Barclays analyst Scott Davis recently made General Electric Company (NYSE:GE) his top stock pick. It's an interesting move, not least because the stock's year-to-date decline of 13.8% means it's underperformed the S&P 500 and leading industrial ETFs by more than 22%. In other words, the decline may well be overdone and value investors should start circling the stock. Let's take a closer look at what Davis said, and at the general case for and against buying the stock.
Outgoing CEO Jeff Immelt tied his mast to the target of $2 of operating EPS (earnings per share) in 2018, and even though he served notice that the $2 target would be "at the high end of the range" at a presentation at the end of May, he still didn't abandon it.
But here's the thing. The analyst consensus is for EPS of $1.89 in 2018, a figure notably lower than Immelt's expectations. In other words, analysts expect GE to miss the target, and it's possible that incoming CEO John Flannery will lower estimates in the fall.
On the other hand, bulls like Davis argue that analyst forecasts are too low and that the underlying business is a lot stronger than many of the bears contend. Let's focus on this argument.
What the bulls say
Davis points out that GE has a significant cost-cutting program in place -- structural cost cuts are expected to save around $1 billion in 2017 alone. Meanwhile, GE's cash flow generation -- disappointing recently -- will improve in the future, and the Baker Hughes deal will add to future earnings. Throw in a near-3.5% dividend yield and a valuation at a discount to its peer group, and the stock is currently attractive.
In addition, there are three other key arguments for why the underlying performance of GE really isn't that bad.
First, GE has been making significant investments in things like digital solutions (Predix and the Industrial Internet of Things solutions) and additive manufacturing that won't pay off for a few years. In other words, you can't see them in the numbers just yet.
Second, major new product introductions in recent years, such as the LEAP aircraft engine and the H-class gas turbine, led to equipment margin falling to just 1% in 2016 compared to the historical run rate of 5%. As production ramps up on both products, GE should be able to cut unit costs significantly in the future, and equipment margin is likely to recover.
Third, there is a case to be made that GE's recent weak free cash flow generation and disappointing results are largely a consequence of cyclical factors rather than structural issues. The two most impacted segments have been oil and gas -- largely caused by weak energy capital spending -- and power. The power segment is set for a flat year in 2017, but a large part of the weakness relates to troubles selling into economically challenging markets like the Middle East -- are oil prices the culprit again?
The bearish case
The glass-half-empty viewpoint is that the potential earnings reduction marks out some structural problems in power. Moreover, GE's difficulties in making its numbers are reducing investor confidence in management's ability to meet expectations -- concerning, as the company needs to execute on the Alstom energy assets acquisition and the Baker Hughes merger.
In addition, the Baker Hughes deal is seen as merely increasing the company's exposure to fossil fuels -- not a great position to be in if energy prices decline, and electricity generation and usage shift away from fossil fuels.
What to do with the stock?
In a nutshell, buy the stock if you are confident about energy prices -- the power segment's problems appear to be cyclical rather than structural. GE's valuation is attractive, and even on analysts' current consensus estimates ($1.64 for 2017 and $1.89 for 2018), EPS is set to grow by 10% and 15% in the next two years, respectively. In other words, even if GE misses its EPS target of $2 in 2018, it's still a good value. In addition, Flannery's appointment raised the prospect of a value-enhancing restructuring of the GE portfolio.
That said, GE's biggest problem in the last year or so has been its exposure to energy capital spending, and any weakening in the outlook for that category will weigh on the stock.