GE's Results Reflect An Industrial Slowdown, But Valuation Isn't Bad

By Stephen D. Simpson, CFA | October 21, 2012 AAA

It wasn't as though there was much doubt about whether industrial markets had slowed down; investors only had to look at the results from companies such as Danaher (NYSE:DHR) or Dover (NYSE:DOV). Nevertheless, the market didn't really like what General Electric (NYSE:GE) had to say, even though organic growth and orders weren't bad relative to peers. GE isn't the cheapest stock out there, but expectations are low and management seems to have cogent ideas about where the company can build value for the long-term.

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Q3 - Sluggish, but Not Terrible
GE was strong into this quarter's earnings, probably on the notion that the company's leverage towards late-cycle or non-cyclical sectors was going to shield it from the slowdown that has hit other industrial companies. While that proved partially true (GE's growth was better than most that have reported so far), it was still a soft quarter in a nervous market.

Overall revenue rose 3%, with reported growth in "industrial" (which is everything outside of GE Capital) of 6%. Stripping out the unusually good wind results leads to a sub-5% growth, though core growth was still on the order of 8% against sell-side expectations of around 10%. Although the magnitude of the company's top-line miss wasn't very big at all, the fact that it hit almost all segments didn't help perceptions.

Profits were likewise OK. Margins were basically on target, with lower revenue being the primary culprit in the industrial earnings miss. Adjusted segment profits were up about 7%, with industrial earnings up around 11%.

SEE: How To Decode A Company's Earnings Reports

Winners and Losers
GE's huge energy business led the day in terms of reported revenue growth at over 12%. Energy infrastructure was up about 17%, while oil/gas was up a little less than 4%. GE saw some major growth in its wind business (a 60% increase in wind turbines shipped), ahead of the expiration of tax credits in the U.S. The thermal business wasn't so strong, though, and the company saw no U.S. turbine orders. Perhaps just as importantly, the company doesn't seem to be losing share to Siemens (NYSE:SI) or Alstom (OTC:AOMFF) and the U.S. utility business should improve post-election.

Healthcare and aviation were both weak, as revenue declined about 1% in each business. Aviation saw some equipment order pushouts, coupled with declines in part orders. As in the energy space, it doesn't seem like share loss (in this case to United Technologies (NYSE:UTX)) was a major issue. For healthcare, GE's results weren't that different than the industry-wide malaise seen by others such as Danaher and Johnson & Johnson (NYSE:JNJ).

On a more positive note, GE's transportation business saw nearly 10% growth, and while Caterpillar (NYSE:CAT) seems serious about growing its locomotive engine business, it's not looking to do so by wrecking the industry's pricing dynamics.

SEE: The Importance of Diversification

GE Capital Still Getting Better
For a business that very nearly wrecked the entire GE enterprise, GE Capital has come back relatively well and this quarter showed more signs of progress. Return on assets improved about 10 basis points, with good gains in energy finance and real estate and stable results in consumer. Tier 1 capital is up over 10%, but management is taking a generally conservative track with the business. In fact, the majority of GE's downward revenue guidance revision appears to stem from a more conservative approach with GE Capital.

The Bottom Line

Although orders were up about 4% excluding wind, the book-to-bill of 0.91 for the third quarter didn't cheer investors who expected GE to set a stronger tone for its industrial business. Perhaps I'm being an apologist for GE, but I just don't see this quarter's performance as terrible. I thought the aviation and oil/gas numbers were disappointing, but I saw no reason to think that healthcare or energy infrastructure would be strong.

Maybe just as much to the point, I don't think investors need to make aggressive assumptions to generate a compelling fair value estimate for the stock. Mid-single digit growth in the industrial segments and a sustained 10% return on equity from GE Capital would support a mid-$20s price target, and that industrial growth assumes that GE's free cash flow conversion is inferior to many other industrials. While the notion that GE disappointed could weigh on the stock for a little while, I think patient investors could be rewarded for going contrarian here, and I think GE looks like an interesting stock today.

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

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