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General Electric Co (GE) - What Return Can You Expect?

July 14, 2014 | About:

Company Overview

General Electric Co is one of the world's largest and most diversified infrastructure and financial services corporations in the world. For more than 100 years, GE has been developing and selling products and services ranging from aircraft engines, power generation, oil and gas production equipment, and household appliances to medical imaging, business and consumer financing and industrial products. It serves customers in more than 100 countries and employs approximately 307,000 people worldwide. The operating segments of the Company include Power & Water, Oil & Gas, Energy Management, Aviation, Healthcare, Transportation, Home & Business Solutions and GE Capital. The Power & Water segment is involved in the development of products and technologies related to wind, oil, gas and water power. It also offers water treatment solutions. The Oil & Gas segment supplies equipment for the oil and gas industry, such as drilling and production equipment and downstream processing and refining services. The Energy Management segment designs, manufactures and services technology for the delivery of electrical power, such as panels, switchgear and circuit breakers. The Aviation segment produces jet engines, turboprop and turbo shaft engines for military and commercial aircraft. The segment also produces aerospace systems and equipment. The Healthcare segment manufactures medical equipment to assist in the diagnosis of bone, heart, and cancer diseases, and traumas and other forms of disorders. The Transportation segment provides technology solutions for customers in multiple industries.

Some Purchase Considerations

GE is everywhere and has a global category leadership position along multiple product lines. And with so many product lines, GE is able to sell something, among its hundreds of products, to virtually every home and business in the world. Although the company's financial arm nearly crippled the firm during the financial crisis and recession, growth in its energy, diagnostics, and sanitation lines remains relatively strong. Further opportunities in emerging markets will also prove encouraging, particularly as GE expands activities in India, Indonesia and China. Growth in energy, diagnostics, sanitation products tracks population and/or per-capita growth in disposable income, and the company has identified geographies with promising demographics for it to target. If GE can successfully grow its presence in emerging markets without sacrificing margins, the impact for investors could be huge. GE has also traditionally been a steady dividend play, though we would like to see these rise along with greater share repurchase activity.

Some Reasons for Caution

A major risk to GE's future is if per-capita disposable income growth slows or if global infrastructural spending declines. What should also be unnerving for GE shareholders is the likely continual decline in defense spending in the U.S. and what this means for aviation and transportation related revenues. Steady upticks in travel volume in the U.S. and internationally will help offset this, but will it be enough? The company is combating its earnings decline with divestures from NBC and its retail finance line--both positive moves that will help it refocus on core industrial activities--but it remains to be seen whether further divestures will be needed to further jump-start earnings growth.

Financial Overview

About $146B in revenues moved through GE's door in 2013. GE’s revenues for the 2004-2013 period clocked in at an average annual rate of growth of 0%. Revenues declined at an annual rate of 4% over the last 5 years and 1% over the last 3 years. GE's inability to keep pace with overall economic growth is a bad sign for a mature firm. Year-over-year GE continues to make substantial sums of money off revenues after subtracting costs of goods sold, though gross profits have been in a continual state of decline since 2009, falling from approximately $99B to $69B. This reflects an annual rate of decline of 7%.

GE needs to get its production costs under control. Flat sales and 7% per year growth in SG&A has compressed gross margins from 59% in 2004 to 47% in 2013. As a general rule, we want to see consistent gross profit margins above 60% for firms in the sector. Companies with gross profits margins consistently above 60% have a strong competitive advantage working in their favour and are generally well protected from competitive attacks.

Over the last 3 years GE spent over 50% of gross profits on hard costs associated with selling expenses, advertising, management salaries, payrolls, advertising and legal fees. We consider spending over 50% of gross profits on SG&A quite high and is a further sign of heavy competition in the sector. Going from spending 64% to 55% of gross profits on SG&A over the last 10 years is, however, a positive trend. With revenue growth trending at an annual rate of 0% and COGS growing at a rate of 3%, the average annual 5% decline in SG&A will provide some margin support.

That being said, GE has continued to see weakness in its operating earnings picture, particularly over the last 5 years. The long-term trend in operating income has been generally downward and volatile, rising from approximately $33B in 2004 to $53B in 2007 only to fall again to $26B in 2013. GE has earned on average about 23% in operating earnings on total revenues over the last 10 years. GE carries a large amount of debt on its books and, consequently, pays out more than 40% of operating income on interest payments annually.

Net earnings have shown a historical downward trend, falling at an average rate of 3% since 2004, with definite volatility. GE’s competitive strengths have allowed it earn net margins of on average 10% over the last 10 years. With flat sales growth and continued tightening in gross and operating margins this is a fairly strong result--though we would still like to see better. GE’s per share earnings figures for the last 10 years, falling at an annual rate of 10%, provide further indication of how the company has suffered from poor sales growth, excessive financing costs, and almost no share repurchase activity.

GE's return on equity, averaging 14% over the last 10 years and 11% over the last 3 years is acceptable. It is being heavily influenced, however, by its use of debt and is evident in its substantially lower ROA, which averaged only 2% over the last 10 years--a poor result for any firm. GE's ROI is also unimpressive, averaging 6% over the last 10 years and 5% over the last 3 years.

GE’s stockpile of cash and short-term investments is enormous, totalling close to $132B, or almost $13 per share. This stockpile has grown at a rate of about 5% per year over the last 5 years and should be sufficient to support business operations and protect itself from any unanticipated economic shocks.

As a general rule of thumb we like to see receivables of less than 5% of revenues. GE’s receivables total 185% of revenues, which is well above our target level. GE’s total receivables have been declining but receivables turnover ratio continues to fall, dropping from 12 in 2004 to 7 in 2013. To us this is a clear red flag that the firm's cash collection efficiencies are deteriorating.

Inventory build-up remains a definite point of concern, growing at an annual rate of 15% over the last 3 years and 7% over the last 10 years. This is well above GE's revenue growth of 0%. This could reflect declining overall product demand, an extended deferral of capitalized costs, or a fundamental deterioration in earnings quality. Investors are well advised to continue to monitor GE's inventory position.

GE’s current ratio, which is derived by dividing current assets by current liabilities and is an indicator of company liquidity, has consistently trended above 2.3 over the last decade and came in at about 2.0 in 2013. Though nothing spectacular, GE shouldn’t face any difficulties fulfilling its short-term obligations to creditors and suppliers.

Net property, plant and equipment make up only a small percentage of GE’s asset base (10%). Intangibles now account for an even larger percentage (14%). Because GE faces intense competition, however, it is required to constantly update facilities to remain competitive, which helps keep expenses up. On average, capital expenditures consume more than 80% of GE's annual net earnings.

GE is an extreme borrower of debt with a long-term debt load of $222B. This is in addition to the current $78B in debt due in 2014. GE’s long-term debt position has remained flat since 2004, showing 0% annual growth. While acceptable given flat revenue growth over the period, GE's total debt load is concerning and deserves continued monitoring. GE's long-term debt-to-equity ratio trended from 5.8 in 2004 to 4.0 in 2013. For an excellent business in this sector we would like to see this fall below 3.0. Accounting for operating lease obligations and unfunded pension obligations, GE’s debt load would require more than 25x average annual earnings to pay-off. This is way above what we would consider an acceptable level of debt and will act as a continued drag on dividends and share repurchases for the foreseeable future.

While over the last 10 years GE's operating cash flows have remained fairly strong, they continue to decline with earnings falling at a rate of 3% per year since 2004. Free cash flows also continue to decline, falling by 5% per year since 2004 and 17% per year since 2010--not a positive sign for investors looking for fundamentals driven stock price appreciation.

Long-Term Rate of Return Estimation

Since 2004, GE has shown a 61% drop in earnings per share—while never experiencing a losing year. This translates into an annual decline of 10%. With EPS of $1.27 in 2013 and a market price of $26.86, it can be argued that GE is producing an initial rate of return of 4.7%. Since 2004, GE’s book value per share has grown by 24%—having minor ups and downs but compounding at a rate of 2.4%.

To estimate the company’s long-term rate of return, it is assumed that GE’s EPS will grow at 1 of 3 rates: its 2004-2013 historic rate; its sustainable growth rate; or at a rate derived using econometrics processes. Firstly, if GE’s EPS growth rate matches that between 2004-2013, then EPS will be $0.44 in 10 years. Based on the firm’s sustainable growth rate of 5%, which is calculated by multiplying the firm’s 3 year average ROE (11.08%) by the firm’s 3 year average retention rate (45%), EPS in 10 years will be $2.07. Using what’s is known as a dynamic autoregressive regression process, EPS is projected to grow at an annual rate of only 1.6% over the next 10 years. This means that GE should have per share earnings of $1.49 in 2024.

Figure 1: Historical EPS, DVP, Dividend Payout Ratio and Regression-Based Projections

What will GE’s earnings growing at each of these rates be worth in 10 years? The answer to this question will depend on what P/E multiple the market is using to value the stock in 2023. It is useful to look at the distributional properties of GE’s historical P/E multiple.

Mean

31.94

Variance

1884.802659

Std. Dev.

43.41431399

Skewness

3.529775319

Kurtosis

16.00342101

Median

17.26950355

Mean Abs. Dev.

23.2616854

Mode

17.70974018

Minimum

9.418604651

Maximum

184.4736842

Range

175.0550796

Count

15

Sum

479.1556287

1st Quartile

14.98019802

3rd Quartile

29.25547445

Interquartile Range

14.27527643

The table below summarizes what GE could trade for in 2023 based on the 3 growth estimates and under bear, normal, and bull conditions.

 

P/E Bear (9)

P/E Normal (17)

P/E Bull (25)

Historical Growth (-10%)

3.96

7.48

11

Sustainable Growth (5%)

18.63

35.19

51.75

Regression Estimate (1.6%)

13.41

25.33

37.25

Based on the sustainable growth estimate, if GE trades at Bear multiples, then the market price for the stock in 2023 will be $18.63. If GE trades at Bull multiples, then the market price will be $51.75. Based on historical data, in normal conditions GE trades at about 17x earnings. The price of the stock would then be worth $35.19 in 2023. Assuming the firm's payout ratio remains at about 55%, it would produce $7.84 in additional income over the forecast horizon. Added to the price of $35.19, the position would generate a total return of 60% and a compound annual rate of return of 4.8%.

If it is felt that the sustainable growth estimate is too high given its historical growth rate and that a regression based estimate is more appropriate, then the firm’s stock price in 2023 under normal conditions would be $25.33. Adding the dividend of $7.84, this would produce for investors a compound annual return of 2.1%.

The question that remains is: is a compound annual return of between 2.1% and 4.8% sufficient enough for investors to qualify for investment?

About the author:

SEENSCO
SEENSCO, a Canadian Corporation founded by Daniel Seens, CFA, is an investment research firm located in Ottawa, Ontario. Our Safety-First approach to identifying and evaluating companies helps investors to protect their principal and generate exceptional rates of return.

Visit SEENSCO's Website


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