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Better Buy: General Electric vs. Verizon

By Lee Samaha – Aug 31, 2020 at 10:18AM

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Let's examine what free cash flow means for investors.

Sometimes comparing two very different companies leads to a better understanding of the investment case for one stock or the other. In this case, looking at telecommunications company Verizon Communications (VZ -1.90%) and industrial conglomerate General Electric (GE -2.68%) helps to better define the investment case for both stocks. Here's why.

Low growth, high yield

Verizon's 4.2% dividend yield is eye-catching enough, but in a world of low interest rates, it's positively grabbing investors' attention. If you are just looking for a good, reliable dividend, Verizon might well fit the bill. That said, many investors will be concerned by the lack of growth in revenue and earnings with the stock.

A bag labeled Risk balancing a bag labeled Reward on a seesaw.

Dividends aren't everything in investing. Image source: Getty Images.

Simply put, selling wireless equipment and services does not create a high-growth business anymore. Moreover, even low growth might not be enough to satisfy investors. Let's put it this way: Verizon's revenue and earnings before interest, tax, depreciation, and amortization (EBITDA) have gone nowhere in the last five years, and they're not expected to improve anytime soon.

Wall Street analysts have Verizon at $134.2 billion and $48.8 billion in revenue and EBITDA, respectively, in 2022. These figures imply five-year (2017-2022) compound annual growth rates of just 1.27% and 1.62% , respectively. In other words, Verizon isn't growing its revenue and earnings enough to beat inflation.

VZ Revenue (TTM) Chart

Data by YCharts.

That's fine from a dividend perspective, at least for now, because its dividend is well covered by free cash flow (FCF). In other words, Verizon has plenty of potential to grow its dividend in the near term by simply increasing how much of its FCF it allocates toward dividends. However, the problem is that the dividend is not likely to prove sustainable over time unless earnings and FCF are on a growth path.

If Verizon is going to get back to growth, it will need to see its investment in 5G pay off by boosting its hardware and services revenue.

VZ Dividend Per Share (Annual) Chart

Data by YCharts.

Unless 5G does produce a significant boost to revenue, given a combination of Verizon's growth prospects and current FCF generation, it's reasonable to expect $20 billion in FCF in 2024. Currently, Verizon trades at 12.2 times 2024 FCF. I'll come back to this point later.

A turnaround in prospects

FCF considerations are, of course, the key to understanding the investment case for GE. Unfortunately, GE's FCF expectations have taken a hit in 2020 due to the COVID-19 pandemic.

Management entered 2020 with a plan of relying on a combination of growth in FCF at GE Aviation and solid FCF from its healthcare business. The cash flows from these businesses were intended to offset cash outflows in the power and renewable energy segments while the latter businesses were being restructured.

The initial plan was for $2 billion to $4 billion in industrial FCF in 2020, leading to a substantial increase in subsequent years as Power and renewable energy started generating FCF again. In terms of longer-term growth considerations, GE Aviation (commercial aviation engines and aftermarket) and renewable energy (wind power) were seen as businesses with mid-single-digit growth prospects. Meanwhile, healthcare is still seen as a low- to mid-single-digit-growth business, and power has low-single-digit growth prospects.

Unfortunately, the COVID-19 pandemic has significantly impacted those plans. All of GE's segments have been hit, particularly the jewel in the crown, GE Aviation. GE's recovery plans have been set back because commercial air traffic remains severely challenged by travel restrictions. Management is now forecasting a cash outflow in 2020 and a return to positive FCF in 2021.

General Electric looks like a good value

That said, GE's stock price has also taken a hit in 2020 (down nearly 44% at the time of writing), and it's arguably already trading at a discount to the company's long-term earnings/FCF potential.

A man writing the words cash flow with arrows pointing from each word to the other.

GE has an opportunity to significantly improve cash flow in the coming years. Image source: Getty Images.

For example, many commentators are expecting commercial air traffic to return to 2019 levels in 2023 or even 2024. If that means that GE Aviation will get back to 2019 levels of FCF in 2024, you can pencil in $4.4 billion in FCF from the segment in 2023. The healthcare segment generated $1.2 billion in FCF in 2019, and given its growth prospects, an FCF figure of $1.3 billion to $1.45 billion is reasonable for 2024. A return to mid-single-digit net income margin and FCF margin in power and renewable energy could lead to $1 billion apiece in FCF.

All told, it's not hard to see that GE has the potential to generate around $7 billion in FCF in 2024, meaning that it currently trades at just 7.9 times 2024 FCF. 

Of course, a lot of things need to go right before GE gets there, and investors in the stock need to be both patient and willing to tolerate some negative headlines along the way. It's unlikely to be an easy ride. 

General Electric or Verizon?

There's nothing to stop you buying both stocks, but on a risk/reward basis, GE is the better buy for the long-term investor. Based on the rough calculations in this article, GE would trade at a cheaper multiple than Verizon in five years' time, and it has better ongoing growth prospects.

There's a greater amount of risk around GE's earnings, and the company has a lot of work to do in the coming years. However, the potential is there for GE, while it's hard to see how Verizon can raise its growth rate over the long term unless 5G provides a significant boost. On balance, GE is the better buy.

Lee Samaha has no position in any of the stocks mentioned. The Motley Fool recommends Verizon Communications. The Motley Fool has a disclosure policy.

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Stocks Mentioned

General Electric Company Stock Quote
General Electric Company
$62.73 (-2.68%) $-1.73
Verizon Communications Inc. Stock Quote
Verizon Communications Inc.
$38.64 (-1.90%) $0.75

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