GE (GE) reported first quarter earnings on Friday and the stock fell 4% on the day. The decline was the result of tempered forward expectations expressed in the company's conference call. Weakness was felt in the company's European business and in its Power and Water Segment, plus on some foreign exchange impact. The stock has fully enjoyed the ride with the market through 2012 and in early 2013, but its beta coefficient indicates it should also exaggerate any downside that could result from a change in the economic cycle globally. Since that is exactly what I see happening, and because I believe GE's EPS estimates could be reined in while GE's P/E contracts, I think the stock's total return upside is limited to perhaps 5-6% or so over the next 12 months. While that may be enough for long-term holders to bear over taking tax gains, it's not enough for me. Besides, even if the stock can manage the return I expect, there is heightened near-term risk for it due to my expectations for a downward shift in near-term economic expectations and realities and for cuts in EPS estimates for GE this year.
Reviewing GE's Quarter
The company's first quarter report showed volatile operations and mixed results across geographies. China stayed strong for General Electric, the U.S. was mixed, and Europe proved weaker than GE expected. In the U.S., housing related operations improved but its shorter cycle energy segment saw some push-outs of March business into Q2. Foreign exchange acted as a headwind on results in the Oil and Gas Segment. The company's reported $0.39 in EPS per share should be adjusted to $0.35 on a continuing operations basis. Thus, the EPS result was in line with the analysts' consensus estimate for the quarter. However, investors will note that the same estimate was adjusted lower by the analytical community from $0.37 at the start of the quarter. So, overall the report reflected the cyclical issues I have been pointing to in my reporting on the global and U.S. economies over recent months.
Orders were up 3%, and up 6% when excluding GE's wind segment and the foreign exchange impact. Equipment orders were up 10%, and GE's Oil and Gas and Aviation segments showed particular strength. The company had a 1.3X book-to-bill ratio at the end of the quarter, giving management some confidence in the delivery schedule for the second half and beyond.
Still, European industrial segment revenues were down 17%. The company expects improvement in Europe in the second half of the year, but I have my doubts. Orders in China were up 67%, Latin American orders were higher by 44%, and Africa and the Middle East were strong as well, but I see economic growth slowing globally this year. Revenues by region were up more than 10% in 5 of 9 regions, but Europe knocked five points off the growth of service revenues. In the conference call, management indicated organic growth was down 6 points but up 2 points excluding the Power and Water Segment.
Accelerated restructuring actions helped GE to take out $200 million in structural SG&A costs in Q1, on the way to at least a billion dollar reduction in 2013, according to management. That is commendable, but GE also indicated that margins were negatively impacted by revenue shortfalls, and I see those continuing as we move forward.
In summary, industrial segment profits were about $200 million below internal expectations. According to management, this was a function of European weakness and some "short-cycle push-outs" from March into the second quarter. However, GE offset the gap created by those issues with gains made in corporate costs cuts and strong GE Capital performance.
The operating profit margin contracted by about 80 basis points, but would have expanded by about 40 points excluding the Power and Water Segment cycle issue that the company notes should "be a tailwind in the second half of the year." GE expects four of its businesses to post a greater than 70 basis point operating margin improvement for the full year 2013 thanks to cost cutting initiatives and value creation through pricing strength and better material cost achievement. The Oil and Gas Segment operating margin was impacted by foreign exchange, but the company sees some of that coming back during the year. Overall, the company's tough first quarter that cost the operating profit margin 40 basis points has led GE to reduce its operating profit margin expansion expectation for 2013 to 90 basis points now, down from its previous 130 basis point expectation. I think this could continue to contract as a poorer economic outlook evolves.
Why I Would Sell GE
In times like these, when economies are slowing their growth, or contracting in the European case, companies will often fail to adequately compensate for the possibility of further deterioration in forward quarters. Unfortunately, that is exactly the case I see developing globally and in the U.S. Even though GE shares declined by 4.0% on Friday, in this case, they could fall further. The company's beta coefficient of about 1.4 reflects its tendency to exaggerate market moves (higher or lower) on economic expansion or contraction. GE is still a cyclical company as evidenced by its leading holding position within the Industrial Select Sector SPDR (XLI) and despite its diversification both across businesses and geographies.
Even while GE contracted Friday, you can see by its one-year chart here that it has also fully participated in the market's gains in 2012 and in 2013. If the S&P 500 Index contracts from here and the SPDR S&P 500 (SPY) falls, say 5% to 10%, then GE's beta coefficient (excluding all else) would indicate GE could fall 7% to 14%. If a stock is expected to decline more than the market, analysts are charged with applying a sell recommendation for the shares against the benchmark expectation.
According to data at DailyFinance.com, GE's low and high P/E ratios of the last five years ranged from 5.7X to 21.6X. Obviously, that low point is an exaggerated outlier due to the depths reached in the panic of the financial crisis in 2009. As of Friday, GE's trailing P/E was about 16.8X. The average of the 5-year high and low P/E ratios is 13.65X, and that would mark 19% downside on potential P/E contraction alone. However, applying the 13.65X bad case P/E to the analysts' consensus forward EPS estimate of $1.67 for 2013, we get a target stock price of $22.80 or about 5% appreciation from the current stock price. Considering the EPS estimate downtrend from Q1 and the quarter's performance, and waiving the company's optimism for the second half of the year and assuming its margin expectations don't quite pan out, I could trim $0.04 off the estimate confidently, bringing it to $1.63. That would bring the target price down to $22.25, or 2.3% up from Friday's close. You can add the dividend yield of 3.3% to that and you have the potential for a total return of maybe 5.6% over an approximate one-year time horizon. Long-term holders of the stock might find that adequate, versus taking tax gains, which is perfectly understandable, but it's not enough for me and so I would sell GE here. Besides, even if my modest return forecast plays out perfectly over the year, there is greater near-term risk in the stock due to what I see as a near-term shift in economic expectations and analysts' estimates for GE's EPS for 2013.