General Electric Company (GE)

Around April 15th 2008, 256-point drop in the Dow, precipitated by a surprise earnings miss from General Electric (GE), reminded investors that this remains a volatile, high-risk stock market. GE's stock tumbled 12% on Friday after the company reported a sizable first quarter earnings shortfall ($0.44/share versus expectations of $0.51).

GE's current 3.7% dividend yield is roughly equal to the interest on the richest savings accounts. Moreover, in today's volatile market GE is relatively safe, sporting a β of only .8, trading within about 10% of its 4-year low and at a P/E of about 15 - the very low end of its 10 year range.

General Electric (GE), one of the largest and most respected companies in the world, has seen its shares drop nearly 24% from its 52-week high of $42. In April alone, shares dropped from $38 to $32, a 16% decline precipitated primarily by continued weakness in the financial markets. GE’s Q1 2008 earnings, announced on April 11th 2008, came in below both analyst and management expectations, missing the mark by nearly 14%. Blood in the Streets A certain investor once said that those who seek to invest intelligently should “buy when there’s blood in the streets.” Heeding this advice has served this particular investor well. In fact, it has made him the richest person in the world, and he goes by the name of Buffett. Warren Buffett. (Not to be confused with James Bond, although the similarities are striking.) See, Mr. Buffett believes that the price of a stock both rises and falls faster than the value of the underlying business. Thus, when blood is spilled, as it has been for GE, it’s a pretty safe bet that it was an over-reaction.

Now, don’t get me wrong, the Q1 results were pretty bad. Net profit and earnings fell 4% and 12% quarter-over-quarter, respectively. CEO Jeff Immelt, who – as recently as early March – re-affirmed prior guidance, is being raked over the coals for the underperformance. But it wasn’t all bad. Revenues rose 8% from Q1 2007, and strong global growth – 22% – provided hope that it would weather a significant downturn in the US economy. So if there’s a silver lining to be found, strong global growth in the Infrastructure segment would be it. A History of Excellence But let’s take a step back and take a birds-eye view, if you will (or even if you won’t), of the global powerhouse that is GE. Throughout its 115 year history, GE has had its ups and downs but it also has consistently increased shareholder value. (look at the prior reason)

The GE news was significant in several respects. GE is the second largest stock in the U.S. (only Exxon Mobil (XOM) is larger) and has long been considered a barometer of the U.S. economy due to the diversity of its business lines. GE has businesses in a multitude of sectors, including industrial equipment, health care, finance, energy, consumer electronics, and media.

Historically, GE has been a model of earnings consistency; the company last missed earnings in the third quarter of 2005, and then it was only by a penny. The size of GE's first quarter earnings miss (7 cents) is notable in and of itself, as is the fact that the weakness was highly concentrated late in the quarter, evidently surprising GE and leaving the company no time to guide down expectations in advance of the earnings report.

GE attributed the earnings shortfall primarily to its financial businesses; the company's CEO stated that "the extraordinary disruption in the capital markets in March affected our ability to complete asset sales and resulted in higher mark-to-market losses and impairment." But there was weakness in other key GE business units (e.g. industrial and medical) that were simply reflective of a weak economy.

The GE earnings miss was not the only data point on Friday signaling a recessionary economy. The University of Michigan reported that its Consumer Sentiment index fell to a new 25-year low, dropping to a level not seen since 1982, which is not surprising given declining household net worth (on account of falling home and stock prices), $111 oil prices, and a weakening employment market.

Markets are likely to remain choppy and volatile over the coming fortnight as the bulk of first quarter earnings reports are released. We expect that, on balance, such reports will contain more negative than positive surprises. It will be instructive, however, to observe how investors react to the coming earnings news.

Given the heavy pessimism that now exists, which suggests that expectations are quite low and that there is a lot of liquidity on the sidelines, it is possible the stock market may hold up reasonably well in the face of bad news and rally on any good news. Psychology could conceivably shift towards the notion that the first quarter will represent the trough in corporate earnings, and that the worst of the housing and credit crisis is behind us. We don't share this view, but it may come to predominate for a period of time.

One of the main knocks on GE is “earnings quality.” Analysts have knocked them over low tax rates and this past quarter, their financial engineering (or lack thereof). One of the complaints is that much of their other business comes from asset sales (some of which didn’t come off this past quarter, hence the Q1 disappointment) and so there is an aspect of uncertainty. But a quick look at the past 5 years shows that GE has averaged $22B in free cash flow. Keep in mind this is based on operations (FCF = OCF - CapEx). Tallying items classified as “sale of business” or “sale of fixed assets”, I get a 5-year avg average of $14.5B from these sales so it’s not as if GE is utterly dependent on exits to run their business. And if you are going to criticize GE as a pseudo-financial company, then apply that standard across the board. How many financials can borrow money with a AAA rating, have access to cash flow many levels removed from the credit crunch and don’t have liquidity issues to the same extent as other financials?

Through dividends, which have been increasing steadily since 1962, stock buybacks ($1 billion worth in Q1, 2008) and earnings growth, GE shareholders have been treated very well. The financial markets are in unchartered waters right now, but they will emerge from the crisis and so will GE. In a few quarters when all this has blown over, GE will continue along the same path it has been for over a century. And you’ll have pocketed some seriously sweet dividend payouts. In the interest of full disclosure, the author of this article does not hold any positions in any of the companies mentioned.

GE is one of the market's most consistent performers. At $35, it boasts an attractive 3.5% yield and trades at a P/E ratio slightly above 16, below its long term average. Given that GE is well positioned (through its diversification and global operations) to weather a slowing economy, its shares may outperform the broader market. The company has a market cap of 335 Billion, and for the past five years, has steadily increased its revenue YoY, earnings per share, dividends and per share book value, yet its share price has gone literally nowhere.

GE's main segment is its financial segment, so it may be a stretch to equate GE's troubles with the broader economy at large. The earnings miss was largely predicated on writedowns and missed targets in the financial segment. But the healthcare segment also disappointed significantly, making it difficult to dismiss this as solely a credit crunch phenomenon.

My sense is that they would do well to divest themselves of NBC, which is poorly run from my view in the cheap seats (just go to the CNBC website, which can't seem to update podcasts, or MSNBC, which can't stream video properly). The financial segment seems a bit of a black box. Healthcare apparently is vulnerable and faces regulatory issues. Everyone loves their infrastructure and energy segments but apparently those can't pull the train.

Immelt had been under a low-pressure cooker to do something about GE's stock price; after this miss, I imagine the heat will be turned up and if things don't turn around soon, his position will be threatened, which would be a negative in my mind. But at some point, the stock's got to move up or he will be gone.

The current turbulence in 2008, is just noise in a crazy market. In the intermediate to long term, GE will grow its business and increase its dividend at a steady pace. My quick DCF analysis shows GE is undervalued by at least 20%. Will this stock double in the next 2 years? Probably not but if they can get back on track, there’s no reason we won’t see $40 again in the relatively near future and if the market really tanks, you’ll get a chance to buy a nice dividend yield and wait it out. Even in a “post-American-superpower” world, GE will be a prominent player so we should have some cushion against the weakening dollar.

Apart from the main reasons, there are various other factors which point at GE being a great buy: 1) GE stock is significantly oversold, indicative of a bottom.

2) GE insiders have started buying shares in the open market.

3) GE can borrow at decreasing costs, while most competitors have to pay more.

4) The writer's strike is finally over and NBC Universal can contribute an increasing share to GE's profitability.

5) Expect GE's under-appreciated Healthcare segment to improve performance – there is pent-up demand.

6) GE will grow foreign revenue, especially in emerging markets – China Olympic Games projects are especially important.

7) GE Energy is the only US based company that has the technology to build a nuclear power plant and has the most advanced design for a safe nuclear power plant. Reservations have to be made, the money will roll in eventually, not all the plants will be built and GE might have to share the revenue with other possible partners, but the growth potential here is huge for GE, estimated to increase revenue by atleast 10% (huge considering GE has revenues of a shade less than $50 Billion).

GE also has leading edge geothermal products – the way of the future for commercial heating in extreme climates, as well as leading edge wind turbines as well as a range of solar products. Granted that they catch only 12% of the energy at present, the efficiancy rate of the solar panels has been steadily increasing and is expected to commercialization very soon.

GE's current 3.7% dividend yield is roughly equal to the interest on the richest savings accounts. Moreover, in today's volatile market GE is relatively safe, sporting a β of only .8, trading within about 10% of its 4-year low and at a P/E of about 15 - the very low end of its 10 year range.

In Q2 2008, GE's orders grew 30% more than shipments, increasing its backlog during this period. This strong demand is largely caused by the international infrastructure boom being driven largely by the BRIC countries- in spite of slow economic growth in the US and Western Europe. This trend should continue and spur continued demand for GE's products, replacement parts, and service contracts.