The BMW Method
GE -- a Flight to Safety?

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By kelbon
December 18, 2007

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Perhaps like me, watching various positions lose money on paper, day after day in this pessimistic and uncertain market, leads to thoughts of flights to safety - with acceptable returns of course.

With this in mind there's one little nagging ticker symbol that occasionally whispers in my ear: ge, GE.

Now we know how well GE had done over the decades if you were a true buy-and-hold investor, even given the bubble that burst around the millennium. But what of the future?

Over time there have been two reasons I haven't bought GE and now - as then - I don't know how much weight to give them.

Here they are: clearly GE manages their earning, they come in to the penny more often than not as reported earnings match their own projections - basically an impossibility; especially given the diversity and complexity of their many different businesses - yet, this has been accepted as the norm for so long that there has never been any obvious consequences.

The other issue for me has been, and continues to be, that GE is as much a financial company than a light-bulb company. One very easy to understand, the other: not so much. This raises questions about GE's valuation. About 50% of earnings come from the financial services arm, the other 50% from GE's other diversified divisions. If GE were a stand alone financial services company their valuation would be on the high side and almost certainly the stock price would have suffered substantially in the current climate as doubts about mortgage backed securities or other dubious financial instruments hidden somewhere in all the mumbo-jumbo surfaced. Now I'm not smart enough to know what all their 'financial services' divisions do exactly, or what lurks beneath. But I do know that GE plans to divest themselves of some of them, don't expect earnings to be so great from that direction in the near term, and expects greater earnings from other divisions to compensate for the short fall here.

So perhaps it would be reasonable to conclude that in fairness perhaps a p/e of around 10 would be inline and appropriate for that 50% of the company (earnings wise). GE's forward looking p/e is about 15. They, as a whole company, expect earnings growth of 10% for the year ahead - and you can pretty much bank on it as, remember; they manage their earnings. Which brings up the question: are the remaining businesses on average worth a p/e of 20, which logically they would have to be to justify an overall mean of a p/e of 15 - assuming you accept that the financials should be worth around 10. The financial arm's earnings are expected to be flat for the year ahead, so Graham would say they merit a p/e of 8. Consequently, the 10% earnings growth will come exclusively from the other divisions which by de facto I've given a p/e of 20. In today's market there are a lot of good businesses with lower valuations that will probably grow earnings by 10% next year, yet of course there is rather more uncertainty involved than with GE with it's regular-as-clockwork earnings march, which I suppose it might seem reasonable to pay a premium for.

Nevertheless, here's the conundrum: General Electric seems quite reasonably valued historically, in fact as far as share price to fundamentals goes in most areas it's almost as cheap, relatively speaking, as it was at the end of 2002 when GE shares hit a low of $21.40. These were and are the kind of valuations not seen since 1996/7. Since 2002 the share price has been on an upward march, instep with earnings growth. If this were to continue without any expansion of the p/e ratio etc. it would be reasonable to expect a price CAGR of about 10%. It might be worth considering though that we now seem to be firmly entrenched in a difficult, jittery and for the majority of stocks, a down market and consequently GE's share price may drop further - a better buying opportunity may be around the corner in '08.

As far as the BMW method goes GE also seems to be in 'buy' territory too. Based on a 40 year chart GE sits at a -0.73 RMS which is its lowest since the early nineties.

All the same GE isn't the efficient money-making machine it once was and Return on Capital has sunk to around 6% from a heady 23.4% in 2002. Much of this is attributable to the more than doubling of long-term debt in 2003 and it's steady growth since. However, ROE has picked up a little in the last few years and is flirting with 20% currently, but is still lower than the mid twenties it enjoyed five years ago or so. Net profit margins have dropped from nearly 21% in 2001 to around 13% today also.

As far as dividends go, GE has raised the dividend every year for over twenty years and currently the payout ratio is around 50%, which seems a little high for a dividend yield of 3%. Perhaps because of this annual dividend increases going forward are expected to lag earnings growth by a few percentage points.

Into the future hopefully management will concentrate on high-growth opportunities, this has been the method of the past; though not always quite successful - therefore the key is getting it right and looking ahead further than the next bend. The energy, water infrastructure, and aerospace divisions were recently highlighted as catalysts for growth. Also GE's exposure to China and India, provided these economies don't stall, should propel profits into the future. Hopefully GE's diversified income streams will cushion problems or volatility in any one sector, therefore the downside should be somewhat protected.

So just maybe GE isn't quite worth the sum of its parts, but as a whole its enormous size and strength minimize and mitigate areas of weakness which hopefully will be made over or jettisoned. So in uncertain times perhaps General Electric stock might represent a flight to safety.