Description
General Electric is a diversified company that is a microcosm of the global economy. GE owns world-class assets in engines, power equipment, medical imaging and healthcare, appliance manufacturing, media, and water infrastructure, as well as commercial and consumer finance. With a 3% real dividend yield and a 50% payout ratio, GE is trading at under 15x FY2007 earnings estimates of $2.25 per share. The valuation of GE relative to the 10 year Treasury, TIPS, and small-to-midcap US stocks is currently at historically cheap levels.
As one of only six Triple A rated industrial companies in America, over 30 years of growing dividend payments, over 100 years of consecutive dividend payments, a strong buyback program, and the only remaining member of the original Dow Jones Industrial Average, GE presents a low-risk, exciting investment opportunity for investors over the next 3-5 years. GE is likely to perform well in a slowing economic environment in the US and experience multiple expansion and earnings growth in a base-case scenario. Alternatively, GE will at the minimum be an excellent defensive stock if the market declines significantly and/or the economy enters a recession.
This report will argue that GE’s low valuation is due to several reasons. 1) Mega-cap companies usually trade in a group and are very cyclical. For understandable reasons, small-to-midcap stocks in the United States have had relative leadership in the market since the vicious sell-off of 1998 until the first quarter of 2006. A lot of analysts and investors erroneously think this will last forever. GE and other mega-caps including conglomerates were overvalued in the late 1990s. Investors have a difficult time understanding and/or are apathetic now that GE is undervalued eight years later. 2) The “natural” owners of GE who are large mutual funds have weak 1, 3, and 5 year performance according to the Lipper rankings and thus are having a difficult time raising money from individuals and institutions who have been mostly speculating on housing, commodities, hedge funds, and/or emerging markets. 3) Since the October 2002 / March 2003 bottom, watching the VIX was like seeing paint dry, the Federal Reserve has been on auto-pilot, and very few investors have taken the prospect of risk seriously. In this type of environment coming out of a recession, the safety, diversity, and durability of GE’s earnings stream and dividend mattered little to investors who felt invincible and flocked to the most speculative parts of the market. 4) Hedge funds have become the new asset class de jour. Value investing in small-to-mid caps has never been more popular. Even on VIC, it is nearly impossible for any company to get a good rating unless it is a misunderstood spin-off or breakup where the numbers are sandbagged, a company emerging from bankruptcy that will beat the plan, no analyst coverage, in a cyclical business, or international in nature. Over the last two years, only two large-cap companies (Viacom and Tyco) have received 6.0+ ratings and both of them were spin-offs.
Company-specific reasons include: 1) Investors believe that GE is too big to grow at the same rate it has in the past. 2) Growth opportunities in China and India among other emerging markets are being given little to no option value. 3) The market does not believe organic revenue growth can be 5% - 8% in the future and that total earnings growth can exceed 10%. 4) GE is perceived to be a financial services company in disguise supposedly warranting a lower multiple comparable to Citigroup, JP Morgan, and Bank of America due to its ‘black-box’ nature. A lot of investors do not understand the business profile of GE’s financial services businesses, what the risks are, and how the business has changed recently.
With clear evidence of housing and commodities slowing, weakness at the consumer level, the inverted yield curve, and the economic expansion into its fifth year, the time is right for GE to come back into favor among investors as its irresistible combination of stability and solid relative earnings growth will attract investors as it has done in countless number of economic and market cycles—most recently in the ‘Goldilocks’ period from 1994-1998.
Business: GE is a diverse company with the following business breakdown in order of size.
Global Infrastructure: 35%
Commercial Finance: 20%
International Consumer Finance: 11%
Industrial: 10%
Healthcare: 10%
Media: 10%
US Consumer Finance: Only 4%
Misconception about GE: We believe that GE is too big and diverse for investors to have much of an edge analyzing the individual prospects of each business. For more information, please review GE’s Annual Report and/or sell-side research. Performing field checks, talking to customers, or meeting with suppliers is not going to add much value. A lot of people on VIC do not want to invest in equities where there is no information edge.
On a company-specific level, the important thing is that GE is not a US financial services heavy company anymore given the Genworth Financial IPO and secondary offerings complete as well as reinsurance having been sold to SwissRe. Both are low-multiple businesses. However, GE is now a low-cost provider of global financial services with a bullet-proof credit profile. GE generates returns from its intimate understanding of niche business and consumer markets and its low cost of capital. GE is neither a broker-dealer as it terminated Kidder Peabody in 1994, a retail bank serving Mom and Pop customers since it owns no retail branches in the US, nor hedge fund in disguise.
If anything, relative value investors should compare GE to Berkshire Hathaway instead of bulge bracket firms and large commercial banks. GE is adamant about the fact that it seeks a matched book. The low volatility of its financial services profits over time speaks for itself. In addition, GE makes a conscious effort to generate returns from fees and originations during times such as today when risk is under-priced and there is strong appetite for all types of paper. GE tends to use its balance sheet during weaker times.
Currently, a lot of analysts are encouraging GE to spin-off the entertainment unit because of underperformance, but we believe this perception is being driven by a cyclical distrust of conglomerates and large companies. The pervasiveness of this group think has caused several media, industrial, and business services companies to believe that breaking up is a permanent solution to business issues and will lead to higher valuations by the market. Maybe some of these companies will benefit from the split-ups, but it has yet to be proven. With the breadth of GE’s businesses, it is likely that from time to time certain businesses will experience short-term hiccups or potentially even experience secular issues, but in aggregate they are unlikely to result in declining earnings over the long-run.
Specifically, we believe a lot of investors are misunderstanding GE’s businesses. From a big picture perspective, a majority of GE’s earnings come from late-cycle plays including infrastructure, commercial finance, energy, and industrial. This is demonstrated by the fact that GE’s revenues and operating profits were not particularly strong out of the gate in 2002-2003 after the 2001 business recession. If the housing slowdown and recent weakness in the consumer continue as the inverted yield curve and other data points suggests is likely, we believe GE’s strength in the latter part of the economic cycle will help improve investor perception.
In 2002, a lot of noise was made by Bill Gross and other experts about GE’s funding strategy and reliance on inexpensive commercial paper funding to support its growth. Previously, GE exploited its strong reputation in the capital markets to fund many acquisitions in 2001. The committed bank facilities in place to back its CP program were not reassuring. In addition, GE’s pension plan used to be under-funded and there were some questionable gains booked through the P&L in 2002 and 2003. Earnings Per Share was not correlating with Operating Income.
Whether or not this was responsible is up to debate, but GE now has a fully-funded pension plan using very conservative assumptions and increased committed bank facilities in place. In 2003, Bill Gross eventually admitted he was aggressively buying GE paper in the market shortly after making his controversial remarks. Three years later, operating free cash flow minus maintenance capital expenditures is growing much more rapidly than many expected, new orders and the company backlog are robust across its business lines, and GE has an excellent liquidity position to support a growing dividend, capital reinvestment, and stock buyback program. In the future, we believe 110 years of unparalleled excellence is sufficient for GE to use its low funding cost to support its acquisitions and internal growth globally, especially given the low risk premium for other pieces of paper. We expect the company to use unsecured paper to make many global acquisitions to enhance its footprint.
Will the capital markets freeze funding on GE? Maybe, but this scenario is extremely unlikely and difficult to imagine.
International Growth Opportunities: In 2005, approximately 52% of GE’s revenue was generated from outside the United States. Specifically, developing markets are likely to contribute 15% - 20% of GE’s revenue in the next couple of years. Many investors may not know that GE started doing business in China and India before World War I and it would be one of the largest companies on a stand-alone basis in either country.
CEO Jeff Immelt has publicly stated that revenue from India will grow over 50% a year over the next several years to $8 billion by 2010. For example, GE has established a partnership with the State Bank of India to sell financial services to millions of consumers through branches and wholesale relations. GE’s expertise in infrastructure has allowed the Company to make significant inroads in India. In addition, GE has indicated sales in China are growing over 40% annually as of the second quarter of 2006 and Immelt has guided investors to similar growth targets as India. Revenues in China were over $5 billion in 2005. FYI, Citigroup has an excellent report from June 19 illustrating the growth opportunities of China and India.
On April 26th 2006, Immelt stated that revenue from emerging markets could double from $25 billion in 2006 to $50 billion in 2010 led by growth in infrastructure and financial services. While this goal may seem aggressive, we believe this profit stream and option is extremely valuable regardless if Immelt’s aggressive targets are reached. At least some of GE’s businesses should have relevance to emerging markets. Investors who are rightfully optimistic about the prospects of emerging markets will eventually realize owning equity in GE is an ideal, low risk way to capture this upside.
Management Guidance: Over a full economic cycle, management has guided investors to 8% revenue growth or two to three times global GDP and earnings per share growth over 10%. This organic revenue growth estimate was raised from 5% in 2004. Given that GE is a disciplined acquirer of businesses with a proven ability to integrate better than almost any company in the world, we believe these targets could potentially be exceeded. It is strange to us that that the market has such little respect for GE’s growth plans given the strong history of execution, several recent insider purchases by Immelt and other Directors at comparable price levels, and reasonable assumptions. With a 3.0% dividend yield and management’s estimate of over 10% earnings growth, GE could generate a nominal return of 13%. This yield relative to Treasuries at 5.2% and inflation expectations currently around 2.5% over the long-run is quite attractive.
Price Target: We believe that GE is currently undervalued based on intrinsic value. The diversity of GE’s business units and the unparalleled success of the conglomerate over all types of economic environments combined with strong free cash flow and high incremental return on invested capital is attractive. If earnings and dividends can grow 8% to 10% a year in the next 10 years, which is lower than management’s guidance and significantly lower than the 12% rate at which GE grew over the last 30 years, then we believe GE deserves a P/E multiple of 20x to 23x forward earnings based on a cost of capital of 6% - 8%. This is a reasonable premium that is 140 bps above GE’s 10 year paper and 200 bps over the 10 year swap curve at 5.7%. Low tax rates on long-term capital gains and dividends after the 2003 tax cuts relative to Treasuries as well as decreased transaction costs are also solid reasons to support multiple expansion for GE.
In three years, we believe GE will be valued at approximately $60 a share based on analyst estimates of $2.75. Including dividends, investors could receive a return of approximately 20% per year with very low risk.
Earnings Dividends
FY2006: $2.00 $1.00
FY2007: $2.25 $1.12
FY2008: $2.50 $1.25
FY2009: $2.75 $1.37
If the economy experiences a recession that affects business and consumer spending, we believe GE could miss FY2009 earnings estimates by 25% and earn around $2.00 a share—which is the FY2006 estimate. Given the strong balance sheet and solid history of the company, we believe a worst-case 13x multiple on depressed earnings would likely result in a $30 stock price in three years including dividends. However, this multiple is very unrealistic in our opinion unless 10 year Treasury rates rise to 10%+.
The ironic thing about GE is that all of the dumb money investors who were willing to pay any price in the late 1990s and during the Nifty Fifty period were generally right about the big picture. In the future, GE will be well positioned to benefit from global growth in emerging markets such as China and India in addition to continued moderate growth in the US and other mature countries. There is no substitute for buying a great business that pays a nice dividend and grows its earnings steadily each year provided the price is reasonable.
A lot of small-to-midcap value investors will have difficulty understanding how and why paying a relatively high multiple for GE is better than paying what appears to be a low multiple of earnings for weaker, smaller businesses in many cyclical industries that have questionable sustainability of earnings power.
We are confident sentiment will eventually change—it’s more a question of when, not if.
Options: We believe GE options are a lucrative way of capturing the upside in the stock price because of the low implied volatility due to low interest rates and a tight trading range recently. The price of January 2008 $30 calls is only $5.80 and the $40 calls are only $1.15 on a stock price of $33.33. If GE stock appreciates to $50 by January 2008 which is very reasonable, the $30 calls and $40 calls would provide upside of 240% and 770% respectively. The implied premium including dividends is under 8%.
Risks
1) The strength in the economy continues. GE continues to grow but experiences multiple contraction or stagnation. Investors prefer riskier assets for longer than we think.
2) Interest rates go to 10% or higher and the earnings and dividend yield are not as attractive to TIPS. Profit margins decrease and GE does not grow earnings for some time.
3) GE does a poor job allocating capital in the 21st century by overpaying for acquisitions and spending too much money on R&D.
4) GE fails to gain any traction in emerging markets and the United States economy experiences Japanese like deflation.
5) GE Capital experiences a six-sigma event and blows up. In a less dramatic scenario, GE has to hold more capital like Fannie Mae and Freddie Mac or experiences significant price competition thus depressing ROE.
Catalyst