5 Generals for Your Portfolio?

This is the first in a series of commentaries that will take a look at five companies, all of them beginning with the word "General." Most of them are household names and recognized as global conglomerates with operations (just like our military) throughout the world. The companies I'll review are: General Electric (NYSE: GE  ) , General Dynamics, General Motors, General Mills, and General Communication. As you might imagine, these corporate leaders have few similarities other than their names. The word "general" is synonymous with leadership and historically we have had both great and mediocre generals leading the fight. And so it is with these five companies.

The earnings quality of these companies is the subject of this series of commentaries. The questions are: Do any of these companies deserve to be five-star generals based on their earnings quality? Should any of them be reduced in rank?

Earnings quality is reflected in the financial statements
The Motley Fool offers two databases -- EQ Scan and EQ Score -- that are used to uncover cash flow and revenue recognition issues in addition to overall quality of earnings red flags. Smart financial officers can use several techniques to manipulate financial results, and manipulation of any of the three financial statements usually affects the other two. To be fair, the GAAP rules are complex and open to interpretation that requires the employ of experts (i.e., CPAs). But, a critical eye on these statements can often uncover mistakes or trends that could be important for investors to understand before the battle has been lost.

When I review a company for earnings quality, I assign an index rank to the company from 1 (the lowest quality ranking) to 5 (the highest quality) and an associated numerical score. Just like in the military, a company can earn a "5-star" rank or a "1-star" rank. Different companies with the same index rank can have different numerical scores. As a company's financial status changes over time, we can adjust its rank and score. I look for trends that affect earnings quality.

GE gets three stars
The first commanding officer we will review is General Electric. Founded in 1892, GE is the only surviving member of the original stocks in the Dow Jones Industrial Average. GE has four operating divisions: energy, technology infrastructure, capital finance, and consumer and industrial. Forbes Magazine ranked GE in 2011 as the sixth-largest company in the U.S., but for our purposes GE is ranked as a 3-star general.

GE may be capitalizing expenses
Here are data from GE's financial statements:

Metric

2011
(in billions)

2010
(in billions)

2009
(in billions)

2008
(in billions)

Revenue $147.3 $150.2 $155.3 $182.6
Other Assets $119.3 $96.3 $103.3 $106.9
OA/Revenue 81.0% 64.1% 66.5% 58.5%

Source: GE financial statements; Yahoo! Finance; Capital IQ.

GE's revenue trend during the past three years indicates decreasing revenues, however slight. The company claims a record $200 billion in backlogs, but this means that sales are not being converted to revenue. The table above reflects an onerous metric on GE's balance sheet -- other assets -- at a startling $119.3 billion, and as a percentage of revenue the trend is upward. Any company's use of other assets can mean that expenses have been capitalized, or moved off the income statement to the balance sheet. This could indicate an understatement of expenses and a corresponding sizable overstatement of profit as well as possible overvaluation of assets. Shareholder equity decreased by $3.5 billion in 2011. Tangible book value per share has decreased from $4.37 at the end of 2010 to $3 this quarter.

Other disturbing metrics portend future performance?

Cost of Goods Sold Increased to 75% of revenue from historical average of 50%
Cash Conversion Cycle Increased 45% (amount of time to convert sales to cash)
EPS (quarterly, 4th quarter 2011) $0.37
Earnings Growth (2011-QOQ) 11%
Earnings Growth (YOY) 4%
Trailing PE 15.28 ($1.24 per share)
Forward Estimated PE 10.74 ($1.76 per share)
Earnings Growth Compared to Forward PE 11% versus 10.74

Source: GE financial statements; Yahoo! Finance; Capital IQ.

On a positive note, GE has been spending cash to pay down debt and to buy back shares. The company has increased its quarterly dividend to common shareholders from a low of $0.10 two years ago to the current rate of $0.17. Unfortunately, this is little more than half of the $0.31 per share GE paid as of February 2009. Here is another disturbing earnings quality metric -- the spread between EBITDA margin and operating cash flow margin over the past 12 months has widened an alarming 11% (-6% to 5%) during 2011. When the spread widens, it means the earnings reported on the income statement aren't translating into cash flow.

Conclusion: GE is its own worst enemy
GE is perhaps its own worst enemy when it comes to providing earnings quality; it no longer provides quarterly financial data, and this lack of transparency continues. There is a huge amount of "other assets" on the balance sheet. Backlogs are at record levels -- whoopee! Earnings are not translating into cash flow. GE is transferring businesses overseas, where it is easier to make profits, and pay less U.S. taxes. Did anyone mention a looming European recession? GE continues to rely on its other businesses to support its problematic capital finance division and the commercial real estate crisis is still ongoing.

One thing GE certainly has going for it is a solid 3.6% dividend yield. If you'd like to check out some of our favorite dividend stocks, take a look at our special free report "Secure Your Future With 11 Rock-Solid Dividend Stocks." For free access to all 11 of these high yielders, simply click here.

Fool contributor John Del Vecchio is co-advisor to Motley Fool Alpha and co-manager of the Active Bear ETF. You may follow him on Twitter @johnfdelvecchio. He does not own any shares in the companies mentioned in this article. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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