It's no secret that the economy is slowing, and investors need to brace themselves for some potentially bad news on earnings in the coming months. However, it's also true that stocks have sold off aggressively in anticipation of it. As such, stocks like industrial giant General Electric (GE 0.95%) and United Parcel Service (UPS 0.40%) now look like excellent value. Here's why.
General Electric faces risk but also offers significant reward
The industrial giant is symbolic of the value available in the market now. There's no doubt that its near-term earnings and cash flow projections are under threat. However, that threat mainly comes from its inability to overcome supply chain disruptions in its aviation, healthcare, and renewable energy businesses. The ongoing issues are lowering GE's earnings potential and pushing out its free cash flow (FCF) generation.
GE HealthCare (a business set to be spun off in early January) is a case in point. For example, at the recent Morgan Stanley Laguna Conference, GE CFO Carolina Dybeck Happe noted that the GE HealthCare team "has had a tough couple of quarters", but she pointed out that the issue wasn't coming "from the demand side." In fact, GE HealthCare's revenue growth has been significantly held back by supply chain issues in 2022. As such, GE now expects to generate about $3 billion in healthcare profit in 2022 compared to a previous estimate of $3.1 billion to $3.3 billion. She has a point; after all, GE HealthCare orders were up 5% organically in the first half, and the company is likely to deliver on its backlog when the supply chain issues ease.
Turning to valuation matters, the downgrade to near-term expectations is reflected in the Wall Street analyst consensus estimates for GE on the whole. For example, the consensus is for $6.5 billion in FCF in 2023 (compared to management's target of $7 billion). Still, even that figure ($6.5 billion) would put GE at a 2023 price-to-FCF multiple of less than 11 times FCF. Put another way, GE (as it stands now, including healthcare) could be generating 9.2% of its market cap in FCF in 2023. That's a very cheap valuation for a company with good long-term growth prospects in aviation and healthcare, and solid demand in power.
With plenty of opportunity to play catch-up on cash flow in its aviation, healthcare, and renewable energy businesses in the future, the potential reward of buying GE stock outweighs the downside risk from a near-term reduction in earnings/cash flow expectations.
UPS continues to transform its business
Package delivery is a cyclical business, and any economic downturn will hurt UPS sales. Indeed, UPS's rival FedEx has already warned of deteriorating end markets in 2022. And during the last earnings call, UPS CFO Brian Newman said macroeconomic conditions in the second quarter were "challenging." CEO Carol Tomé would go on to say that the weak environment caused its U.S. domestic package volumes to decline "more than we planned."
There's little doubt that, based on FedEx's commentary, and signs of weakness in the economy, UPS could disappoint investors in its earnings report on Oct. 25. Still, with the stock down 23% this year, it's hard not to think that a lot of bad news is already priced into the stock.
A quick look at UPS's ratio of enterprise value (market cap plus net debt) to earnings before interest, taxation, depreciation, and amortization (EBITDA) shows how cheap the stock is based on current EBITDA.
Data by YCharts
Moreover, there's ample evidence that UPS is achieving its aim of repositioning its business to maximize profitable deliveries rather than chasing volume for volume's sake. In addition, UPS is focused on sweating its existing assets rather than ramping up expenditures in order to chase less profitable e-commerce deliveries. In particular, its strategy of focusing on small and medium-sized businesses and healthcare is helping grow earnings and profit margins as it takes action to be more selective over deliveries. That's likely to continue when the economy recovers from slowing growth. So, all told, now looks like a good time to invest in a business that is improving its underlying fundamentals even if it faces near-term pressure on its earnings.
