Absent A Quick Turnaround In Power, GE Has Gone Far Enough For Now

By Stephen D. Simpson, CFA | June 13, 2013 AAA

General Electric (NYSE:GE) has been one of my go-to industrial stocks since around mid-2009, and the stock hasn't disappointed in that time – rising more than 140% and besting the return of the S&P 500 by about 30% or so. Companies and stock picks are always fluid, though, and the recent developments in GE's industrial margins and free cash flow (FCF) generation haven't been all that positive (particularly in power). While some of this is cyclicality and some is likely growing pains, a somewhat longer ramp back to strong operating performance leads me to think that GE is close to fair value absent a big turnaround in industrial demand and/or margins at GE.

SEE: Turnaround Stocks – U-Turn To High Returns

Power Is A Tough Business
GE's recent performance in power and water – revenue down 26% in the first quarter, with margins down more than 300bp – is not exactly out of line with what we've seen from other power-oriented companies like Siemens (NYSE:SI) or SPX (NYSE:SPW), but that doesn't make it any better. While the thermal side of the business is doing pretty well (gas turbines), the wind business is getting hit hard these days.

Over time, I think this will reverse. GE has taken the lead from Vestas in wind turbines, and the economics of wind power are such that I think it will be a viable long-term opportunity, but it will take time for the industry to absorb the impact of lower subsidies and regulatory uncertainties. On the thermal side, I like GE's position quite a bit – the company is a leader in gas turbines, which I expect to be in even higher demand in the U.S. and China over the next decade or two.

For now, though, this is likely to be a volatile business with uncertain margins and free cash generation.

SEE: Free Cash Flow Yield: The Best Fundamental Indicator

Oil, Gas, And Mining – Building For A More Lucrative Tomorrow
GE has become a real player in the oil and gas equipment space in a relatively short time, largely through multiple acquisitions. The company is also starting to repeat that pattern in the mining industry, though on a smaller and more restrained scale thus far.

Unfortunately, these aren't the best of times in these markets. Rivals like National Oilwell Varco (NYSE:NOV) are seeing orders pick up and GE is doing particularly well in its subsea operations, but the margins have yet to really materialize and likely won't for at least a year or two. In the mining business, GE still lacks the scale to really operate efficiently, and the ongoing downturn in the coal market isn't exactly helping.

Like the power business, though, I believe these trends will reverse. Energy/resource equipment is always going to be a more cyclical business than GE's historical trends, but it's difficult to see how the world is going to meet economic growth and power generation targets five and 10 years down the line without significant investments in the sort of production equipment that GE sells.

SEE: The Ups And Downs Of Investing In Cyclical Stocks

GE Capital Well On The Way Back
The turnaround job at GE Capital has proceeded to a point where the business is no longer a problem asset for GE and it is contributing worthwhile dividends to the parent company. To that end, I think it's reasonable to assume that the business will once again generate returns on equity (ROE) near 10% for the long term.

What's less certain is the shape and size of GE Capital in the coming years. It's largely accepted as fact now that GE will exit the private label credit card (PLCC) and retail operations, most likely through an IPO (though I would think there would be strategic buyers for PLCC). All told, shrinking GE Capital is not a bad idea as it will reduce the discount assigned to GE's stock. It also doesn't hurt that financial company valuations have recovered to a point where GE will likely get a decent price for the assets it chooses to divest.

SEE: How To Choose The Best Stock Valuation Method

The Bottom Line
The problem, and opportunity, at GE today is that the company has a high-quality collection of industrial assets that are not performing up to high-quality standards. I believe most of this is due to cycle issues (the wind power downturn and early-cycle energy equipment) and growing pains (sub-optimal margins in acquired businesses) and will get sorted out in the coming years. I do believe, though, that it's going to take a little longer than I previously believed, and the near-term consequences will be a little worse.

As a result, I've revised my fair value target down a couple of dollars to around $24.50. While I believe GE Capital is worth at least $7/share today, the longer ramp to better margins and cash generation in the industrial business does push the fair value down for today. On balance, I'd still be a buyer of GE as I believe the Street underestimates this company, but it's not quite a slam-dunk idea today.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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