General Electric (GE) assured investors at its December outlook meeting that it was on track to achieve its much-discussed 70 bps operating margin growth target for 2013. Yet, when it released its quarterly results recently, the company unexpectedly fell 10 bps short of its target in an otherwise in line but relatively noisy quarter. Just before Christmas, the company discovered an external supply chain problem with one batch of faulty wind turbine blades deprived the company of $500 million in quarterly revenues and $100 million in operating profit. GE bears seized on this miss, fueling profit-taking following the quarterly results; however, we think it was overdone. The underlying fundamentals still remain strong. It is important to note here that although the company missed its 70 bps margin growth target, GE Industrial operating margins increased 66 bps, excluding the impact of acquisitions. Moreover, the operating margin growth target miss is not expected to meaningfully impact 2014 results.
Simplification Benefits Continue
The company's headline EPS of $0.53 was in line with consensus estimates. Higher-than-expected restructuring and corporate expenses were offset by larger-than-expected gain in GE Capital and slightly lower industrial tax rate. GE continues to benefit from its Simplification initiatives and a positive value gap. As part of the company's Simplification efforts, GE saw an opportunity to accelerate restructuring actions and incurred 2 cents of naked restructuring in the quarter; GE was able to pull forward $0.05 of industrial restructuring, partially offset by $0.03 of gain. These actions reaffirm confidence in GE's ability to hit $1.0 billion of cost reduction target for 2014 and reach 14% SG&A as a percent of sales next year vs. 16.5% in 2012.
Despite what the bears have been saying, we think GE regained a lot of credibility coming very close to its full-year margin target. Not many thought the company could recover from the 1Q hole, but they did. More importantly, 2014 is looking strong on the margin front, supported by a large amount of restructuring in 2013 and structural SG&A cost out. Jeff Immelt expressed greater confidence in the $1.0 billion cost reduction target for 2014; in fact, the company now expects to exceed that target. On the value gap, despite weaker pricing in 4Q, GE still expects positive gap in 2014, roughly $0.2 billion, less than the 2013 tailwind of $0.8-$0.9 billion.
Weakness A Good Entry Point
GE is not a simple company, it's huge and it's complicated and that is something that won't change anytime soon. Although bears tend to highlight such issues, GE is not a stock that you buy/sell on results. There were gains in the quarter including sale of Swiss bank and BAY driving $1.6 billion in GE Capital benefits. Mostly offset by restructuring, but bears typically seem to dislike that. Looking at the bigger picture, we remain long on GE. The 2014 outlook remains good. GE's YTD performance may come a surprise, but for some reason GE never seemed to be a great January stock (4Q is typically a noisy quarter for GE). Maybe it's related to oil and gas capex or maybe the strong 2H13 sets up for some profit-taking here. Either way, the recent weakness in stock provides a good entry point. And if there were ever a time for General Electric to step up share buybacks, now seems appropriate.
We have a buy rating on GE. Simplification of the company's industrial holdings, shrinking asset base in GE Capital, improving margin structure, sector-leading dividend yield, and cycle tailwinds make GE one of the most compelling investment opportunities in 2014, and the recent weakness in stock provides a good entry point. GE is also increasingly willing to look at the balance sheet to create value for investors, which is an underappreciated lever that we think the market is not appreciating yet. The company has reduced risk significantly lately, and the management has taken a more shareholder-friendly approach. Overall, the GE story is improving at a much faster rate than is generally perceived. We think the market still does not fully appreciate the GE potential and it is reflected in GE's valuation.
Portfolio simplification should continue to be a powerful stock driver in 2014, particularly keeping in mind the company's recent announcement that it will be divesting its North American Retail Finance business in a two-part process, to be completed by end of 2015. GE's oil and gas, power, and commercial aerospace end markets also position the company for top line outgrowth in 2014 and over the rest of the cycle. Higher-than-expected orders in powergen, good execution in acquisitions, and GE's executing on material dispositions in GE Capital could provide further upside. Finally, GE's shares still appear cheap compared to its peers. However, assuming a successful spin of its North American Retail Finance business and as the company becomes more pure-play industrial stock, GE should see multiple expansion.