher returns for a small change in the stock price. They also are time limited, such that the option will expire and become worthless if not executed. The result for a public company like GE is a management team eager to do whatever it takes to make the stock price go up as quickly as possible.
3. Welch was highly reactive to stock prices.
But greed alone does not tell the full story. The backdrop for industrial companies at this time was negative market sentiment for manufacturing companies, characterized by low price-to-book ratios. Essentially, other large, publicly traded manufacturing companies had a lot of depreciating assets in the form of factories that were not generating huge returns (the assets are the book part), so investors put a low price on the stock (that’s the price part). As those factories aged, the management found few investors willing to give them the investment necessary to invest in new factories, especially for factories to be built in the US. While these companies were profitable, companies with newer factories were beating them in the market. Current investors in those companies were left with the choice of letting the company reinvest their cash in the company to build new factories or asking for the money back to invest in other companies. Based on the relatively low price-to-book ratio, investors were no longer interested in backing the growth of older companies; most asked for money back.
This reputation left companies like Nabisco, Sharon Steel Corporation, and even US Steel susceptible to what is known today as a corporate raid, a usually hostile takeover bid for failing or undervalued companies by shrewd but ruthless investors seeking to extract a quick profit at the long-term expense of the company. The executives at these companies were not without blame, as they often lived large off the company’s assets (the chronicle of corporate raiding in the 80s, Barbarians at the Gates, says that Nabisco had seven corporate jets for their execs). Certainly the workers preferred their jobs to the asset sales, plant closures, and layoffs that the corporate raiders would bring. Welch saw what was happening to inefficient companies and ran in the other direction. If the tactics raiders used made shareholders happy, he would use them himself. He would only keep the best business units. He spared no sympathy for underperformance because Wall Street would spare him no sympathy. Emphasizing increasing, predictable profits and shareholder value while keeping assets low was what Wall Street wanted to see—and a driving force for deindustrialization generally.
4. Welch had no patience for industrial business units that could not deliver immediate results.
Welch had one essential mandate: GE must be #1 or #2 in a market to keep a business line. As a conglomerate, GE often found new ways to commercialize research; however, that did not mean new products were highly differentiated. Instead, many of their products, like consumer appliances and plastics, would be commoditized with time. This commodification posed a risk to the stock price. He gave several business units time to turn around, but he was not complacent to ride out market cycles. He demanded immediate strategic shifts if there was any threat to miss the expected quarterly numbers. The stock market outright hated conglomerates, slapping them with the ‘“conglomerate discount,’” which resulted in their earnings being capitalized at lower multiples than for single-business companies.
For example, if investors wanted to give jet engines a 7x valuation of the company’s price to earnings but consumer appliances a 3x valuation, the entire company would be valued at 3x. In his first four years, Welch would divest 117 different units representing 20% of GE’s assets4. In his first five years, he cut headcount by 25%, impacting 100,000 jobs. The company would shrink in headcount until 1994, down 45% from the start of his tenure, shedding 182,000 mostly US-based jobs. The full fate of these companies is not known; presumably, some were acquired for their patents and others for their factories. In at least one circumstance, the company’s products have survived. Malcolm Gladwell alludes to one company, GE Central Air Conditioning and Heating, being sold off to Trane, who still manufactures some air conditioning components in the US. While it is reassuring that survival and success is possible outside GE, few seem to have survived.
5. To drive market-leading returns, Welch put financial engineering ahead of mechanical engineering.
GE had been and would continue to be an innovation-focused company that intended to research and develop technologies, especially in materials science. However, those returns were insufficient to distinguish GE to investors. Welch sought capital-light businesses to augment the profits of his hardware lineup5. Welch leaned into services and financialization: extending credit to customers to earn interest on their purchases. It was a new way to monetize their existing customer base that did not require additional capital. “And you don’t have to build a factory,” as Welch said. In the same spirit, GE would become an early entrant in “software in a box” through the predictive maintenance software, a complement to their existing industrial equipment that they only had to build once and could sell to their current customers. In 1980, products represented 85% of GE’s revenue; by 2000, services represented 70%.
GE was truly transformed. They were no longer a company making life better in people’s homes and work. Under Welch, they existed to make the number (profits) go up, even if it meant borrowing from the future. GE became a financial services giant, with internal incentives that put financial engineering before mechanical engineering. Building a new factory was effectively betting your career, a move that only made sense if the competition was going to kick you out of the top 2. This new strategy still pushed progress forward in meaningful ways, thrilled investors, and sustained for over 20 years. It would continue to serve GE for 7 years after Welch’s retirement, a kind of “coyote time” where Wile E. Coyote has gone over the edge of the cliff. In 2008, the company faced an existential threat from the financial crisis that simultaneously crushed the lending market, re-priced bad debt GE had issued, froze credit markets that GE relied on for liquidity of their operations, and reduced demand for industrial products. GE’s stock would fall over 40%. The company would continue to contract until it finally broke apart in 2024. GE’s rebirth was only a reprieve, the hour was much later than they believed, and there was no more future to borrow against.
Defining Welchification and How to Avoid It
Welchification is the strategy of deprioritizing physical world progress in the face of declining returns on those assets. Financial products that make technology easier to buy and software that improves the usefulness of machines are incredibly important to making industrial technology successful—companies need those profits to be able to continue driving material progress—but when such products represent 70% of a company’s revenue, something has gone seriously wrong.
Welchification puts profits before any logical connections in the business i.e. a lack of focus. At some point, all material progress is limited by physics. When that happens, how do you find new growth? GE got real weird with it, making jet engines but also buying NBC (which gave us 30 Rock so I can’t complain too much). In contrast, car companies like Tesla look to move into new vehicle styles at different prices before shifting to new, tech-powered business models like robotaxis. While their ability to execute on this vision is in question, at least there is a logical progression from one technology to the next. Apple looks for new paradigms of personal computing, from your pocket to your wrist, ears, and eyes. These progressions build on one another, taking a technology for an application space to maturity then finding a new wave to follow. It helps that these are companies with a digital component that can follow wherever Moore’s Law takes them. Analog businesses like housewares have no power law driving their improvement, save for the manufacturing plant. Reindustrializing must embrace the power laws that they have.
Welchification prioritizes investments that deliver high-certainty results over the lower-certainty results later that might deliver bigger profits. Jeff Bezos, founder, executive chairman, and former CEO and president of Amazon, alluded to this problem in his original 1997 Annual Report: “We believe that a fundamental measure of our success will be the shareholder value we create over the long term.” Every year until his retirement as CEO, he revisited this thread and linked his original paper. In 2016, he wrote about what Day 2 looks like: “Day 2 is stasis. Followed by irrelevance. Followed by excruciating, painful decline. Followed by death. And that is why it is always Day 1. To be sure, this kind of decline would happen in extreme slow motion. An established company might harvest Day 2 for decades, but the final result would still come.” Post break-up, all three of the different GE business units have demonstrated growth and increased their market cap, in large part because they each only have one future to focus on and invest in.
To avoid Welchification, leadership needs to find new ways to drive progress in their product, operations, and manufacturing. Leadership needs to align their internal incentives with long-term shareholder value creation, such that teams can chase bigger opportunities without career-ending risk for experiments that do not work. Leadership must have a vision for why their products need to exist, then invest in it with conviction. The best founder-led companies do this today, often taking a short-term beating, but are rewarded long-term if their vision is right. The market will reward growth stories and focus, and the vision will energize teams through difficult periods. Leaders also need to be able to justify building new factories, ideally using their existing cash flow. They will still have to convince investors that they offer the best return on invested capital, and the best way to do that is with durable, growing free cash flow from prior investments. Industrial subsidy makes new factories easier to justify, but it is difficult to believe the US would provide subsidies indefinitely. At some point, these companies must be able to stand on their own. Rather than seeing factories as a weight around their neck, leaders need to see them as the product itself, a digital platform for driving innovation. A few key performance indicators if a US factory is an innovation driver are their ratio of robots to humans and their labor productivity (revenue per employee). In a country with relatively high wages, these measurements are critical to assessing if the company can produce sufficient goods and revenues for their investment. Ultimately, avoiding Welchification requires investing company capital to deliver long-term value for shareholders. Company leaders have to be looking at what it takes to make great products and developing the factories that make that possible. Amazon’s culture is a good model: a lean culture that constantly experiments, assesses effectiveness, and bets boldly when it sees an opportunity to win.
Investors should reward leadership teams that know how to wield their factories as competitive differentiators. It is a strategy that works,as evidenced by the valuations for Tesla, SpaceX, and now Anduril. Policy makers and citizens must expect some of these experiments to fail, but they should also expect new ones to rise in their place.
And if every company keeps coming to the same conclusion that building in the US is an unproductive use of capital, policymakers will need to partner with companies to better balance policy goals with material growth. Getting this right will deliver better products, profits, and material progress that, in Jason Crawford’s words, “moves us up the hierarchy of values, freeing up time, money, and energy spent on the basics and letting us redistribute them towards the fulfillment of a richer life.”
Thanks to Rob Tracinski, Shreeda Segan, Lauren Gilbert, and Jeff Fong for reviewing drafts of this post.
Charts primarily from GaTech AE6440, taught by Dr. Rick Gaeta in 2008
When I think of GE and the old school industrials that it competed with, I can’t help but wonder if today’s hyper scaling tech companies are unwittingly waltzing into the same trap. They’re spending billions in capex on data centers to power their ai dreams—the very same ai whose large language models increasingly look like commodities: these are in some sense latter day dishwashers and plastics from ge’s era. I know that Zuck et al see trillion dollar markets in the future, and Zuck et al are savvier operators than Welch ever was, but history is littered with examples of companies that invested heavily in capex, only to not have revenues sufficient to generate a return on that capex.
I think this is a good reason to be long China- they deliberately squashed their finance sector to try and discourage this, and their general strategy of becoming the indispensable industrial nation has been very effective, with the hits (killing off the non-Chinese solar industry) still rolling in.