Is General Electric a Buy After the Recent Sell-off?

Shares of General Electric have underperformed the broader market in 2014. Is now the time for investors to take advantage?

Aug 14, 2014 at 11:23AM

Shares of General Electric (NYSE:GE) are down 4% since reporting its second quarter earnings results on July 18th and have underperformed the broader market in 2014, with shares down nearly 10%. 

However, I think long-term investors can reap the benefits of this sell-off, by adding to their position on this decline. 

The valuation looks stretched, but...
Many have come to know and think of General Electric as a slow-growth, dividend-paying value stock. While the stock still has value and has a handsome dividend yield of roughly 3.5%, the company is making strides to ditch its sluggish business segments. 

Currently, shares of General Electric trade with a price-to-earnings (P/E) ratio of 17.7. 

Although this valuation is higher than its five year average of 16, it is lower than its "diversified industrials" industry average P/E ratio of 19.4 and S&P 500 average of 18.2, according to MorningStar.

This valuation can be justified, because CEO Jeffrey Immelt isn't just focused on spinning off General Electric's slower growth businesses, but in developing its higher growth ones as well. 

For all intents and purposes, General Electric has two main businesses: financial and industrial. 

The financial business has been an anchor on the stock price, as well as its earnings multiple. 

However, the company's industrial business has faster growth and higher margins, making it more appealing to investors. Because the company is set to grow revenues faster and generate more profit from each sales dollar with expanding margins, the P/E ratio of 17.7 can be justified and even considered undervalued to the industrial sector. 

A closer look at this so called "higher growth" industrial business
Okay, OK, I keep talking about how great this industrial business is. But is it really that great? In the company's second quarter earnings report, investors got a glimpse at just why General Electric is focusing more on this segment.

For the quarter, General Electric's industrial business grew revenues and net income 7% and 9%, respectively, from the same last year. 

Here is a closer look at General Electric's industrial business: 

Segment

Revenue 

Net Income

Revenue Growth (yoy)

Net Income Growth (yoy)

Oil & Gas

$4.76 B

$665 M

20%

25%

Aviation

$6.09 B

$1.19 B

15%

12%

Power & Water

$6.29 B

$1.13 B

10%

4%

Appliance & Lighting

$2.12 B

$102 M

0%

23%

Healthcare

$4.48 B

$730 M

0%

1%

Energy Management

$1.85 B

$69 M

(6%)

N/A

Transportation

$1.3 B

$270 M

(18%)

(14%)

         

Total

 $26.9 B $4.16 B 

7%

9%

Source: General Electric's second-quarter earnings presentation, table by author.

As you can see, not all of General Electric's businesses are on the upswing. Two of the seven segments posted flat growth, while the Energy Management and Transportation segments posted revenue declines of 6% and 18%, respectively. 

Still, the company's other more profitable segments — Oil & Gas, Aviation, and Power & Water — have all grown revenues by double digits. Net income growth is also strong, especially in Oil & Gas and Aviation. 

Overall, the industrial business generated revenue growth of 7%, ~70% of which was organic growth (representing 5% of revenues), while slightly boosting margins for the overall segment by 20 basis points. 

For perspective, the financial business saw revenues and net income slip 6% and 5%, respectively, to $10.25 billion and $1.70 billion from year ago results. General Electric forecasts for this segment to continue underperforming, with revenues expected to be flat for the year at best and drop 5% at the worst. 

For the third quarter, management said net income for GE Capital should be around $1.6 billion, about 15% lower than year ago results. The recent drops in revenue and earnings is mainly attributed to lower earnings power and fewer tax breaks, as well as having lower assets, as the company intentionally reduces its exposure to this segment. 

While earnings and revenues are dropping for GE Capital, I wouldn't find it as much of a concern from an investor's standpoint. The company is intentionally reducing its exposure, so it makes sense that its profits continue to make up a smaller and smaller piece of the overall pie, (roughly 29% of net income in the most recent quarter). 

Foolish takeaway
When prospective investors take a look at General Electric as a possible stock to buy, the P/E ratio may give them some hesitation, considering the valuation the stock usually trades at. But they should not take this at face value. 

As discussed, the company deserves a higher valuation, and the recent pullback should give potential investors comfort when buying the stock. General Electric is now lagging the S&P 500 by roughly 14% in 2014. 

Investors will also enjoy the company's annual dividend payout of $0.88. This equates to a dividend yield of ~3.5%, which will pay investors to wait and see if General Electric can continue posting solid earnings results and reap the benefits of its more efficient businesses.

If the company can continue expanding margins and generating organic growth, the stock should move higher. The recent pullback likely makes for limited downside and attractive upside, while the dividend will pay investors to wait for that move. 

 

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Bret Kenwell has no position in any stocks mentioned. The Motley Fool owns shares of General Electric Company. 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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