General Electric Co (GE), one of the largest companies in the world, reported its 2Q13 earnings on Friday and joined the list of firms that surprised investors with better than expected quarterly profits. The company unveiled a surprise jump in its backlog of orders for locomotives, X-ray machines and scores of other industrial products.
GE reported adjusted profit from continuing operations of $0.36 per share, beating the consensus estimates of 13 analysts' projections compiled by Bloomberg. Quarterly revenue declined by 3.5% to $35.1 billion. Analysts were expecting earnings of $0.35 per share and revenue of $35.6 billion.
Commenting on the results, Deutsche Bank's John G. Inch said:
"We believe expectations were relatively low for GE heading into the quarter, driven by concern toward the company's margin expansion target of 70 bps (we believe many investors and analysts expected the company to officially lower its targets). While 2Q was never intended to be a blockbuster fundamental quarter given still challenged European and power generation markets, GE's beat is a welcome relief from previous quarters where market expectations had exceeded operational results. We expect sequential quarters to improve."
Industrial Margins Improve
The Power & Water segment mainly drove the beat, with rest of the segments largely in line. Total revenues of $35.1 billion were slightly less than the consensus estimates of $35.6 billion. Industrial segment revenues declined 1% Y/Y; however, the segment's margins increased to 15.3%, an increase of 50 bps from the same quarter last year. Within the industrial segment, Power & Water margins were up 10 bps Y/Y after witnessing a 320 bps decline in the first quarter. Margins improved Y/Y in all Industrial segments, except for a flat performance in Home & Business Solutions.
GE Capital ("GEC") revenue fell by 3.3% to $10.98 billion, while profit declined by 9.4%. The company has been downsizing GEC since the financial crisis in a bid to reduce risk. The shrinking of the GE Capital dented overall results but the market was already expecting this, as the company has been taking steps to move away from its financial business in recent years. Earlier this month, the company transferred its chief financial officer, Keith Sherin, to help oversee the streamlining of the unit.
Commenting on GEC Perry Adams of Northwestern Bank, which owns GE shares said, "GE Capital is shrinking quicker than expected," and that's "good from a capital allocation standpoint."
General Electric not only posted better than expected results, but also reaffirmed its outlook for 2013. Management said that its "overall framework for 2013 is unchanged", including double-digit industrial earnings growth, 70 bps of margin expansion, and Industrial organic revenues at low end of +2-6% range. GE Chairman and CEO Jeff Immelt said, "We executed in a business environment that was slightly improved versus the first quarter. Emerging markets remain resilient, and in the U.S. we saw strong growth in orders this quarter. Europe is stabilizing but still challenged. We expect margin expansion to continue and segment profits to grow in the second half of the year."
Record Order Book Brings Further Positive News for Investors
After a 3% growth in the first quarter, infrastructure orders were up 4% Y/Y in the second quarter to $24.1 billion. GE's backlog of equipment and services at the end of the quarter was its highest ever at $223 billion, up $7 billion from the first quarter. Infrastructure order pricing rose 90 bps, after 60 bps increase in the first quarter, which bodes well for the 'value gap' in the next 12 months. The order book rose 20% in the U.S. alone. The huge backlog gives the company plenty of work across its seven industrial units. "This is as close as GE comes to a positive surprise as possible," said Tim Ghriskey of Solaris Asset Management, which owns GE shares.
GE is the world's largest manufacturer of jet engines and along with subsea oil blowout preventers and other aviation and energy products, jet engines represents one of the largest growth areas for the company. These are also the areas which comprise most of the backlog. At the Paris Air Show last month, GE announced more than $26 billion in jet engine orders and earlier this month it closed on its nearly $3 billion buyout of oilfield pump maker Lufkin, broadening its offerings of pumps that pull oil and gas to the surface.
Valuations and Financials
Compared to its industry, General Electric is trading at very attractive valuations. It has a current P/E ratio of 17.2 compared to the industry average of 18.4. GE has a PEG ratio of 1.6 and a forward P/E of 12.8, compared to 14.7 of S&P 500. The company has a price-to-book ratio of 2.1 compared to the industry average of 2.8. It has price-to-sales ratio of 1.8, slightly more than the industry average of 1.6. Finally, GE has a price-to-cash flow ratio of 8.8 compared to the industry average of 12.1. The company has a sector leading dividend yield of 3%.
Conclusion and Investment Thesis
We have a buy rating on General Electric. Investors should be encouraged by the earnings power in GE Industrial, and the positive valuation implications from higher visibility and faster Industrial growth into 2H13. The company has a strong and high margin services business, good emerging market positioning, and a strong R&D franchise. Moreover, GE's cost cutting initiatives are on track; the company is aggressively cutting costs and has sliced expenses by more than $474 million YTD. The company has a record industrial backlog of $223 billion and previous order strength has begun to show up in the shipped results. The 50 bps increase in industrial margins came considerably better than the consensus estimates of flat to down margins. The results increase confidence in the full year target of 70 bps margin expansion. The huge backlog also supports second half re-acceleration. Europe is still challenged but stabilizing.
GE's simplifying of the portfolio (i.e. NBCU divestiture, GECS reduction), should drive cash to support the dividend and ongoing share repurchase program. The company is on track to use $10 billion of the NBCU divestiture proceeds on share buybacks in 2013, enough to retire roughly 4% of the shares outstanding.
A GE back to its core roots is a very compelling investment story. The focus is on businesses where it has core competitive advantages e.g. infrastructure, focusing on being the low-cost supplier, beating margins in a clean way, showing better orders than expected, executing on most initiatives in a far better way than the recent past. Overall GE is moving in the right direction and looking at a healthy 2H13, particularly 4Q13. In the meantime, a sector-high dividend yield of 3% pays investors for their patience.