GE: Fair Value Is About $35

Jul.20.14 | About: General Electric (GE)

Summary

GE reported an in-line quarter with solid organic growth and shares remain attractive.

Aviation and energy are powering the majority of growth thanks to secular trends and would be worth $90 and $36 billion on a stand alone basis.

At book value, GE Capital would be worth $86 billion, and combining the rest of GE's industrial units, fair value is about $35.

As long as investors remain patient, GE is a great buy.

Shares of General Electric (NYSE:GE) fell by about half a percent on Friday as investors digested a roughly in-line quarter. GE has been one of the worst Dow performers year to date with shares down by nearly 6%. Shares are also badly lagging the broader market over the past year with a relatively meager 7% gain. Still, the company does offer a solid 3.3% dividend yield with exposure to the growing aviation, energy, and healthcare sectors. GE suffers from what I call a "conglomerate discount." The sum of the value of each business unit far exceeds the valuation GE as a whole currently receives. I believe this offers investors the chance to purchase great businesses at a very attractive price. Over time, I expect this discount to diminish and shares to push past $30.

In its second quarter, GE earned $0.39 on revenue of $36.2 billion while analysts were looking for $0.39 on $36.3 billion in revenue (all financial and operating data available here). Still, the company did grow revenue by 3% this quarter, which is an acceleration from some past reports. GE's industrial unit has been performing even better and generated 5% of organic growth in the quarter. The backlog now stands at an impressive $246 billion, which will keep units like aviation and energy running at capacity for several years. This backlog is up over 10% compared to last year. While General Electric is undoubtedly a large company, it clearly still has growth.

When evaluating GE, it is important to separate results from it industrial units and GE Capital as valuation metrics are far different. Let's first look at GE Capital, which is essentially a bank that lends primarily to mid-market firms and GE customers. The unit generated a solid $1.7 billion in segment profits this past quarter. Profit was down 5%, though this is mainly the result of management slowly cutting the size of Capital to a more sustainable size by slowing lending growth and spinning out consumer oriented units. At the end of the quarter, Capital's book value stood at $85.8 billion, up $3.1 billion year to date. Its Tier Common Ratio is a solid 11.7%, and net interest margins remain robust at 5%. By streamlining operations and increasing capital, this unit will be able to pay more consistent dividends to the parent. Many banks are trading around book value, and I would value GE Capital similarly, making GE Capital worth about $86 billion. With a $266 billion market cap, the market is valuing the industrial units at $180 billion.

Put simply, this is too low. Aviation continues to be the stand-out performer as GE is a major supplier for Boeing (NYSE:BA) and its Dreamliner and 777x, which have seen incredible demand. In the quarter, aviation revenue grew by 15% to $6.09 billion. Year to date, it is GE's largest unit with $11.87 billion in sales. It is also the most profitable with quarterly segment profits up 12% to $1.2 billion. With a multi-year backlog, supply constraints are the only limitation on growth. Aviation should deliver 10%+ revenue growth through 2020 and remain one of GE's top money makers. Based on market valuations for stand-alone aviation firms, this unit is worth upwards of $90 billion.

GE's oil and gas unit is benefiting greatly from the US energy boom thanks to fracking and major finds in the Permian and Bakken. GE is a major supplier to these rigs and profits from increased drilling activity. It is no surprise then that sales jumped 20% to $4.76 billion, sending profits up 25% to $665 million. Given the multiples of oil service companies Schlumberger (NYSE:SLB) and Halliburton (NYSE:HAL), GE's oil and gas unit has a stand-alone value of $36 billion.

These three units are worth a combined $212 billion. Meanwhile, GE still has strong businesses in healthcare services, power and water generation, light bulbs, and transportation equipment. It also will be adding Alstom's portfolio of energy assets, which should boost 2015 profits further. Even valuing them at 13x after-tax earnings, which would be a discount to the vast majority of the S&P 500, GE would be worth around $350 billion, or $35. Investors could buy companies in each of these industries or just buy GE and get the businesses for about 20% less. While some conglomerate discount may remain for some time, this discount is too steep to ignore. Additionally, its dividend pays you to be patient. After this quarter, GE is still a buy with significant upside to fair value.

Disclosure: The author is long BA. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.