I’ve been pretty circumspect about how I’ve been deploying capital lately, keeping a fair bit in cash given how frothy the market – and especially dividend equities – have become right now.
That said, there’s a cost associated with every choice, and by keeping so much tied up in cash, I’m also eroding the value of my entire portfolio as the silent killer of wealth – inflation – continues it’s inexorable march upward.
So recognizing that no one can know for certain what will happen, least of all me, I will continue to deploy a limited amount of capital cautiously, into companies that I believe I understand, and that I analyze to be trading at or below “fair value.”
As such, on 10/7/16, I added 100 shares of General Electric (GE) to my FIRE fund at a price of $29.14 per share for a total purchase price of $2,921.95.
Earlier this year on July 27th I purchased 86 shares at $31.50, so if I thought that the price was fair then, naturally I was glad to see the cost come down even further.
In this article I’d like to explain why I think GE makes for a rather solid investment choice in a rather uncertain world.
General Electric was formed in 1892 and is one of the largest and most diversified industrial conglomerates in the world.
GE is currently in the midst of a massive portfolio transformation, and reshaping itself into the world’s first “digital industrial company,” and a “simpler, more valuable company.” (2015 GE 10-K)
At a high level their transformation strategy is to put dedicated digital resources at the core of each business and divest some of their less competitive businesses like appliances & GE Capital.
It’s hard to talk about GE monolithically as a company since it’s such a large, sprawling conglomerate encompassing diverse businesses, so in order to understand the opportunities and risks inherent in GE, we have to look at the businesses that comprise it, as follows:
The GE power segment is designed to provide power generation and water technologies to its’ customers.
Major products include: power generation services, gas turbines, engines & generators, steam turbines & generators, nuclear reactors, and water systems.
Revenues in this segment have increased from $19.3Bn in 2013 to $21.5Bn in 2015, Margins are at 20.9%, up 20 basis points from the previous year.
Power has a backlog of $77.1Bn, with an additional $50Bn backlog added by its $10Bn acquisition of Alstom power.
Positives of this segment include continued growth in natural gas supplemented by the Alstom acquisition. Negatives include excess capacity in developed markets with continued pressure on oil & gas applications
Outlook: Improving global competitive position despite intense competiton & positioning the business for growth with Alstom.
GE Renewable Energy
The renewable energy segment is dedicated to making renewable power sources affordable & accessible to people everywhere.
Major products include: onshore & offshore wind turbines, hydropower plants, solar power plants, geothermal power plants, and biomass power plants.
Revenues in this segment have increased from $4.8Bn in 2013 to $6.38Bn in 2015. Margins are at 6.9% down 390 basis points from the previous year.
Renewable energy has a backlog of $12.4Bn, up 123% from the previous year (Again, driven largely by Alstrom).
Positives of this segment include that this is the fastest growing energy market & a continued push towards carbon-free energy. Negatives include challenging new product transitions in onshore wind.
Outlook: Positioning the business to deliver high returns
GE Oil & Gas
The oil & gas segment provides products & technologies to bring this energy to the world.
Major products include: Surface & subsea drilling & production systems, floating production platform equipment, mechanical drives & compressors, artificial lift solutions, and sensing & inspection solutions
Revenues have decreased from $17.3Bn in 2013 to $16.5Bn, due to continued pressure on oil & gas prices. Through cost reductions, margins have increased to 14.8% up 30 basis points.
Oil & gas has a backlog of $22.9Bn, down 9% from the previous year.
Positives of this segment include a demand for technical & value oriented solutions. Negatives include continued pressure from oil prices, excess capacity & lower customer capital expenditures.
Outlook: Improving competitive position in a tough environment through cost reductions & strategic investments
The goal of the energy management segment is to be a technology leader for the transmission, distribution, and conversion of electrical power.
Major products include electrical distribution & control products & services, lighting & power panels, grid management products & grid modernization services, industrial automation & software solutions, advanced motor, drive, & control technologies.
Revenues have remained flat between 2013 – 2015 at $7.6Bn. Margins are up 20 basis points to 3.6%
Energy Management has a backlog of $11.7Bn, up 134% from the previous year (primarily driven by Alstom acquisition).
Positives of this segment include grid solutions growth through Alstom, strength in electrification, and more renewables on the grid
Negatives include continued pressure from oil prices & excess capacity.
Outlook: Positioning the business for long-term growth & margin expansion with Alstom.
The goal of the aviation business includes providing aviation customers with technologically advanced and productive engines, systems & services.
Major products include jet & turboprop engines, components for commercial, military, and general aviation aircraft.
Revenues have increased from $21.9Bn in 2013 to $24.7Bn in 2015. Margins are up 160 basis points to 22.3%
Aviation has a backlog of $151.2Bn, up 13% from the previous year
Positives of this segment include lower fuel costs & continued strength in air passenger traffic. Negatives include uncertainty around military spending.
Negatives include continued pressure from oil prices & excess capacity.
Outlook: Positive, delivering through commercial product transition
The goal of the healthcare business is developing transformational medical technologies & services that are shaping a new age of patient care.
Major products include diagnostic imaging systems (MRI, etc), surgical imaging products, ultrasound, and research tools.
Revenues have decreased slightly from $18.3Bn in 2014 to $17.6Bn in 2015. Margins are down 40 basis points to 16.3%
Healthcare has a backlog of $17.2Bn, up 4% from the previous year
Positives of this segment include continued growth in developed markets and demand for IT/ analytics based solutions.
Negatives include pressure in emerging markets.
Outlook: Positioning the business for long term growth.
The goal of the transportation business is being a global technology leader & supplier to the railroad, mining, marine, stationary power, and drilling industries.
Major products include locomotives, diesel engines, drilling motors, mining equipment and propulsion systems, motorized drive systems, software & analytics solutions to optimize rail & mining operations.
Revenues have been flat between 2013 and 2015, at $5.9Bn. Margins are up 150 basis points to 21.5%.
Transportation has a backlog of $22.4Bn, up 6% from the previous year
Positives of this segment include digital & global expansion.
Negatives include decreased North American locomotive usage & global commodity price pressure.
Outlook: Navigating a highly dynamic industrial environment by launching new products & transforming business to align to a more global/ digital future.
GE Appliances & Lighting
The goal of appliances & lighting is leading a global lighting revolution to deliver innovative solutions that change how people light and think about their world.
Major products include home appliances (which were sold to Chinese company Haier earlier in the 2nd quarter of this year), lighting products & services, and industrial-scale lighting solutions.
Revenues were up slightly from $8.3Bn in 2013 to $8.8Bn in 2015, with margins up 260 basis points to 7.7%.
Positives of this segment include “LED market momentum” with negatives including a continued decline in traditional lighting.
Negatives include decreased North American locomotive usage & global commodity price pressure.
Outlook: As mentioned, GE concluded their sale of the appliance business earlier this year. GE will continue to grow LED lighting solutions.
GE Capital’s sprawling finance business was a huge money maker in the years before the 2008 financial crisis, but quickly became an albatross as frozen credit markets nearly brought the entire institution to its knees.
In April 2015, GE Chief Executive Jeff Immelt said the company would largely disband GE Capital, to focus on its industrial assets, and they have been unwinding $200 Billion of GE Capital businesses since.
As such, GE has transformed its capital division into a smaller, safer financial services company that will remain a part of their “GE Store,” a group comprised of all the businesses that supports all the other businesses at GE.
As mentioned, GE is a company in the midst of a fairly exciting transformation.
Its acquisition of Alstom was arguably one of the best in the company’s history. It has moved aggressively to divest itself from it’s GE Capital assets. It has shed it’s appliances division, a streamlining-oriented removal of a somewhat immaterial portion of GE’s overall business. This narrowing of focus will ensure the GE can marshall all its’ resources towards industrial segments where it has a significant competitive advantage.
Moreover, GE has recently strategically acquired two European 3D printing companies which is positioning the company well for the growing 3D printing market in the coming years. In my opinion, 3D printing will be the next technology to revolutionize manufacturing in the next several years. If you’re looking to capitalize on this trend in the long term, GE would be a great way to gain 3D printing technology exposure.
3D printing is the translation of “digital to physical reality.” Here’s an example of 3D printing an Eiffel Tower in under seven minutes:
Further, GE has an aggressive plan in place to allocate capital back to shareholders through dividends and buybacks.
GE generates cash from:
- Operating activities
- GE Capital asset sales
- Synchony Financial split-off
- Other dispositions
This will give the company $145Bn in capital to allocate through 2018 (plus potential leverage opportunity).
The company plans to allocate this future capital as follows:
- Return $55Bn to shareholders via buybacks
- Sustain the dividend of $35Bn
- Reinvest in organic growth
- Disciplined M&A (that feeds GE strategic momentum and are accretive to the business)
In 2016, GE is expecting organic growth of 2-4% and core margin expansion to drive operating earnings per share to a range of $1.45-$1.55 and has a forward P/E of 16.9.
Cash from operating activities is expected to exceed $30bn for the first time since 2012.
GE has strong liquidity, which is key to ensuring the safety of the dividend. Moreover, as noted above, they have an extremely strong and growing backlog of ~$320Bn of business, with major cost cutting programs underway which gives the business resilience and the ability to deal with anything the economy might throw at it.
The firm has a balanced capital allocation strategy with significant cash returned to shareholders in recent years. Emerging market growth and infrastructure investments are key sources of investment.
GE boasts a nice dividend yield at 3.16%. The firm has paid an amazing $150+Bn in dividends to investors since 1970 and expects to return another $8Bn in 2016.
The best measure of a firm’s ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (WACC). The gap or difference between ROIC and WACC is called the firm’s economic profit spread. General Electric’s 3-year historical return on invested capital (without goodwill) is 26.1%, which is above the estimate of its cost of capital of 8.9%. (Valuentum)
Fair Value Estimate
The value of a company is equivalent to the amount of cash that you can extract from the business over its lifetime. Because that amount is inherently unknowable, and ostensibly because a dollar today is more valuable than a dollar tomorrow (in most cases, notwithstanding negative yield environments around the globe), estimates on fair value tend to vary from source to source.
Based on a discounted cash flow (DCF) model, GE is worth $32 per share, with a fair value range of $27-$37.
This fair value range assumes a range of plausible scenarios, with a compound annual revenue growth rate of 2.5% for the next five years (higher than the firm’s 3 year historical rate of -7.3%), and an operating margin of 18.6%, above their trailing 3 year average, and assuming beyond year 5 free cash flow will grow at an annual rate of 2% for the next 15 years and 3% in perpetuity, and further using an 8.9% weighted average cost of capital.
Please note that fair value estimates can never be fixed in stone as one single number, given that these estimates are derived from plausible estimated scenarios. Thus one might have a pessimistic scenario, and an optimistic scenario. These calculations by definition would provide a range of potential “fair values.”
Addressing the Bearish Thesis
GE has had some bad luck in recent years.
The once-sprawling conglomerate was hit hard during the financial crisis and it was forced to slash the dividend during that time. But it’s now moving back to its’ roots with its acquisition of Alstom and divestiture of many of it’s financial assets. The executive team has taken its fair share of lumps, but GE will once again have its’ day.
As of late GE’s share price has been on a negative downtrend:
3 Month Share Price, Source: Google
It appears forward looking assumptions surrounding GE’s industrial-focused operations, and weakness in Honeywell’s aircraft shipments have been the source of investor concern (Honeywell’s weak guidance spooks investors in industrial shares). Though GE’s backlog continues to climb, total orders fell 2% (partially buoyed by recently-acquired Alstom orders, services orders, and the growing GE Digital segment) in the second quarter from the year-ago period.
Organic orders fell 16% in the quarter, as equipment orders were materially pressured by market weakness in its Oil & Gas and Transportation segments and its Power and Aviation segments’ reported order growth suffered from strong performance in the comparable period in 2015. Despite the weakness in its equipment orders,services orders are up 9% in the quarter, which are the basis of its massive backlog and consist of attractive long-term contracts. (Valuentum)
Though many investors collectively may not have been pleased with GE’s quarterly report, GE’s massive backlog is evidence that its businesses remain as durable as any other point in its 120+ year history.
GE is in the midst of an exciting transformation, and is currently fairly valued, which isn’t a particularly bad thing given the safety of the company and potential volatility around the corner that the market has been fearing with potential rising rates and political/ global slow growth & uncertainty.
The company has kept momentum of its GE Capital exit plan, having signed $181 Bn in asset sales, completed its de-designation of a significantly important financial institution (SIFI), and closed GE Asset Management. This increases GE’s financial flexibility going forward.
Certainly, no one can predict with certainty what will happen in the future. What we do know is with a long enough time horizon, the market becomes a weighing machine, not a voting machine (so says Uncle Warren).
Market timers and traders among us could think about setting a limit order for $27, or writing $27 puts, to generate income while potentially entering a position at a better price. If the stock corrects to this level, I would consider adding more shares to the fund.
In short, I believe that GE is a core, safe, “steady Eddie” company to hold for the long run, as well as through the potential uncertainty of the next few years. The dividend is safe, supported by robust cash flows, and a slight blip in GE’s orders of late hasn’t muddied the broader, brighter picture, as the company continues to get leaner & transform itself into the world’s first digital industrial company.
Based on the current $0.92 dividend, this purchase will add $92 to my yearly forward passive income stream.
Thanks for stopping by. Please me know if you have any questions or thoughts about this purchase in the comments below!
Disclaimer: I make no claims as to the accuracy of any of the information in this post. As with everything on this site, information provided is for lulz & informational purposes only. As you can probably tell, I am not an investment professional, in fact, I nearly flunked out of finance class, and so I would just caution you with that before you make any investment decisions based on what some guy on the Internet believes.
Full disclosure: I am long GE